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Using Financial Models to get royalty rates, S Degnan, Les N

Using Financial
Models to Get
Royalty Rates
Parameters for evaluating technology and decision-making process for setting royalty rates are
examined
atrick Sullivan in his 1994 les
Nouvelles article concluded
that the craft of technology
licensing and royalty-rate-setting is
not yet sufficiently understood and
therefore a set of rigid decision
rules or precise codification has not
yet been created. This article attempts to create a theoretically
sound financial model with regular
decision rules that can be used by
licensing executives when deciding
whether to license technology.
Intellectual property derived from
innovation is the most important
asset owned by most corporations.
It has been estimated that over 40%
of the world’s economic growth
since World War I1 has occurred
directly as a result of advances in
technology (Wyss 1981 and Mansfield 1975). With this amazing contribution to mankind, one would
expect that this subject would have
been extensively studied to understand its subtleties. Surprisingly, it
has and it has not.
The credit for focusing the world’s
attention on the nature and significance of intellectual property and
innovation to the world economy
certainly belongs to Joseph Schumpeter, an Austrian economist
Schumpeter in Capitalism, Socialism
and Democracy (1942) set forth in
most impressive terms the preeminent importance of innovation for
the development of economic life.
To a large extent, innovations are
the motor of economic development, of growth and change including technological change. As
such they are an essential function
of an industrial enterprise (Taeschler 1982).
Before the 1980s innovation was

P

les Nouvelles

BY STEPHEN A. DEGNAN*

primarily conducted and consumed by individual business enterprises. It was unusual for U.S.
businesses to license in or out coretechnologies from nonaffiliated entities. At the time most businesses
innovated internally and subscribed to the “Only-Invented-Here”
(OIH) philosophy. The reasons for
this philosophy included the lack of
effective intellectual property protection and the fear of antitrust
prosecutions by the U.S. government.
Prior to 1982, the infringers of
patents were so often successful in
the U.S. federal court system that
patent owners truly had to think
twice before asserting their rights,
even when they legitimately believed that their rights were valid
(Wepner 1985). The legal impediments to technology transfer
licensing started to change with the
creation by the Congress of the
United States in 1982 of the U.S.
Federal Circuit Court of Appeals
(Federal Circuit). After years of controversy, a single court was vested
with subject matter jurisdiction
over all appeals from the U.S. Patent and Trademark Office (PTO) in
connection with pending patent applications, and most significantly,
was also given jurisdiction over all
appeals in patent infringement
cases (Wepner 1985). Almost immediately this new court began
finding in favor of patent holders
and against infringers. The result
since has been a favorable climate
for innovation and licensing within
the United States.
Another condition inhibiting
licensing was that before the Reagan Administration took office in
1980, most licenses were scrupulously reviewed by lawyers for
potential antitrust implications. The
attorneys with their abundant caution, n&ed many potential technology transfer licenses (Horton 1997).

This changed when Reagan instructed his Justice Department to
cease this type of antitrust inquiries.
The final legal impediment was
the lack of intellectual property protection outside of the United States.
Prior to the 1994 signing of the
Uruguay Round of the General
Agreement on Tariffs and Trade
(GATT), which covered the worldwide protection of intellectual property rights, little meaningful enforcement of intellectual property
rights existed in a significant portion of the world.
The changes in the legal environment in both the United States and
in the industrialized world gave
owners of intellectual property the
legally enforceable right to license
technology to some while excluding
others. These policy, treaty, and
legal changes coupled with certain
technological and economic changes
have had a significant impact on the
importance of licensing to business
enterprises in the 1990s.
The non-legal changes that have
also tended to stimulate and encourage licensing during the past
decade are the globalization of the
world’s economy, the rising cost
and complexity of technological
development, and the compression
of product life cycles. These collective forces have forced businesses
to look beyond internal development as a source of innovation
(Sandri 1995).
Today, the competitive business
environment for all technologybased enterprises requires that
some or all of a business’ core technological know-how be externally
acquired. Therefore, licensing has
become a basic component of the
business’ fundamental strategy.
This has meant that businesses
must learn to cope with a broad

* Degnan b Associates, San Ramon,
California.

the survey respondents.

range of complex and interacting
economic, legal, and technology
issues surrounding transfer and
licensing of technology.

THEORETICAL FRAMEWORK
AND DISCUSSION

Georgia-Pacific Factors and Other
Articles
There are at least 10 different articles and studies that have
postulated the factors (evaluation
parameters) utilized when two or
more parties are negotiating terms
and rates of an intellectual property license. These studies have proposed that as few as three factors
(Matsunaga 1983) and as many as
100 factors (Arnold 1989) influence
technology transfer negotiations.
One of the most utilized compilations of factors affecting negotiated
royalties is a 1970 opinion by Judge
Charles H. Tenney in the GeorgiaPacific vs. U .S . Plywood matter. In
arriving at his opinion the Judge
found that 15 factors should be considered. These 15 factors were tested in the author’s 1995 survey described below, and all relevant factors were considered important to

In 1995 this author and Corwin
Horton prepared and conducted a
37-question paper-and-pencil
survey that was mailed to over
2,100 members of the Licensing Executives Society (USA & Canada).
This survey covered various financial, managerial and economic
topics. The results, compiled from
the 428 respondents, were published in the les Nouvelles in June 1997.
The survey gave insight into who
was involved in the technology
transfer process, what royalty rates
businesses were paying and receiving for technology licensed, and
what methods the respondents
were using to analyze technology
licensing opportunities. While the
survey gave useful insights, it did
not answer two important questions. How do parties to a licensing
negotiation evaluate whether to
consummate a technology transfer

license, and secondly, if the parties
agree to consummate a license,
how do they arrive at the amount
of royalties to be exchanged.
Based on a literature search and
discussion with other licensing executives, the author concluded that
most licensing executives consider
their analysis of potential licenses
to be very subjective (seat-of-thepants)-based. Being a student of
finance and accounting, this approach to licensing (the subjective,
intuitive approach) seems to this
writer to be illogical and economically dangerous.
EVALUATION PARAMETERS
After reading of over 150 articles
and books on the subject, conferences with a number of licensing
executives, scheduling out the
Georgia-Pacific factors, and reviewing the nine other studies (Arnold;
Matsunaga; McGavok, Haas &
Patin; Parr and Smith; Mignan;
Rahn; Sandri; Scaligone; and Sullivan), it became clear that at least

FACTORS IMPACTING TECHNOLOGY TRANSFER LICENSES
Nature of the
Invention

Characteristics of the
Licensor

Characteristics of the
Licensee

Nature and quality of the protection offered.
Utility over old modes.
Nature of problems solved.
Degree of novelty and originality.
Advantages over prior art.
Stage of development.
Time and costs required to complete.
Need for other enabling technologies.
Commercial embodiment.
Creates a competitive advantage.
Decreases overall costs.
Ability to exclude or limit others.

Entity size and industry.
Type of organization (government, etc.).
Licensing policy and strategy.
Gain royalty income.
Obtain a cross-license or alliance.
Make their technology a standard.
Expansion into foreign markets.
Entity’s perceived technical proficiency.
Presence of product champion.
Support, know-how and training offered.
Commitment to ongoing support and R&D
Cost paid to acquire the technology.
Grant back of improvements.

Entity size and industry.
Type of organization (government, etc.).
Licensing policy and strategy.
Not-invented-here,
Defensive.
Increase technical proficiency.
Profit maximization.
Entity’s perceived ability to succeed.
Presence of senior product champion.
Need for ongoing support and R&D.
Capital and other resources required.
Ability to substitute or design around the
patent.

Nature of the
License

Economic
Factors

Perceived
Industry Standards

Duration of the license.
Patent status (pending or issued).
Scope of license.
Patent, know-how, etc.
Scope of exclusivity.
Temtory covered.
Type of exchange or transfer of technology
Licensee-licensor arrangement.
Joint venture.
CO-development.
Strategic alliance.
Cross-license.

Anticipated commercial success.
MarketlSales potential.
Licensee’s anticipated profits.
Convoyed sales and profits.
Commercial relationship of the parties.
Licensor’s lost profits.
Licensor’s profits and maintainance costs.
Licensee’s risk adjusted NPV and ROI.
Time and costs required to commercialize.
Probability and degree of success.
Payment terms (upfront or running).
Guarantees, minimum, etc.

(Zomparable

industry royalty rate.
Average running royalites.
Profit sharing percentages.

Negotiating Skills
of the Parties

Table 1

1 1998
June

les Nouvelles

50 evaluation parameters are relevant. These 50 evaluation parameters fall generally into seven
broad categories, as follows:
1. Nature of the Invention – The
nature and quality of the protection
offered. Its utility over old modes.
Its state of development. The need
for enabling technologies. The
nature of the commercial embodiment. The ability to exclude others.
Characteristics of the Licensor The size and industry of the licensor.The presence of a senior product champion. The licensor’s
perceived technical proficiency. The
support, know-how and training
offered. Commitment to on-going
support and R&D. The cost paid to
acquire the technology. The grantback of improvements.
3. Characteristics of the Licensee
– The size and industry of the
licensee. The presence of a senior
product champion. The licensee’s
perceived ability to succeed. The
need for ongoing support. The
capital and other resources required.
The licensee’s ability to substitute
or design around the technology.
4. Nature of the License Offered
– The type, scope, duration and
protection offered.
5. Economic Factors – The current and future economic and
political environment. The anticipated commercial success. The
market potential. The licensee’s anticipated incremental profits. The
commercial relationship of the parties. The licensor’s anticipated creation and maintenance costs and lost
profits. Payment terms including
guarantees and minimums.
6 . Perceived Industry Standards
– Comparable industry royalty
rates including average running
royalties and profit sharing percentages for like technologies and
protection.
7. Negotiating Skills of the Parties – The more skilled and prepared a licensing team is in interpersonal relationships and the
mechanics of licensing the more
likely they will be successful.
For a more comprehensive list of
evaluation parameters and their
grouping see Table 1. Based on
these evaluation factors the author
prepared a model to mirror the
typical decision-making process in

les Nouvelles

technology transfer licensing.
THE FINANCIAL MODEL
Obviously, the decision to license
is a multi-step process involving
numerous individuals and the
passage of time (six months on
average). The process frequently
entails the potential licensor making the decision to license its
technology, the parties meeting and
agreeing to consider licensing options, the gathering and exchanging of information, the licensee’s
determination of whether to continue to negotiate, and the final
negotiation on mode and amount of
royalties. A number of published articles have focused on the economic
benefits of licensing and the most
advantageous ways for licensor and
licensee to meet and reach agreement. The remainder of this article
will focus on the last three steps.
The financial model posits that the
last three processes truly involve at
least 10 discrete actions or steps by
the parties, as follows:
Step 1: Gather Pro Forma Data The licensee, and to a certain extent
the licensor, needs to obtain or
prepare certain pro foma schedules
based on present and future anticipated results. These schedules
will show the net direct and indirect
revenues from new and convoyed
sales – the direct costs associated
with that revenue production (including the anticipated royalty to be
paid), the appropriately apportioned general and administrative expenses, the capital needed for new
facilities, equipment and working
capital, and the disruption or opportunity costs caused from allocation
of scarce resources to this project.
Step 2. Calculate the Licensee’s
Pro Forma “Risk Adjusted Discount
Rate” – Long before the development of modern financial theories
linking risk and returns, chief financial officers adjusted for the time
value of money and the risk inherent in certain proposed transactions. Financial executives realized
that, all other things being equal, a
risky long-term project was less
desirable than a safer short-term
one. Therefore, they developed the
Discounted Cash Flow (DCF)
technique.

The discount rate used for ordinary run-of-the-mill projects is
the company’s “cost of capital”
plus a fudge iactor. This is frequently called the “hurdle rate,” and it
is used to discount future cash
flows back to today. The result of
the summing of discounted current
and future cash flows is called the
Net Present Value (NPV). If the
NPV of a project is found to be
positive, then all other things being
equal, the company should invest
in the project, because the undertaking adds value to the company.
And companies work by creating
value (McPherson 1995).
4

Radar Factor

b

For risky projects various techniques have been created and used to
evaluate projects. For example,
some have suggested reducing the
estimated cash flows for uncertainty. Today, sophisticated financial
executives adjust the hurdle rate up
based on the amount of “systematic risk” in the project. The result
is called the “risk-adjusted discount
rate” (RADR) or radar for short.
Similarly, licensing executives
factor in risk in their licensing arrangements. The licensee evaluates
the whole licensing opportunity in
its totality and then decides
whether to take a license. Currently, licensing executives are subjectively performing this calculation
based on years of experience and
the concommitment wisdom gained. A more systematic way and a
tool for licensing executives would
be the use of their radar.
The determination of the RADR
requires that the company first
determine its weighted average cost
of capital. Various academic techniques are available for obtaining this
information.
One frequently used method is
the Capital Asset Pricing Model
(CAPM). When this rate is determined, the licensing executive
needs to adjust the rate higher or
lower for presence of certain evaluation parameters regarding the
proposed license. The evaluation
parameters that tend to increase the
rate are:
> When the nature of the protection is weak.

Iune 1998

> When the quality of the protection is in question.
> When the ability to limit others
from the market is not assured.
>When the technology is not fully developed.
> When the licensee requires
ongoing support and R&D to be
successful.
> When the duration of the protection is shorter than usual.
> When the licensee has little or
no experience in the relevant
market.
The evaluation parameters that
tend to decrease the rate are:
< When the licensor has a reputation for superior technical proficiency. < When the licensor has committed to provide senior product champions. < When the licensor has committed to substantial ongoing support and R&D. After considering the factors enumerated above and any other adjustment factors the licensee's technology, production, marketing, and legal departments consider relevant, the licensee needs to select the appropriate risk-adjusted discount rate. The range of riskadjusted discount rates is from a low of 20% to a high of 80%, as follows: 50-80% Speculative Projects Substantial risk o failure. Idea usualf ly in the embryonic stage. Intellectual property in question. 40-50% Hi h risk Projects fritoty e has proven capabilities. Nature orprotection adequate. Moderate-Risk Projects 30-40% Technology fully develo ed Excellent chance of commerciarsuccess. Intellectual property solid. . Low-Risk Pro'ects 20-30% Product and technoloev alreadv successful. IP fits into exidkg product or service line. Before proposing risky license-in opportunities to their top management and owners, the licensing executive should prepare a Risk and Uncertainty Profile for their company. Public companies rarely take excessive risk with large amounts of their stakeholders' capital. Most licensees reject projects outof-hand when the capital investment is material and the RADR exceeds 40%. Only businesses with ~ diversified R&D portfolios (e.g. large pharmaceutical companies) and early-stage entrepreneurial start-ups play in the highest percent of capital and RADR ranges, no matter how large the NPV is. Lastly, it is a given that carefully written licensing agreements can minimize certain risks and poorly written agreements can create unnecessary risks. One should always involve an experienced attorney at some point in the licensing process. Step 3. Calculate licensee's NPV using the risk adjusted discount rate - After the cash flow has been calculated in Step 1 and the riskadjusted discount rate has been calculated in Step 2, the project's net present value and internal rate of return (IRR) are determined. The IRR is the rate of return that makes the NPV equal to zero. The IRR is also known as the rate implicit in the cash flow. Step 4: If the NPV calculated in Step 3 is negative, the signing of a license very likely is not in the licensee's best interest. Step 5. If the NPV is positive, determine the licensee's maximum royalty rate - The licensee is willing to pay a royalty to the licensor, only if the licensee's anticipated rate of return exceeds the licensee's normal rate of return. For example, if the licensee normally receives a 10% return on capital invested, and in Step 3 the licensee determines that it will receive a 12% return before paying a royalty, the maximum royalty the licensee can afford to pay is 2%. This 2% is known as the "Excess Profit" percentage. The author recommends readers interested in this topic to review Daniel Burns, September 1995, les Nouuelles article "DCF Analyses in Determining Royalty ." Step 6: Search for noninfringing alternatives by the licensee to a license - Frequently, taking a license is not the only alternative a licensee has. The licensee occasionally determines that it can legally design around the technology and not infringe. Another alternative to taking this license is to take a license with another entity, assuming that the technology is a non-infringing alternative. When the potential licensee determines that either alternative is possible and cheaper; then the maximum royalty the licensee should pay is the lower of the cost to design around the technology or the cost for an alternative license. Step 7: Determine licensor's costs and benefits - At the same time the licensee is determining its revenues, costs and alternatives the licensor should be calculating its costs to create, maintain, and monitor the license agreed to by the parties. The costs include the cost of technical assistance to be provided by licensor to licensee and the licensor's lost incremental profits from lost sales resulting from the license. Step 8: Determine licensor's minimum royalty - After the licensor's costs and lost profits are determined the licensor should determine what is the minimum royalty that will cover the present and future lost profits and costs. Frequently, this calculation is simply the annual costs divided by the licensor's anticipated net revenues. But occasionally, it is more complicated. Step 9: Determine of the "Range of Negotiation" - If the licensor's minimum acceptable royalty rate exceeds the prospective licensee's maximum royalty rate then a nonlitigation license is unlikely. If as is usual the licensor's minimum royalty is less than the licensee's maximum royalty a license is possible. The starting point for licensing negotiations, assuming it falls within the range of negotiation, is the customary royalty rate for like technologies and protection within the licensee's industry. In the absence of agreement on the industry standard, the midpoint of the range of negotiation can be utilized. Step 10: Adust the running royalty within the "Range of Negotiation" for the following factors The industry standard royalty or the midpoint of the range of negotiation is an arbitrary starting point. This rate is adjusted higher or lower for presence of certain evaluation parameters. The evaluation parameters that tend to decrease the rate are: < When the licensee has other acceptable noninfringing alternatives. < When the licensee's risk adles Nouuelles justed discount rate is very high. When substantial technical
assistance will be provided by the
licensor.
>When an exclusive license is
requested.
>When licensor will release important know-how or trade secrets.
>When the licensee has already
infringed the patent.
>When the licensee has a short
payback period for moneys invested.
The presence of committed senior
product champions is extremely important to the ultimate success of a
license. If one side commits more
senior product champions they will
want an adjustment favoring them.
It goes without saying that within
the range of negotiation, the negotiating skills of the two parties’
respective teams is very important to
the eventual outcome of the negotiations. The more skilled and prepared
one team is, the greater the chance
it will prevail.
Lump-Sum Payments
Frequently, the licensor does not
wish to have any of the risk and
therefore requests that it receive a
lump-sum, up-front payment. All

les Nouvelles

things b i g equal, the discount rate
en
that the licensee should use to determine the lump sum should be the
RADR.
CONCLUDING COMMENTS
The transfer of patented innovations through licensing is recognized to be a complex interrelationship of technology innovation, legal
and public policy, finance and economics, and entrepreneurial management. The subject of technology
transfer and its signdance, both for
developed and developing countries,
cannot be overstated.
Licensing contributes to a considerable extent to the process of innovation and economic growth. It
contributes to innovation because
technologies that are fully exploited
yield greater economic returns to inventors, which in turn encourages additional investment in research and development, which
results in more innovation. On the
licensee’s side, licensing of technology generally enables the licensee to get into the business more
quickly and economically and with
greater assurance of success, compared to independent development
(McLain 1976).
Clearly, the creation of a financial
model of the outcome of licensing
negotiations and the resultant agreed
upon royalty rate permit intellectual
property to be more effectively and
efficiently distributed. It is hoped,
the results of this work will be
helpful to future researchers in determining the appropriate financial
model and decision rules.

REFERENCES
Arnold, Tom “1W Factors Involved In Pricing
the Technology or Software License.” Paper
distributed by Arnold, White & Durkee, 1989.
Bums, Daniel “DC3 Analysis in Determining
Royalty.” les Nouwlles, September 1995, pp.
165-169.
Cutler, W. “Acquiring Technology from Outside.” Research Technology Management,
33(3), 1991, pp. 11-18.
Mansfield, Edwin “Impact of Technology
Transfer.” !B Nouwlls, March 1975, pp. 31-35.
Matsunaga, Yoshio “Determining Reasonable
Royalty Rates.” les Nouwlles, v18.4, December
1983, p p 216-219.
McGavock, Daniel M. and David A. Haas
“Licensing in the Real World: A Survey of
Those Who Know.” Licensing Law and
Business Report, 13, no. 1, May-June, 1990, pp.
145-156.
McGavock, Daniel M,, David A. Haas and
Michael P. Patin, “Factors Affecting Royalty
Rates” les Nouwlles, June 1, 1992, v 27.2, pp.
107-116.
McLain, W
i T. “Marketing of Process
Technology.” les Nouwlles, June 1976, pp.
95-97.
McPherson, Robert W. “Model for Gauging
Opportunity.” CA Magazine, F e b r u q 1987,
pp. 6870.
Parr, RusseU L. and Gordon L. Smith “Investment Theory for Royalty Rates.” les Nouwlles,
December 1987, pp. 155155.
Sandri, Stefano “Methodology Approach to
Evaluation.” les Nouwlles, v30.4, December
1995, pp. 181-212.
Scaghone, Placido “Licensor View of Royalty
Rates” les Nouwlles, v16.3, September 1, 1981,
pp. 231-232.
Sullivan, Patrick H. “Royalty Rates Conform
to Industry Norm.” les Nouwlles, September
1994, pp. 1401%.
Taeschler, Max “Licensing and Innovation Frocess.” les Nouwlles, June 1982, pp. 7377.
Wepner, Roy H. “Innovation Wins in U.S.
Courts.” b Nouwlles, June 1985, p. 95.
Wyss, H. “R&D or Licensing Innovation.” les
Nouwlles, June 1981, pp. 169-177.

June 1998

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