Rule of thumb, rule of paw: royalty fix or something more?

"Now where did I put that thumb ...?"

Not a great deal of material relating to the price payable for assignments and licences of IP rights ends up on this weblog, since it's often regarded as a dry topic -- particularly by litigation lawyers (who see it as too transactional for their liking), IP public administrators (since it's too far down the line from the mechanics of granting, renewing, cancelling registered rights to excite their professional concern) and law students (who do not normally have to answer questions on so marginal a topic).  That's why items on price negotiation are more likely to find themselves on blogs that deal with IP money issues, like IP Finance, or transactional topics, like IP Draughts.  However, once in a while it doesn't hurt to run a Katpost on the subject -- particularly where the content is not specific to any particular jurisdiction or field of commercial activity and is this of equal (ir)relevance to everyone.

The event that triggered this post was the fact of this Kat coming across "Agreeing a Price for Intellectual Property Rights", a relatively short, sometimes sweet and definitely green document published late last year by the UK's Intellectual Property Office as the fourth in the IPO's IP Healthcheck series.

The bit that caught this Kat's eye runs as follows:

"RULES OF THUMB

The 25% rule

In many negotiations the royalty rate actually agreed for a patent turns out to be somewhere between 25% and 33.3% of the licensee’s anticipated gross profits (before tax) on sales of products which use the patent. For a trade mark the royalty rate is more likely to be between 10% and 15%.

Calculating gross profits usually involves taking into account manufacturing costs, such as raw materials, labour and utilities, but operating expenses (e.g. costs of sales and general overheads), are usually ignored.

This is the case even though the value of the IPR to the licensee will be affected by its operating expenses. The more the licensee has to spend on things such as marketing, selling and customer support, the less valuable the IPR will be to it. A royalty rate which ignores this is unrealistic.

Most royalties are on net sales, so the 25% rule is adapted to give a rate on net sales. In sectors where profit margins are usually high (e.g. the software industry), the royalty rate will be correspondingly high; where profit margins are traditionally low, royalty rates will also be low.

Some negotiators will automatically challenge you if you depart from this rule of thumb, but you may have good reason for not sticking to it. You will only be able to counter a rule of thumb valuation or industry norm if you can justify your figures.

The 5% rule

In many sectors the average royalty rate based on net sales turns out to be in the region of 5%. This is an average and the figures which underlie it vary widely.

All rules of thumb ignore important factors such as the investment needed, the risks involved and the circumstances of the parties. Any rule of thumb should be no more than a starting point; it should not prevail over a more considered approach to IPR valuation, common sense and commercial acumen".

On the whole, this Kat has encouraged people of his acquaintance to avoid rules of thumb wherever (i) they have the time and the resources to do their own research into the nature, extent, elasticity, accessibility, spending power and durability of the market in which the licensed IP is to be commercialised or (ii) they have enough money to pay someone else to do that research. This means, in practice, that most people end up sticking to rules of thumb.  The worst case scenario is when they pay an expert to take the soft option of the rule of thumb on their behalf: this sometimes feels a bit like paying the bus fare but still walking home.

Another feeling which has discouraged this Kat from warmly embracing royalty rate rules of thumb is that -- though he has  no direct and immediate evidence -- they tend to be a bit self-fulfilling and self-perpetuating in that, when people are told that there's a sectoral rate, they tend to steer towards it (on this topic, see this Kat's recent post on IP Finance, here).

A third reservation which this Kat has is that we live in an era of rapid technological, social and cultural change.  Just think how we used to go shopping, do our banking, communicate with one another and occupy our leisure time back in the 1970s and 1980s and you'll get his drift.  Existing royalty rates, and rules of thumb that pertain to them, are historical in that they relate to conditions that existed that the past and which may no longer be appropriate for rapidly evolving changing conditions, technological convergence and so on. By being led by rules of thumb, we are walking forwards while facing backwards: is this wise, given that, in the field of innovations if nowhere else, we are by definition licensing the hitherto unknown.

This post makes no specific criticism of the piece cut-and-pasted below, since it is written at a level of distant and general abstraction which makes it improbable that anyone would use the advice as anything other than a starting-point -- but this Kat continues to wonder how best the issue of royalty rate negotiation should be approached.  Is there no way we can impart good advice which does not contain the words "rule" and "thumb"?