Royalty Rate Assessment - Royalty Rate Expressions

Royalty Rate Expressions

Royalty in licence agreements is always in consideration of something that is provided by the licensor to the licensee in the agreement, such as the right to use a trademark, patent, know-how, designs, drawings or a combination of them.

Royalty payments take three basic forms:

• 'running' royalties
• 'lumpsum' royalty
• running royalties together with lump-sum royalties

Any payment should be related to:

• the specific entity of the license that bears the royalty
• the unit-base on which the royalty is applicable (e.g. per kilogram of product)
• the period over which payments are due
• when the payments have to be made, currency and transaction mode
• the mutual obligations of the licensor and licensee in relation to the entity.

For instance in a product licensing agreement, the licensee may be called upon to pay a lumpsum royalty of $100,000 on execution of agreement together with royalty of 4% of the 'net sales value' for all licensed products for a period of 6 years, commencing 2 years from the date of starting production.

The selection of the royalty base should not be arbitrary. Each form of compensation has advantages and disadvantages to the contracting parties. What follows is a just an introduction.

Running Royalties

Running royalties are predominantly used in patent, trademark and franchise licensing since they can theoretically be exploited without any other inputs from the licensor once the license has been executed.

Where there is only one product, the royalty base can be either the number of units produced or sold (the distinction is significant) or the 'sales value' (sales realization) of the product. Where the term 'sales value' is the base unit, it has to be very strictly defined; whether it is the 'gross sales value' or 'net sales value' (NSV), and if the latter, what components of the price need to be subtracted (for instance, packing cost, sales taxes, transportation costs, etc.). NSV is predominantly used when there are a multiplicity of products made or processed in some way (say, various thicknesses of plate glass in a glass-manufacturing license).

In some circumstances there may be minimum and maximum (cut-off) royalty stipulations. Minimum royalties are used when there is a possibility that the licensee may not work the license to its full benefit or is incorporated as an incentive to work the technology to the full. The maximum or cut-off royalty can be negotiated when the licensor agrees that a cumulative amount will satisfy the objectives of license; once the limit is reached, no further royalties become due. An alternative is the incorporation of reducing royalties if large volumes are expected in the future.

Lumpsum Royalties

Lumpsum royalties are most often encountered when the principal contribution of the licensor is providing formulae, documentation, designs and the like. That is, once the transmission of the latter is completed, the licensor has no involvement with the licensee so long as the caveats and rights of the license are respected. In some cases, the lumpsum merely represents the 'capitalization' (PV) of a part of the running royalties.

Combined Lumpsum and Running Royalties

This combination of royalties is met with in 'technology contracts' where more than one form of intellectual property is licensed out combined, possibly, with a knowhow license, and in many cases, with a straight knowhow license alone.

Where the transfer of know-how is solely the province of contract, the lumpsum often works as 'insurance' against misuse of know-how by the licensee, since there is no protective statute for it (unlike with patents and trademarks), while the 'running royalty' can be insurance for the licensee in that the licensor would provide inputs so as to maximize income (thus to the benefit of both). Alternatively, the running payments may be to spread an otherwise lumpsum component.