One thorny issue when negotiating a license for intellectual property arises when determining the appropriate royalty rate. Several valuation methods are available, although some may be ill-suited for intellectual property.
The business economic approach
The business economic approach is arguably the most appropriate method for determining royalties in the intellectual property context. It considers several economic factors, examining the subjective economic benefits and costs the licensor and the licensee expect to reap, as well as costs related to entering the agreement.
Among other factors, the approach accounts for:
- The degree of competition between the parties. Will the licensor and licensee compete in the same marketplace at some point? If so, the licensor likely will seek a higher royalty rate.
- The parties' alternatives. The potential licensor may be able to secure a different licensee or simply retain its exclusive use, while the potential licensee might be able to reverse-engineer the technology. The economic benefit of the proposed licensing agreement must be compared to the alternatives available to the parties.
- The parties' mandatory royalty levels. The licensor is unlikely to accept a royalty less than the projected lost profits tied to granting a license. Conversely, the licensee won't pay more than the economic benefit it expects from obtaining the license.
Traditional valuation approaches
Although they don't consider every relevant economic factor unique to intellectual property, several more traditional valuation methods may be used when valuing a technology license for royalty purposes.
The market approach looks at the royalties paid under comparable licensing agreements. The approach is easily applied but assumes an active market with sufficiently comparable technology. It also may be overly reliant on historical information, and it doesn't consider the effect of competition between the parties.
The income approach examines the technology's expected future contributions to the licensee's income, using one of two methods. The capitalization of earnings method focuses on the estimated contribution to income in the immediately upcoming income period, based on projected production levels, sales predictions or historical information.
The contributed income is divided by a capitalization rate. The discounted earnings method looks at the expected contribution over the technology's remaining useful life, typically several upcoming income periods. The contribution is converted to present value using a discount rate.
The income approach offers the advantage of considering the prospective economic benefits of the technology and the effect of capital expenditures. However, it may be too dependent on projections or overly sensitive to capitalization or discount rates. It also fails to account for competition between the parties or their alternatives.
The cost approach values the technology by determining the cost to replace or reproduce it. The replacement cost technique hinges on the cost to research and develop replacement technology, assuming the use of current R&D methods to possibly create improved technology. The reproduction cost technique turns to the cost to research and develop the same technology, assuming the use of the original R&D methods.
Either technique is easy to apply and useful when working with novel technology, but the approach doesn't consider the parties' alternatives and may not demonstrate the technology's full earning potential.
Additional factors to consider
Regardless of the valuation method chosen, several other factors deserve attention when setting a royalty rate, including the structure of the royalty payment. Many structural options are available: a lump sum payment; continuous payments based on units sold or produced, technology use, or revenue or cost savings; continuous fixed payments; or a hybrid.
Considering all relevant factors when valuing intellectual property and royalty rates can certainly help you determine which valuation method is right for you.
Jim Travis and Robert McSorley are executives with consults Crowe Chizek. Reach Travis at (630) 575-4250 or firstname.lastname@example.org. Reach McSorley at (312) 899-7006 or email@example.com.