An article written by Fortunat N. Nadima , Lawyer, Norton Rose Fulbright

Innovation projects are costly and risky, thus the need to sometimes partner up with others. Indeed, creators and innovators are not always the best suited to commercialize their intellectual property (IP) assets. It can be more advantageous for them to earn revenues from their innovations and IP assets by having a third party licensee invest capital and expertise, and share part of the risk to integrate them into viable commercial products, services or processes. Establishing such partnerships requires an understanding of how royalties work.

What is a royalty?

A royalty is a sum of money paid in exchange for the use of an IP asset. It is meant to reflect the value of an IP asset, based on the competitive advantage it is expected to provide.

Setting or negotiating a fair royalty is a complex exercise, for which one should consider obtaining the guidance of an IP professional.

There are three basic methods for valuing an IP asset: the cost method, the market method, and the income method. The cost method is based on the assumption that the cost to purchase or develop a new equivalent IP asset is in line with the economic value that the IP asset being licensed can provide. The cost method therefore assesses value based on the cost of replacing the IP asset with an equivalent one. In contrast, the market method sets a price based on the price of similar IP assets available on the market—assuming that such comparable IP assets exist. Finally, the income method focuses on the expected benefits from the incorporation of the IP asset into a product, service or process. In addition to these, more advanced quantitative and qualitative methods have been used to value IP assets.

All IP assets are not created equal. The valuation exercise must be tailored to the particular IP asset being licensed, which can be technical (e.g., patent, software code copyright), creative (e.g., copyright), operational (e.g., know-how, trade secret), or reputational (e.g., trademark).

The price is right

A question remains: How much? Setting a price requires assessing the value the creator offers against the risk and level of investment to be borne by the licensee (e.g., in research & development or promotion) to incorporate the IP asset into a viable commercial product, service, or process. The greater the licensee’s investment, the higher share of rewards the licensee will seek to retain.

Value is necessarily tied to the specific IP asset being licensed. Different types of IP assets share common considerations, including in terms of their lifetime (or period of validity) and the number of jurisdictions/territories in which it can be used and enforced. But they also raise distinct considerations. For example, it matters whether a given patent is vulnerable to being invalidated by a court, such that patents that have survived litigation against competitors can be perceived as “stronger” and therefore more valuable. The quality of the specifications of a patent is also important, and in particular whether competitors can easily work around the patent and whether the patent can serve as a basis for future patent applications that may extend the owner’s exclusivity rights. On the other hand, trademarks that are registered and well-known by consumers are generally more valuable than unregistered and lesser-known marks. Their value can also depend on how exclusive they are as well as the breadth of products and services classes with which they can be used.

A royalty price also depends on the scope rights granted as part of the royalty package. One can increase value by offering additional perks beyond the right to exploit the IP asset. For example, one could allow licensees to sub-licence the IP asset, offer technical assistance, or cover administrative and/or legal costs incurred to maintain or enforce the IP asset.

Matters of form and timing

The royalty itself can take many forms (e.g., a rate, a flat fee, or a combination of both). Indeed, some may prefer the royalty to be paid upfront (in full or in instalments), prior to any commercial use, while others may prefer that royalty payments be spread out over time and tied to the actual use of the licensed innovation.

Determining the appropriate form of royalty payment will depend on multiple factors, including your cash needs and the third party’s ability to pay. Here too, the nature of the relevant IP asset has an impact, for at least two reasons.

First, it affects the assessment of whether a rate or lump sum payment is most appropriate. A lump sum payment may be appropriate in certain situations, including when the licensed innovation consists in a know-how (e.g., data, technical information, processes or techniques). But setting a fixed price in the early development stages carries the risk of over- or underestimating the value of the licensed IP asset. For innovations tied to particular products or services, opting for a rate (e.g., based on gross or net sales or profits) may allow for a more accurate assessment and distribution of the value derived from an innovation. Some organizations, such as the Licensing Executives Society, provide useful information on licensing practices in various industries.

Second, the nature of an IP asset affects how long a creator can derive revenue from its commercial use by a licensee. Where the IP assets consist of trade secrets, one could potentially require royalty payments for as long as the innovation is used and the trade secrets remain secret. Yet if the IP asset can expire or be invalidated, one would need to consider more carefully how long payments will run and what would happen in the event that the licensed IP asset ceases to exist and the innovation is copied by other competitors.

One size fits few

When it comes to setting a royalty, there are several factors to consider. Choices deemed appropriate for one IP asset may not apply to another. And agreements deemed fair early in the development process may no longer seem so later when a marketed innovation exceeds or fails to meet expectations. This makes it all the more important to take the royalty-setting exercise seriously and get it right.