Patent Licensing Royalty Rates: Everything You Need to Know
Patent licensing royalty rates is a percentage of the gross or net profit made on each sale of a specific product. 6 min read
What Are Patent Licensing Royalty Rates?
Patent licensing royalty rates is a percentage of the gross or net profit made on each sale of a specific product. Generally, a royalty is provided between the inventor (the licensor) and manufacturer, publisher, agent, or distributor (the licensee). Essentially, an inventor will enter into a license arrangement to have the manufacturer, publisher, agent, or distributor of the product sell it for the inventor. Since the licensee is doing the legwork, it will be the main party benefitting from selling the product; however, the license arrangement will establish a royalty rate, which is the rate the inventor will receive each and every time the product sells.
Criteria for Receiving Royalties
One of the most significant steps in licensing an invention or idea is establishing the royalty rate the inventor wants to receive in return for granting a licensee the right to manufacture and sell the invention. To reiterate, the royalty rate is the rate the inventor will receive from the licensee on the product being sold. Therefore, the inventor will receive money (the royalty) for each sale.
Up-front compensation. The up-front compensation paid to the inventor will affect the royalty rate. For example, if an inventor receives a higher up-front compensation for the license arrangement, then the royalty rate will be less. However, if he or she receives a small amount of up-front compensation, then the royalty rate will be higher.
Company standard rates. Generally, each industry has a standard royalty rate.
Those companies that have experience in licensing tend to have standard rates that are applied to specific inventions. Of course the larger the company is, the more financial resources they have to offer a higher royalty rate.
Intellectual property stage. The further along the invention is with regard to commercialization, the less risk the licensee will face, and thus, the higher the royalty rate will be.
Market potential. The royalty rate will also depend on the market potential of the idea or invention itself. For example, if the invention relates to a newly developed type of market, then the royalty rate will be considerably less, as there is no way of telling whether or not it will be successful.
Testing. To reiterate, the further along an invention is with regard to commercialization, which includes the extensive testing it must go through, the less risk a potential licensee will face.
Types of Royalty and License Fees
Most licenses will indicate in the agreement that one or more of the following will be paid by the licensee: an up-front license fee (this is the upfront compensation mentioned above), continuous lump sum license fee payments, and/or rolling royalties. There may, however, be circumstances when the inventor should grant a royalty-free license. A perfect example would be if the inventor is receiving a benefit in some other way. For instance, the inventor may also provide research services in return for compensation.
Sometimes up-front compensation can be treated as a capital payment in which a restraint of trade agreement is filed rather than an actual license agreement. In this case, the inventor is likely selling the invention to the other party.
Below are some additional types of royalty approaches that an inventor and licensee will take in terms of the licensing arrangement being made between the parties:
The Cost Approach
Using this approach, the royalty is a specific percentage that reimburses the owner for the costs over the entire life of the license (i.e. patenting costs).
The Comparable Market Approach
If this approach is used, the royalty rate is based on the royalty offered by others in comparable industries. The flaw in this approach involves the inability to identify reliable data that can truly compare similarly situated deals.
The Income Approach
Generally, the income approach uses the 25 percent rule, which specifies that the inventor is eligible for 25 percent of the licensee’s long-term pre-tax operating profit made from the sale of the licensed product. If using this approach, the agreement itself should indicate that the 25 percent will be on the net sales or, alternatively, a price per unit of each licensed product sold.
Keep in mind that the license agreement should never indicate that a royalty is to be collected on the percentage of profits because the licensee can often manipulate profits. So, for the 25 percent rule to be used, the inventor should be aware of the licensee’s expected expenses and revenues. The inventor can ask that the licensee submit to him or her a business plan on what the company believes such expenses and revenues are. If the prospective licensee fails to do so, the inventor should not accept the deal.
Discounts on Putting a Premium on Royalties
Both parties should keep in mind that the value of the product being sold may increase or decrease in price. There are several factors that can affect the value of a product, including after-market technology that may deem the product less useful, competing technologies, and the size of the market itself. These considerations should be made before choosing to put a premium, also referred to as a surcharge, on royalties.
- Ensure that the license arrangement includes specifics on the companies reporting requirements in terms of audited records, so that the inventor can keep track of what is owed.
- If royalties are solely based on the net sale of a product, be sure that the royalties reflect the market value for that product. The inventor will also want to ensure that the agreement sets forth any deductions from the net sale that may be included, which would reduce the net profit, thus reducing your compensation.
What’s a Reasonable Royalty Rate
Rates can vary between 0.1 and 25 percent or more depending on the industry and type of invention. There are royalty guides out there to assist inventors in determining the right royalty rate to ask for. The inventor should do his or her homework in terms of learning the following:
- What the standard rates are
- How marketable the invention is
- The likelihood that other competitive technologies will be placed into commerce anytime in the foreseeable future
- Whether or not there is already a similar type of product being sold
- If the product itself can be purchased time and time again from a single customer or whether the product is a one-time purchase
- Whether the product will only spark interest in customers in certain geographical regions
- How many customers the product can reach
It is never wise for an inventor to go into a potential licensing arrangement not knowing the industry standard or the value of the invention.
There is a great deal of literature on the internet that can assist the inventor. Such literature should be read and studied before the inventor should even consider looking for potential licensees. After learning what he or she can, the inventor should then look online for companies that may be interested in licensing the product, while also learning more about each company – its net assets, where it operates, how many people are employed with the company, and other important factors that the inventor will want to consider depending on the type of invention.
Once the inventor has come up with a list of targeted companies, a meeting should be held in which the prospective licensee (the company) should provide the inventor with its business plan, assuming the company is interested in the product. Such a business plan will help the inventor determine if this company is the one he or she wishes to do business with.
The inventor should make sure that the potential licensee doesn’t offer a royalty rate far below what the inventor seeks. Again, the inventor will have a list of target companies, so if the first company offers a substantially lower rate than what the inventor seeks, then the inventor should hold off on agreeing to it.
There is no “correct” royalty rate in terms of licensing a product. The royalty rate should, however, be the maximum rate that the licensee is willing and able to pay, which in turn meets the minimum royalty rate that the licensor (the inventor) is willing to accept.
If you need help learning more about royalty rates, or if you need help drafting a license agreement, you can post your legal need on UpCounsel’s marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Stripe, and Twilio.