Setting Licensing Royalty Rates
When an industry’s royalty rate ranges are wide, say from 3% to 10%, or the industry or relevant markets themselves are nearly impossible to pin down, what additional analysis is required to properly set fairly valued licensing rates? Conventional “Relief from Royalty” methods cannot be applied with confidence and, worst of all, guessing begins by relying on the now discredited (after Uniloc v. Microsoft) twenty-five percent rule .
If the license (or royalty) rates are set too low, an IP Holding company (“IPH”) or license agreement, would under-serve its purpose to take advantage of tax and liability arbitrage. If the rates are set too high, the subsidiaries’ financials will suffer, and external (potential) licensing opportunities will likely be lost. So the question is:
Is there a licensing rate that, given the projected profits from the innovation, or other intellectual property, will cover both parties against these risks?
This blog post introduces an alternative approach we have used that can support IP owners, and their advisors in achieving their goals in this area.
The Background: As intellectual assets have become one of the most, if not the most, important portion of the value of the global economy’s leading enterprises, issues such as transfer pricing, valuation, and leverage have come to the forefront of business decisions.
Similarly, the tools used by specialists and other practitioners have to evolve to continue supporting that decision making process. Yet the most common method still being applied in the field is taking simplified Net Present Value (NPV) calculations applied to royalty income streams calculated on the basis of “representative” royalty rates. These rates are typically derived from transactions that are supposedly (but rarely) “comparable,” according to certain established criteria. This, in essence, is what the preferred IRS method (Comparable Uncontrolled Transaction methodology or “CUT”) does.
Obviously, the greatest obstacle in relying on the CUT method is finding past transactions involving unrelated parties with a high-enough degree of similarity. Questions that must be asked to select the “comparable” transactions include whether, or not:
- the patents, or technologies, are similar
- the parties involved are independent from each other
- the market characteristics are similar
- the investment commitments are similar to the case under consideration
- the terms and conditions are comparable (e.g. territory, duration, exclusivity)
While in many trademark, copyright, and even technology licensing cases suitable comparables can be found, it is the nature of patents, in particular, and true innovations, in general, that such transactions will not be easy to identify. That is the main reason new approaches are derived.
The basic alternative to (outside) comparables is making full use of the (internal) information regarding the patent or other item of intellectual property being licensed. In other words, if your company’s transfer pricing analysts cannot find outside comparables, it may be time to look inward.
The Premise: Patent licensing shares at least one attribute with all other relevant business decisions: it involves risk. While this may not be earth-shattering news for most, it does point us in the direction of where an alternative approach can begin.
Where decisions involving financial risk are concerned, sound management principles suggest considering ways and vehicles to hedge that risk. Consider the prospective licensee of our truly innovative technology, wouldn’t it be ideal if the contract commitments could be altered as actual investment, production, and/or sales figures began to be known? Business life does not work like that, so decision makers have a clear incentive to bid for the license in such a way that they are protected from the risk of over investing and spending, as well as from under performing in terms of sales.
One of the central vehicles to hedge risk in modern finance is an “Option.” A financial option on a stock, for instance, is simply the right to buy the stock for a predetermined price (the “strike” price) before the option expires, but it does not entail any obligation to buy (the argument is similar for put options). Consequently, the holder of the option will only exercise this right if it becomes profitable to do so, and will not exercise that right if the future market price of the stock does not surpass the strike price.
Suppose our licensing executive could structure an agreement in such a way that a royalty is payable if, and only if, the project involving the innovative patent turns out to be profitable. Naturally, the patent holder (the IPH in our example) would not find such a contract very attractive in real life. Nevertheless, there are financial methods to determine how much such an option would be worth to the licensee and, conversely, what the corresponding value would be for the Licensor to sell the technology if it is unprofitable to develop it in-house. Financial options have been valued in different ways, but the most solid methods are derivations from the famous “Black-Scholes” model.
Applying The Model: Arguably one of the key conceptual advantages of the Black-Scholes model is the precise isolation of the factors (all “current” values) that determine the price for the option:
- The time to expiration
- The risk of the underlying asset
- The time-value of money (risk-free interest rate)
- The current and strike prices of the asset
Drawing the parallel with our patent, as the underlying asset in the option analogy, it certainly has a finite lifespan, the risk of the industry (or industries) where it is to be implemented can be ascertained, and the prices refer to the expected profit streams from its implementation. The equation that synthesizes the model is quite daunting, and an experienced valuation consulting firm can greatly add value to our licensing executive by thoroughly reviewing the details of the licensing deal and properly using the formula to arrive at the corresponding royalty rate. Although typically the model is expressed in terms of prices, an algebraic equivalent can express the solution in terms of a royalty rate, as a proportion of the price.
An application of this model to a past engagement, and further details on the equations can be found on my paper at the Social Sciences Research Network.