How to Determine Royalty Rates

How do you determine a royalty rate when licensing a patented invention? This is a fairly difficult question to answer since it depends upon several factors. Generally speaking, royalties are based upon what the market will bear. But that perception is sometimes wildly different between an inventor and a licensee. Inexperienced inventors all too often get greedy and expect high royalty rates. They think that just because they have a patent, it is worth millions. Not true.

How do you determine a royalty rate when licensing a patented invention? This is a fairly difficult question to answer since it depends upon several factors. Generally speaking, royalties are based upon what the market will bear. But that perception is sometimes wildly different between an inventor and a licensee. Inexperienced inventors all too often get greedy and expect high royalty rates. They think that just because they have a patent, it is worth millions. Not true.

Think about this, if you are asking for a 10% royalty, you are essentially asking for an equal amount of income as the licensee’s profit margin! A licensee will usually have a 10% profit after all costs are deducted.if even that. And the licensee is the one that must invest substantial money, time, people resources and so on, as it creates the market and builds sales and inventories. Doesn’t it seem absurd that the inventor would want as much profit as the company that is really taking all the risk? Asking for high royalties usually-and irretreivably-kills the deal. So, what’s reasonable?

Keep in mind that royalty rates tend to vary depending upon the industry and type and number of intellectual properties being licensed. The toy industry may vary from 5% to 15%, but is trendy so the earnings may be short-lived. Housewares, appliances, electronics and hardware may vary from 1% to 7%. The packaging industry tends to fall between 1% and 5%. Tools and sporting goods tend to be between 3% and 10%. Automotive aftermarket about 3% to 8%. Gimicky infomercial products may be much higher, as great as 20%. But they’re usually dead in a few months. The pet supply industry and baby goods will tend to be between 5% and 10%, with sales in lower volumes. Computer software tends to have royalty rates as high as 25%.but the life cycle is usually very short-lived. In most every field, there are too many variables to have “one standard rate for all”.

Some well-known royalty rate examples include Disney’s and Warner Brother’s copyrights, which have a 5%-7% royalty for most of its products. Michael Jordon gets 17% for his product endorsements. But these are well-known names. Are your creations as sought after as theirs? On the other hand, licensing something for as little as 1/100 of 1% may be extremely profitable due to the high volume. An example is the flip top opener on aluminum cans that stays attached to the can. The annual royalty earnings were well into the tens of millions. Or, how would you like to have been the inventor of the blinking cursur used on computer screens at 1 cent per unit? Generally speaking, products that sell in high volume will have much lower royalty rates than those in lower volumes. But the earnings can get quite interesting. In contrast to the high volume of the flip top can is the Ant Farm, which has supported a 20% royalty with its year-in, year-out, annual sales of $1 million. The anticipated sales volume of a new invention/product is one key reason why royalty rates tend to vary so widely within an industry.

There are other factors to consider as well. How easy is it to design around your patent? How broad is its scope? Will it support an invalidity challenge? Do you have one patent or several? The more patents you have, usually the more secure your position and perhaps the more you may be able to charge. If patent protection is weak or easy to design around, no one will want to license your inventions/patents.at any royalty rate. The same goes for any patent that is of only minor improvement over existing products.

Another factor is based upon the basic economic theory of price elasticity. A 2% higher price on a commodity product is usually enough to put that commodity out of the 99% sales category. In other words, the product that cost 2% more is likely to be virtually shut out of the mainstream market in which it competes! This holds true for many products such as plastic resins, well-established wood and paper products, metals, trash liners, fruits and vegetables, bread and milk, automobiles (sold by different dealers) and even computers (to a lesser degree). So it is important that a new invention and its accompanying patent(s) do something wonderful to the product that will make customers want to pay more. And keep that royalty low.very low with commodity products. As low as ½% or less such as the flip-top can patent. Higher royalty rates for a commodity-oriented product may only be warranted if you have developed a new concept (for instance a new high-output process) that can replace an existing commodity product and reduce costs by say 10% or more.

Of the many inventors I have met over the years, I can say that most of them agree that a median royalty rate would be about 3%. Also, you can ask your potential licensee what they think would be fair. If the company has licensed other technologies, it will be able to tell you what some of the standards are. One thing you may also consider is a sliding royalty rate. Start with a higher rate for lower volumes and a declining rate as the sales volume increases. For instance you might have a rate of 5% for sales up to $1 million, then 4% for sales from $2 to $4 million, then 3% for sales from $4 to $8 million and 2% for sales over $8 million. This also serves as an incentive for the licensee to really go out there and make things happen.

Another factor that can play a part in determining the royalty rate would be based upon how much up front money you receive. It is just like a mortgage on a house-you can buy down the rate with an up front fee. So can licensee buy down royalty rates. Keep in mind that an exclusive license will probably command a higher rate than a non-exclusive license. And if there are more than one licensee, you will probably have some special favorable rate for the first one since it is investing more time and money during the initial start-up and marketing phase.

In addition to up front money, consideration for a lower royalty can also be given a licensee if he is willing to pay all your costs for R&D, patenting, traveling expenses and so on. With exclusive licenses, consideration may include the licensee’s defense of the patents if infringed or if there is an invalidity challenge. Make sure that you share in some of the profits in the event such a suit takes place. Usually this is a good incentive since you can only sue for lost royalties, whereas a licensee can sue for lost sales! In other words a lot more money!

What is usually more important than royalty rates, is to make sure your licenses have performance clauses that the licensee has to meet, or else the license-if exclusive-is voided or perhaps made non-exclusive. And of course, immediate retribution if royalties and their accompanying reports are not received on time. If you are selling your patent as a condition of a purchase agreement or a license, never assign it until you have been paid in full. It is like the mortgage to the ranch. You wouldn’t want to deed it over to someone after they have only paid the down payment!

–Bob DeMatteis
inventor/author

You can learn more about licenses and licensing in Bob’s book, From Patent to Profit. It will help point you in the right direction. Available at PatentCafe’s
Bookstore
.

About Bob DeMatteis (5 Articles)

You can learn more about licenses and licensing in Bob’s book, From Patent to Profit.