How to Establish Royalty Rates

Despite the passion we may hold for our ideas and life’s work, we also want to be compensated fairly for our time and innovation. Therefore, setting royalty rates becomes an important component of the technology licensing agreement.

Most royalties are calculated against net revenues rather than profits. But anticipated profits must also be considered when establishing royalty rates. This is because different industries carry vastly different profit margins. It would not make sense to set a royalty rate of 25 percent on a licensing agreement that only stands to gain the licensee a profit of 5 percent (such as in the food service industry). However, that rate becomes perfectly reasonable when the expected profit margin amounts to 80 percent (as is common in the software industry, for example).

While exceptional situations do exist, and you should certainly seek counsel and fully negotiate your position if you believe yours to be unusual, most licensing royalty negotiations begin from a standard point of reference. From that point, both sides will consider questions such as the following:

  • Is this technology a breakthrough innovation, or simply an improvement or ancillary product?
  • How strong is the intellectual property? Will patents and copyrights keep this product unique?
  • When can the technology be put into use? Is substantial research and development still needed? Is regulatory clearance required?
  • How much risk is involved with this product? What is the certainty that it will work as designed, and meet market needs?
  • What is the expected profit margin? How much support will be required, and will that support decrease the profit margin?

The answers to these questions could result in smaller royalty rates of 0-5 percent for products still in development, to rates of 20 percent or more for technology already developed, launched, and proven.

Of course, multiple legal considerations must also be negotiated and agreed upon. Topics such as exclusivity, transferability, and duration should be heavily considered. Market scope and territorial scope can limit or expand the agreement accordingly.

And finally, the matter of payment of royalties must be defined in detail. Will payments be advanced, or dependent upon performance?

An experienced attorney can help you investigate and negotiate these issues, resulting in a fair and reasonable royalty rate for both parties. Call us if you’d like help in evaluating your technology and its licensing potential.

 

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