Valuing and Licensing Intellectual Property

HEADS OF AGREEMENT FOR A LICENCE

Sometimes, it might be more appropriate to choose a minimum sales figure, which is different to a minimum royalty, in that it ensures the market is kept alive, whereas the minimum royalty obligation only provides for a minimum payment, irrespective of the level of sales or of any sales at all.

The licence fee is intended to reflect a number of considerations:

In taking an alternative approach to the negotiations, it could be more lucrative for the licensor to share in the value of the company than have a share of profits. A deal structured on the assignment of an equity share means that, as the value of the company increases, the licensor’s shareholding becomes more valuable, whereas royalties on sales still would be related only to revenues, which may not necessarily increase in line with the company’s share value – particularly where a subsequent listing on the stock market, or a trade sale, might achieve a valuation in the order of 10 times the company’s earnings. If the technology works, both profit from the risk and, if it does not, both have shared in the loss.

For a licensee to benefit from licensing a technology, he must be satisfied that he has performed a detailed evaluation of the technology, a thorough analysis of the IP and a reasonable calculation of projected profits to ensure that:
The company will be more competitive with the IP than without it; and
That the profit margin is sufficient to pay a royalty.

Figure 2: Factors that affect the royalty rate

That the royalty must come from the licensee’s profit margin and, irrespective of what the published tables for a particular industry sector indicate the royalty rate should be, if the product cannot be produced and sold at a price to pay that royalty and leave a reasonable margin for the licensee, then there is no business proposition; and
There always is an element of risk in the commercial proposition (ranging from high risk for early-stage embryonic research results to minimum risk for mature turn-key technologies), which needs to be factored into the rate.

The sales revenue less the cost of goods sold (COGS) gives the gross margin. Deducting selling, distribution and administrative costs gives the net margin (operating profit). The 25% share of the net margin is then expressed as a percentage of the sales to give the royalty on sales figure (as a percentage of net sales).

However, royalties generally are not paid as a share of the profit (in fact, the licensor might never know the real profit margin on a product) but usually are expressed as a percentage of the sales price for some unit of sale, such as a product, a volume, or a weight of a manufactured item (known as the royalty base). So the objective is to express 25% of the profit from the sale of the product in terms of a percentage of the unit sales price.

The generally-agreed recommendation is that the operating profit obtained by a manufacturer on a licensed product should be divided approximately 75/25 in favour of the manufacturer (reflecting the higher risk for the licensee in bringing the product to market).