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I have been getting more and more questions about royalty agreements: what they are, how they work, how to negotiate them, etc. This is a typical question I got just the other day:

We are beginning negotiations for a royalty/license agreement. What is the customary way to value what we should receive as a royalty/license fee?

To clarify the subject, let's start with a simple explanation from answers.com:

Royalties are payments made by one company (the licensee) to another company (the licensor) in exchange for the right to use intellectual property or physical assets owned by the licensor. For example, software giant Microsoft invented the Windows operating system for personal computers as a means of managing files and performing operations. Computer manufacturers such as IBM and Compaq pay a royalty to Microsoft in exchange for being allowed to use the Windows operating system in their computers. Other common situations in which royalties are paid include the following:

1. In the fashion industry, designers such as Ralph Lauren and Calvin Klein license the right to use their names on items of clothing in exchange for royalties. For example, they may sign a contract with a company that makes jeans that allows the company to place the designer's name on the jeans.
2. In book publishing, authors are commonly paid both a fee for their services and a royalty rate that entitles them to a percentage of their books' profits.
3. In the music industry, royalties are paid to music copyright holders and to songwriters by radio stations and anyone else who derives a commercial benefit from the copyrighted material.
4. In the television industry, popular satellite TV services such as Direct TV and cable television services pay network stations and superstations a royalty rate so that they can broadcast those channels over their systems.
5. In the oil and gas industry, companies pay landowners a royalty rate for the right to extract natural resources, such as petroleum and natural gas, from the landowner's property. Similar agreements exist in the mining industry for minerals such as copper and silver.

Royalty agreements are intended to benefit both the licensor (the person receiving the royalty) and the licensee (the person paying the royalty). For the licensor, signing a royalty agreement to allow another company to use its product or intellectual property can mean expanding into a new market, or increasing market share in an existing market. For the licensee, the agreement can mean gaining access to products that may have been too expensive or too difficult to produce on its own, or that were protected by patents it did not own. If done right, the royalty arrangement is a win-win situation.

 

Royalty agreements generally are one of two types. The fixed price per unit agreement pays the licensor a set price for every one of its products sold by the licensee. Often, this type of agreement is used when the licensor's product is one that will be a small part of a larger product produced by the licensee. An example of this might be a new type of windshield wiper motor developed by Company A. The motor drastically changes the way windshield wipers work and is granted a patent by the U.S. Patent Office. Company A approaches General Motors and offers to license the motor to the automaker so that it can be included in all GM cars and trucks. In return, GM agrees to pay Company A $10 per unit for every motor it purchases. This price would cover the materials and labor needed to produce the motor, as well as include an extra sum to cover Company's A investment in developing the motor. In fixed price arrangements, the amount per unit can be adjusted for inflation, or a minimum royalty amount can be specified.

 

The second type of agreement is a royalty that pays a percentage of revenues or operating profit that results from the sale of the licensed product. This is more likely to be used when the item covered by the royalty agreement stands alone or when the cost of using the item can be clearly itemized. Percentage agreements are generally more intricate than fixed price agreements because more terms must be defined—what rate will be paid for discounted items, what happens to items that are returned, whether sales commissions affect the percentage paid, whether updated versions of the item are covered by the agreement, and more. Agreements based on a percentage of the operating profit generally result in a more equitable settlement for both parties, but those agreements are also more complicated. As a result, it is more common for companies to agree on a percentage of revenues.

 

In terms of negotiating the rate itself, there seem to be a few general "rules of thumb" to arrive at "fair" royalty payment:

1. The first is sometimes called the "25% Rule" and relates to how much one would expect to receive as Royalties as a percentage of the increase in profit that your intellectual property provides to the licensee's business.  This rule of thumb will often give the licensor about 25% of the profit made by the licensee from the exploitation of the intellectual property over the life of the license gives the licensor. This is only a guide and in at all to be considered to standard rate.
2. Another is the "5% of Net Rule" and is based upon a payment from the licensee to the licensor of 5% of the net selling price.  Much care must be taken here in terms of what "net selling price" means and how it is calculated.  This means Gross Sales less certain items such as Discounts and Returns, but could also mean less Advertising, Sales Costs, etc., so be sure to define this clearly in the agreement.

The are many key deal terms when negotiating a Royalty or License agreement are here are a few based upon the needs of each party:

 

	Licensor (Small Co. with Idea or Product)	Licensee (Larger Co. with Established Market Presence)
What each party wants…	Royalty revenue Recognition and visibility Brand extension Exploit manufacturers’ manufacturing and commercialization capabilities (including sales force) Require Development and Commercialization of Product	Brand recognition and cachet New fresh product to differentiate itself from the competition Tap new customer base Maximize manufacturers’ manufacturing and commercialization capabilities (including brand, marketing and sales force)
What each party is concerned about…	Reasonable Value Diligence on the Licensees' part Monitoring and reports Remedies (including having the asset revert to their control if certain minimums have not been met)	Manage overall financial risk Manage overpayment risk Cap development and marketing expenses Ability to terminate

 

Other tips on negotiating the agreement (from a presentation by law firm Cohen Tauber Spievack & Wagner) include the following checklist of items to include in the agreement:

 

The ideal “win-win” agreement should:

• Matches parties’ strengths to responsibilities and objectives
• Avoiding pitfalls of taking on responsibilities that cannot be financed or are economically unsound
• Time frames for obligations – an effective due diligence clause
• Recognize true market for ultimate product
• What are competing products?
• What sort of pricing will the market bear for the ultimate product?
• Recognizing what everyone is looking for and not overreaching means expressing in good faith abilities, expectations, goals, and desires during negotiating process

They also offered up the key agreement terms in a royalty agreement that need to be negotiated and clarified between the parties.  (You can start with by downloading a simple agreement template here, but you will obviously want an attorney to assist you with the final agreement due to its complexity:

 

License Grant and Restrictions:

• Exclusive
• Non-Exclusive
• Semi/Co-Exclusive
• Granting Clause
• Licensor’s Reservation of Rights

Territory: Worldwide or Specific Countries

• Infrastructure and Abilities of Partner
• Available Patent, Copyright and Trade Dress Protection
• Strategic Goals
• Certain Rights May be Limited to Specific Territories
• Other Issues (e.g. product leakage)

Intellectual Property: Define Rights

• Utility and Design Patents
• Copyright
• Trade Dress
• Trademark and Trade Name

Other IP

• Confidential and/or Proprietary (trade secret)
• Protecting Confidential Information

IP Prosecution, Maintenance, Defense and Enforcement

• Control
• Cost
• Protection against competition
• Managing IP 

Compensation Structures

• Royalty-Bearing License
• Fixed Sum Per Unit or Period
• Variable or Fixed Rate
• Based on Invoiced Amounts or Amounts Received
• Reductions, Credits, and Caps
• Bundling
• Licensees tend to only want to pay royalties on sales in markets where there is patent or other protection

Compensation Structures

• Upfront Payments
• Milestone and other Payments
• Based on sales levels

Compensation Structures

• Profit Sharing
• Net sales less cost of goods and enumerated expenses
• Can be more lucrative than royalties
• Enhanced decision-making posture
• Beware of sharing losses

Diligence

• Standards
• Best Efforts
• Commercially Reasonable Efforts
• Reasonable Efforts
• Internal Standard
• Performance Requirement
  • Minimum Sales or Profit
  • Minimum Royalty Payments
• Consequences
  • True-up
  • Convert to Non-Exclusive
  • Reversion of Rights
  • Liquidated Damages
  • Termination of Specific Rights or Agreement

Other Matters

• Indemnification
• Sublicensing
• Licensor Concerns
• Licensee Concerns
• Change of Control
• Non-Competition
• Governance and Monitoring
• Licensor Support
• Creative Business terms to close a deal

Termination

• Grounds
• Standard Termination Provisions
• Licensee Contests Validity or Ownership of Licensor’s Rights
• Commercially Unviable
• May Be Country Specific, Product Specific or Complete
• Other
• Effects of Termination
  • Reversion of Rights
  • Reimbursement of Certain Costs
  • Survival of Sublicenses
  • Access to IP and License to Use It

 Dispute Resolution

• Internal Escalation
• Non-Binding Mediation
• Binding Arbitration
• Judicial Intervention 

Other good input on royalty agreement strategy from this blog:

 

…licensing can be a good way to turn a tidy profit on a product if your expectations are realistic, and you take the time to learn the ropes.  It is an arrangement where a company pays you a royalty in exchange for the right to make, sell and use a product which you have patented.  Companies rarely license un-patented ideas.  On the other hand, the patent is worth only as much as the market and development research that underlies it.

Licensing can be a great way for an individual inventor to profit from an invention without risking a lot of funds up front to develop manufacturing and distribution capability. However, it is almost always less profitable than manufacturing a product.  The real rewards generally go to the party that has the financial wherewithal and is willing to assume the risk of actually bringing the product to market, as opposed to merely conceptualizing it. When you enter into a license agreement, you generally agree to take a small share of the profits from a product you let someone else produce using your patent rights. Manufacturing often yields profit margins in the 50% range.  A typical royalty is 2-5% of the sales price per unit.

The discussions you have with a prospective licensor in the early stages of negotiating a licensing agreement should center on the market for the product, and how close the product is to being ready for market. 

Usually, at the initial stages the inventor and licensee (e.g., manufacturer or distributor) review the projections of profits to be made and come to a sort of shared vision of the market. Remember, the manufacturer is taking a financial risk, in deciding whether to market this new product at all.  At this stage the inventor should build a sense that the economic interests are aligned and that this is too good an opportunity for the prospective licensee to pass up.  Bringing a visible, verbal lawyer in too early sends the wrong message. It can play into something we call the "greedy inventor" scenario, which can kill a deal.

The inventor should be careful to form a good relationship and come off as someone the manufacturer will want to work with at this stage, and possibly on future products. However, the inventor should not give up important legal rights by disclosing too much too soon. The inventor should be careful to check with an attorney before providing copies of patents, patent numbers, etc. at this stage. Unfortunately, some manufacturers lull inventors into a sense that a license offer is forthcoming, when really all they want to do is get information to design around the invention or get the inventors' market concept down. It is by no means the norm, but it happens.

Licensing is basically contract law, and the specialized aspect of a license is not so much the contract law itself, but rather the overlay of specialized practices to each particular industry. I am not aware of rigid or standard royalty rates in any industry for products, but I am aware of ranges. There are ascertainable ranges for royalties based on industry comparables, but royalty rates within these ranges truly depend on a variety of industry, competition, market and other factors unique to each product. It is the job of the inventor (or agent) to know and address these factors well in pitching their product, and to research comparable products. Advances and minimums (i.e., up-front payments before actual product sales) are negotiable but not standard, since these things depend on the leverage of the inventor and the risk the manufacturer perceives they are taking. Many license agreements do not offer them at all, and sometimes it is quite reasonable they do not.

With the understanding that all products, markets and stages of development are different, here are a few more tips for negotiating a license for an invention that is near-ready for market.

Consider leveraging interest expressed by one manufacturer to contact others. There is no prohibition on this. Don't drop off communications with the rest of the industry just because one prospective licensor has started a dialogue with you.  In fact, rev it up. Generating a sense of competition at this stage, when done appropriately, can help an inventor negotiate a higher royalty.  Plus not every deal goes through; it's a good idea to be in contact with multiple prospects. Consider non-exclusive and territorial licenses, and do not rule out the possibility of manufacturing yourself later, which means that the manufacturer will have to view you as a source of potential competition as well. (Manufacturing yourself, when possible, inevitably leads to higher profits.)  

Once the parties have a sense of the market, hopefully the inventor has done their homework. At this stage the inventor should:

• Know rates of royalty for similar products in the industry.
• Be prepared to argue why their product justifies a royalty at the high end of the range.
• Work with an attorney to identify additional points for negotiation such as actual payment terms, rights retained by inventor, etc

As the inventor, you should be prepared to make good, logical arguments based on facts and market analysis as to why their product justifies a royalty at the high end of the range. The Licensee/Manufacturer/Distributor will then make a counter offer, etc. Once the parties have reached a general agreement, a lawyer can look at the terms or draft an agreement to ensure that expectations are met and there are no clauses which will surprise the inventor unfairly down the road. Sometimes, there is an advance payment to seal the deal, but many times not. Inevitably, attorneys will look closely at the method for verifying the sales on which royalty payments are made and exclusivity issues.

Recommended Resources:

• Patent Licensing and Royalty Agreement
• Content Licensing and Royalty Agreement
• Licensing and Royalty Agreement Negotiating Tips
• Mutual Non-Disclosure Agreement
• Partnering Documents Kit (includes all of the above)