Royalty Rate Assessment - Royalty Rate As Profit Share

Royalty Rate As Profit Share

To start with, a very simple illustration is provided to describe the profit-sharing concept, which will be expanded upon subsequently. ( See Guidelines for Evaluation of Transfer of Technology Agreements, United Nations, New York, 1979, pp 40).

Any enterprise marketing a product would expect to obtain a profit which is some percentage of its sales price. If the product arises from working a license, then its licensor would want to share a part of that profit. (The licensed product can be expected to command a higher price in the market-place than its competitor by virtue of higher yield, lower cost, better quality, convenience or other factors). In the discussion below, the royalty term that is illustrated is 'royalty on sales' with the sale involving one unit of product. (Other forms of royalty are discussed later).

Arithmetically, royalty (on sales) can be expressed as:

Royalty = Payment-to-licensor/Product-sales-price

or re-expressed as

Royalty = Licensor-profit/Product-sales-price

or as

Royalty = Licensor-profit/Enterprice-profit x Enterprise-profit/Product-sales-price

or more formally as

ROS = LSEP x POS (A)

where:

Thus, if a licensor wants to receive a 20% share of the enterprise's (licensee's) profit (LSEP) on a product that sells for $5, and on which the licensor estimates the licensee's profit would be $1.50, the licensor would negotiate to apply a royalty rate (ROS) of 6% on the sales price. (POS=$1.5/$5.0=30%).

(The terms 'price' and 'profit' as used here are undefined; they will receive greater precision in later discussion).

Expression (A) above can be re-expressed as:

LSEP = ROS/POS (B)

It exhibits an important facet of the royalty rate concept. For a given royalty rate (i.e. ROS), the licensor obtains a greater percentage of the profit on the product the lower the profitability of the product (and, vice versa, the enterprise gives away a smaller share of the profit to the licensor for a product of high profitability).

It is important to differintiate between the percentage share of the licensor in the profit from the percentage royalty rate which is its most common form of statement.