I am frequently asked by colleagues and fellow entrepreneurs if I think a royalty rate in a licensing transaction they are contemplating is fair. And my answer invariably is, "it depends." It depends on the expected value and timing of profitability from the expected product or service, the stage of development of the technology, and the structure of the deal.
It's important that the licensor and licensee both understand where the technology is going in terms of products, development milestones, and time to profitability because at the end of the day profits are what the parties have available to share. As an example, assume a licensee is going to make a widget that sells for $100; the royalty rate of 5% is established. If the gross profit of the product is $20 (or 20%), then $5 represents 25% of the product’s gross profits. Is that fair?
Maybe. In part it depends on the stage of development of the technology when it was licensed. The further along in development/commercialization, the less risk there is. That is one of the primary reasons why a technology at a prototype stage has more commercial value than an idea that has only been confirmed with some data. And it is also why it is not uncommon in a license to have fees attached to key risk reducing milestones.
Benchmarking is a valuable exercise to go through as it gives you a real sense of how the market is valuing technologies similar to the one being licensed. But beware of using only royalty rates as a benchmark without understanding more about the structure of the deal and other key terms. Deal structure can vary significantly depending on the needs and objectives of the institution, company or inventor. There is always the trade off among upfront fees, milestone payment, royalty rates and equity (in the case of start-ups).
As a licensor or licensee you must determine the relative importance of cash now (higher upfront fees or milestone payments) vs. the potential for cash later (higher royalty rates or equity). If you are a company flush in cash you may be able to negotiate very good royalty rates with a cash stapped licensor. Or as a financially secure licensor you may be able to obtain significant equity in lieu of upfront fees from a cash strapped start-up. So saying a licensing fee of X, or a royalty rate of Y, is not necessarily indicative of the value of the transaction without knowing what other fees, minimum payments, and other resources are part of the transaction.
Royalty in the Making
It is very important to think through the basis for the royalty. Take this example from the life sciences area. An invention may have both therapeutic and diagnostic value. If someone is selling a drug that results from the invention, the basis for the royalty may be clear (number of doses sold, at what price, and so on). And if diagnostic kits are sold, the basis may also be clear. But what if the licensee intends to provide a diagnostic service rather than selling a diagnostic kit? A licensor could lose out on royalties if they do not understand how the licensee is going to extract value from the technology. Further, the royalty rates may be (and probably should be) different for a therapeutic vs. a diagnostic kit as opposed to a service because the resources required to turn the technology into a revenue producer, and the profitability of each product/service will be different.
With early-stage technologies it is impossible to know what a sales price or gross profits are going to be for an end product or service. Going through this kind of exercise can be very useful to both licensors and licensees in figuring out what's fair with respect to licensing terms.
Neil Wyant is currently
President of O'lala Foods, Inc., an early-stage
company applying nano- and micro-technology to
solve food and nutrition problems. He has been
involved in commercializing a broad range of early-stage
technologies for more than 20 years. For the last
10 years, he has been a senior manager or consultant
to start-up companies coming out of academia, government,
and the private sector. He has extensive experience
in licensing early-stage technologies having spent
over six years with the licensing and venturing
group commercializing technologies coming out of
the University of Chicago and Argonne National
Laboratory. Wyant has bachelor's degrees in chemical
and biomedical engineering from Northwestern University
and an MBA in marketing and finance from the University
of Chicago.
It's important that the licensor and licensee both understand where the technology is going in terms of products, development milestones, and time to profitability because at the end of the day profits are what the parties have available to share. As an example, assume a licensee is going to make a widget that sells for $100; the royalty rate of 5% is established. If the gross profit of the product is $20 (or 20%), then $5 represents 25% of the product’s gross profits. Is that fair?
