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Q. How do I establish an appropriate royalty rate for a property?

A. In the overall licensing world, there are four different methodologies used by economists to establish or set an appropriate royalty rate for a transaction:

  • Cost Approach
  • 25% Rule
  • Income Approach
  • Market Approach

The first three valuation techniques are primarily used for setting royalty rates in transactions that involve patent and/or technology transfer licensing. In these areas, there can be a vast difference between the types of properties being licensed, e.g., software, computer hardware, biotech, chemical processing methods, etc., as well as the way the licensee uses the licensed property. As such, there are aspects of virtually every technology licensing transaction that make comparing them almost impractical.
In the merchandising area, the market approach which is the approach frequently used in the merchandising area for setting royalty rates, particularly for “average” properties that are being licensed for commodity type products, e.g., T-shirts, board games, etc. This approach is, by far, the easiest to understand and to calculate. The “market approach” considers the rates charged in the market for similar types of properties and then compares the property to the overall market. It requires both an active public market, and an abundance of comparable properties. When considering average properties and commodity products for merchandising, both factors are widely present, and the resulting royalty charged will most likely allow the licensed item to be marketed at an attractive price point.
The challenge, of course, is to find truly comparable properties to compare or, for that matter, comparable products. For example, both STAR WARS and MEN IN BLACK are properties based on popular motion pictures, yet one commanded royalty rates significantly higher than the other. The reasons for this difference are attributable to several factors, including:

  • The strength of the property in the industry;
  • Whether the property is dominant in its industry;
  • The existence of an identifiable customer base;
  • The demographics of the audience;
  • The strength of the licensees that were brought onboard; and
  • The commercial history of the property.

So, how does one arrive at the “right” royalty rate for a property when licensing it for a specific product? For the experienced licensor with a long track record, the inquiry typically starts with looking at the last deal the property owner did for a comparable property and a similar product. In most cases, the licensor then will “adjust” that rate depending upon a number of factors unique to the specific deal, e.g., the licensee’s anticipated profit margin, the extent of the competition, the popularity of the particular property, the manner in which it is going to be sold, whether there are significant development costs in creating the products, whether the licensee will need to invest significant sums in advertising and promoting the product, whether the property is protectable, etc. In some instances, the desired retail price point may also be a factor in establishing the royalty rate.
Most property owners rely on published lists of average royalty rates for different types of properties/products. One such source is the book Licensing Royalty Rates 2018 published by Wolters Kluwer and authored by Gregory J. Battersby and Charles W. Grimes.
The following is a table of average royalty rates from such work:

 

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