Search

site map

IP Handbook Blog

Your source for expert commentary on IP management issues.
Go to the blog

About

MIHR

PIPRA

Fiocruz, Brazil

bioDevelopments-   Institute

Home > IP Topics Index > Evaluation and Valuation of Technologies > Pricing the Intellectual Property of Early-Stage Technologies: A Primer of Basic Valuation Tools and Considerations

Pricing the Intellectual Property of Early-Stage Technologies: A Primer of Basic Valuation Tools and Considerations

Editor's Summary, Implications and Best Practices

Abstract

This chapter introduces technology managers to certain key issues and to six methods of valuation and pricing. The value of a technology to a buyer (licensee) depends upon how it is to be commercially employed, taking into account the cost of development, the time the technology takes to generate returns, the extent of such financial returns, and the risk involved in the process. At the time of a licensing/sale transaction of an early-stage technology many, perhaps all, of such factors need to be assessed and quantified by making judgments about how the future will unfold with respect to the technology being developed. This assessment and forecast assessment are the essence of all pro forma business models. Valuing license rights for early-stage technologies is in this sense no different than making other future business forecasts, though the details may differ because the forecast time horizon may be longer, the uncertainties may be greater as to the market size and profitability, the operating performance of the technology as it will be used in commercial operation may be less well defined, and other factors. The price paid for a technology transferred between parties is the amount of money (present and future) and/or the financial value of noncash assets given in exchange for the transfer of the technology, which can only occur if both the seller (licensor) and buyer (licensee) have by some process reached a common, present understanding of value that makes agreement possible.

A key consideration in valuing a technology and arriving at a price is determining what is to be provided or transferred between the parties. This may include exclusive or nonexclusive rights to specified patents, know-how, and copyrights (IP [intellectual property] rights), technical data, rights to future-seller improvements, rights to sublicense, and the like. The price can consist of any combination of a variety of types of consideration, including running royalties, fixed payments, common stock (equity), R&D funding, lab equipment, consulting services, grant backs, or access to other proprietary buyer resources.

Although sometimes used, cost-basis pricing is a poor basis of valuation, because it fails to consider a technology’s value based on future commercial applications: the market pays for value to be received, not the cost to create. This chapter introduces and explains six methods for valuation and pricing that are based, to one degree or another, on the market’s expectation of value.

• Method I: The Use of Industry Standards Method looks at the range of published royalties (and other forms of payment) from technology licenses within an industry category and uses that information to guide valuation of a technology currently under consideration.
• Method II: The Rating/Ranking Method looks at several existing license agreements for similar technologies, comparing and ranking a technology currently under consideration against the existing license agreements in terms of stage of development, scope of IP protection, market size, profit margins, and other such factors.
• Method III: The Rules of Thumb, such as the 25% Rule (and Other Rules) Method, which apportions anticipated profits from the commercial use of the technology between the seller and buyer.
• Method IV: The Use of Discounted Cash-Flow Analysis with Risk-Adjusted Hurdle Rates Method seeks to split expected returns but adjusts basic profit and loss accounting terms to take into account the timing of investments and returns and the risks borne by both parties. The method introduces a discussion of the different possible structures of payments that are possible, as they affect both timing and risk.
• Method V: The Advanced Tools Method applies statistical methods, such as Monte Carlo simulations, to discounted cash-flow models to test the influence of various value assumptions and license terms on the possible outcomes of a deal.
• Method VI: The Auctions Method allows interested parties to bid on the technology, based upon their own independent efforts at valuing the technology, thus comparing their respective valuations, identifying the highest valuation, and striking a price based on that highest valuation.

Preface

Although we will consider each of the valuation methods one at a time, doing so does not suggest that only one method is to be used in any given valuation, nor does having six methods mean that all should be used in every situation. Depending on the circumstances it is likely to be advantageous to consider more than one method in any particular valuation. Yet, not all methods work equally well in all circumstances, and there is always the practical consideration of the commensurate level of valuation analysis appropriate to the magnitude of the potential licensing opportunity.

The context of the valuation and pricing discussed in this chapter and with the valuation methods is licensing (sale) generally known as opportunity licensing, as distinct from licensing in litigation contexts. In litigation matters there is normally a very narrow focus on certain claims of certain patents that have been infringed as of a particular date with respect to specified products and which patents are known to be valid, enforceable and infringed. On the other hand, opportunity licensing of early-stage technology is normally performed prior to a licensee’s commercial use, includes deal elements other than a narrow enumeration of certain patent claims, and anticipates the potential future use for a range of products, applications, and markets.

This chapter is necessarily a short introduction to a complex subject. The author has written three published books that give a much fuller treatment of these valuation and pricing matters than is possible here. Two of the books are currently in print and available from online sources such as Amazon^® and are recommended for those who are charged with valuation and pricing of technology.

• Valuation and Pricing of Technology-Based Intellectual Property, Dr. Richard Razgaitis, published by John Wiley & Sons, 2003.
• Dealmaking Using Real Options and Monte Carlo Analysis, Dr. Richard Razgaitis, published by John Wiley & Sons, 2003.
• Early-Stage Technologies: Valuation and Pricing, Dr. Richard Razgaitis, published by John Wiley & Sons, 1999 (now out of print, and supplanted by the 2003 valuation and pricing book).

Finally, the views expressed here, as in my above writings, are solely those of the author, and are not intended to represent the views of CRA International or that of any professional society of which I am a member or officer.

1. Introduction

One of the most interesting and challenging tasks facing a licensing manager is determining the value and price of its specific opportunities. This chapter provides an overview of useful tools and methods for this purpose and offers general observations on licensing practices.¹ Because each valuation situation depends on numerous, case-specific factors, such generalizations may not apply universally, so readers are encouraged to be cautious when drawing parallels or imagining similarities.

Pricing, of course, is a crucial issue in the commercialization process. The customer for early-stage technologies can be viewed as a value-added reseller. Resellers will be induced to buy (license), if and only if they believe that they can conduct all the value-added activities needed and sell the result to their customers at a price significantly greater than what they paid to acquire the rights.

When selling rights to early-stage technologies, there are (usually) significant uncertainties facing both the owner of the technologies and the licensee. These uncertainties include important issues such as:

• Does the technology really work in a production setting as opposed to inside a cloistered laboratory?
• What product development and manufacturing activities will need to be conduct-ed—and at what cost—to bring the technology to commercial maturity?
• Will there be any commercially valuable patent protection to bar copycats?
• What product do end users really want from the technology, and how much will they be willing to pay?
• What regulatory requirements will need to be satisfied?
• How much better is this technology than what is already available?
• Will competitors develop an even better way of meeting the end user’s needs?

One way to begin to get around the pricing issue is to use royalties. The advantage of the royalty (and equity) concept is that it spreads, to some degree, these uncertainties and risks between the parties. Under a royalty (or equity) arrangement, technologies that ultimately become wildly successful in the marketplace will return high financial rewards to both the licensee and the licensor in some direct proportion to the degree of commercial sales achieved. This helps remove some of the anxiety of determining the right price—but not all of it.

Technologies that lead to highly profitable outcomes for a licensee typically warrant a higher royalty rate on behalf of the licensor. Similarly, smaller returns (with all relevant factors considered) warrant a lower rate. By fixing a royalty rate, an equity split, or any combination of royalties and equity, the technology transfer manager is apportioning the total financial reward between the creating organization and the commercializing organization. That split should depend on the relative value-creating contributions of both parties.

Determining a fair royalty depends on a present understanding of the commercial use and economic impact of the licensed technology. From this perspective, it is better, when feasible, to defer setting the royalty rate to the time, or closer to the time, of commercial introduction. When licensing early-stage technology, this means that the license or option agreement would leave the royalty rate unspecified. The parties would commit to engage in good-faith negotiations on this matter at a later date, preferably when a projected income statement based on more robust market and manufacturing projections was available.

But prospective licensees generally look at this approach with disfavor. They argue that the royalty rate is an important factor in reaching a decision about licensing the technology in the first place. Further, the licensees argue that they cannot commit substantial product- and market-development investments and risk facing a carnivorous licensor seeking unreasonable compensation at the eleventh hour. And there are also some good reasons why a technology seller might not prefer to defer royalty negotiations. Depending on the final royalty values, the seller might have elected to pursue a different commercialization approach (taking equity in a spinout or pursuing industry-wide nonexclusive licensing) or to find a different licensee willing to pay more for the opportunity.

Further, if a market window has closed, a reversion of rights back to the seller because of an inability to agree on financial terms may be of little business value. Clearly, it is in the interest of both parties to conduct royalty negotiations based on accurate projections of a license’s economic impact. Agreements reached before the impact is known are more likely to be disappointing to either the licensee or licensor. A disappointed licensor will normally not have any recourse as long as the licensee fulfills its end of the deal. A disappointed licensee, however, can come back to the licensor and threaten to drop the license unless it gets some relief from a royalty rate that the licensee later perceives as too high. The licensor can decline such a request, but it could be put in a difficult bargaining position because of the cost, delay, and risk associated with finding another licensee, and because the term of years remaining under the patents may have been reduced significantly while in the hands of the original licensee. A royalty rate determined well before commercial introduction can thus be viewed as a royalty cap by the buyer, regardless of what is called for in the agreement. Of course, the buyer cannot count on a seller agreeing to such a downward renegotiation in royalty rate; the buyer may face the choice of proceeding to commercialization under the agreed terms, or dropping its license and losing its own investment in the technology.

Parties seeking win-win arrangements should seek ways to make these negotiations as fair as possible, even while each party is looking out for its institution’s interests. This requires as much economic information as possible and some tools for using that information. Presented in the sections below are tools and considerations in determining such splits of the commercial reward. To set the stage, consider the following excerpt from an actual letter received by a venture capitalist:

“… we are asking for Forty Million Dollars ($40,000,000), which will provide the capital needed …. As planned, at the end of the two-year period, we will have ramped up to 100% with an expected pre-tax profit of $211,832,258. ”²

Now, is this a good deal? Even more importantly, what methodology could be used that would lead to a fair price for such an opportunity and form the basis for a rational decision?

Although the general principles in this chapter apply to both a licensee (buyer) and a licensor (seller), this chapter primarily looks at these matters from the point of view of the licensor. The form of an agreement is not detailed in this chapter; many differing approaches as to royalties and equity are possible. This topic is sufficiently complex to warrant coverage in other chapters in this Handbook.³

2. Getting Started

Prior to delving into this discussion, it is helpful to review the definitions of two key, related terms.⁴

• value: an amount considered to be a suitable equivalent for something else
• price: the sum of money or goods asked or given for something

In this chapter, price will mean the quantification or specification of value. Price should be the expression, in monetary and other forms of consideration, of what the technology manager believes is an appropriate starting point for discussions and ultimately represents a fair exchange for the institution’s willingness as a licensor to enter into a commercial agreement.

This requires that the technology transfer manager determine, from the outset, what the institution is willing to provide as its end of the bargain. Table 1 summarizes ten sources of value, from the perspective of a licensor of early-stage technologies.

Item No. 1 is the key source of value provided by the licensor for a typical early-stage technology agreement—the right to practice the technology described by the intellectual property (IP). The licensor may also provide something within the categories of Item Nos. 2, 3, and 4. Item No. 5 is usually a left-pocket/right-pocket grant: if the licensor agrees to pay the patent costs for the licensee, then the licensee reimburses the licensor for these costs, dollar for dollar.⁵

From the perspective of licensors of early-stage technologies, Item Nos. 6, 7, and 8 are strictly the responsibility of the licensee and are, thereby, not part of what is granted. Although the costs associated with these boxes may be small on average, the risks of a very significant cost associated with them on a given deal are both so large, and primarily or solely under the control of the licensee, that it is imprudent for a licensor to bear them (this is discussed in greater detail in Section 6.4).

The last two Items, Nos. 9 and 10, may involve the licensor in some way; most often, however, the licensor will grant only a willingness to assist the licensee in these activities on a cost-reimbursement basis.

Generally, therefore, the licensor of early-stage technologies is offering Item No. 1 and, possibly, Item Nos. 2–4. Within each of these boxes, figuratively speaking, are yet smaller boxes that further define the contents of the grant. For example, in Item No. 1 the license may be exclusive for all fields and territories for all patents in the technology package, for a specific application, for a specific territory, for a specific term (such as five years, after which time the licensor can license others), or exclusive but for one other licensee (a limited exclusivity, sometimes referred to as a second-source approach), and so on in a limitless array of possibilities and combinations. Each of these options will have a different economic value; accordingly, each should bear a different price. Such issues are sometimes referred to as aspects of value (see Section 6.2).

As the licensor, a technology transfer manager needs to determine what boxes (and contents thereof) the institution is offering as its package.

It is a very good practice to document the contents of the package in some detail for internal purposes, and perhaps in a more succinct fashion for initial discussions with prospective licensees. For example, part of a licensing package could include product prototypes or customized test or development fixtures, as well as data unpublished or not yet published that provides additional information on potential applications, costs, or areas of potential improvement.

Similarly, the technology professional should document in detail what the institution is seeking from the licensee as fair exchange. Some items to consider in determining this exchange are:

• royalties (often termed running royalties)
• other cash payments (an upfront cash payment, progress payments, or annual minimums)
• common stock or partnership interests (as partial or total offset for royalties)
• R&D funding at the institution to advance the technology or other R&D objectives
• lab equipment
• consulting agreement(s)
• improvements to inventions (so-called grant backs)
• access to proprietary and/or technical data related to the invention

There is a long list of sources of consideration that the institution may wish to seek from the licensee. By thinking through these items and writing down those that are desirable from the institution’s point of view, the technology transfer manager can develop a rational framework for expectations. From a negotiating perspective, following this process can prevent the institution from being perceived as a nibbler: that is, an organization that is always thinking of something more that it should get for the deal.

3. The Context of Pricing

The seller’s pricing expresses belief about value. Such belief arises from considering the innate economic benefit associated with the use of the technology being offered, the competitive alternatives available to a prospective buyer, and an overall negotiation strategy.

As mentioned earlier, there are an unlimited number of combinations that could be agreed to by the licensor and licensee. It is impractical to price all these combinations and offer a price list. Instead, a price is needed for what is considered to be a basic deal that is of interest to the institution and that the technology manager believes will be of interest to a licensee.

In the process of discussing an opportunity with prospective licensees, a licensing professional will learn that there are different items that each licensee wants and different values that each licensee places on what it has to grant (surprisingly, not all companies view money the same way; there can be a big difference between funding R&D and upfront cash, or between upfront cash and royalties, and so on). As new information is learned, the technology transfer manager should be prepared to reenter the pricing methodology and reconsider assumptions and elections. The technology transfer manager will also learn about the competitive alternatives that prospective licensees have use of the institution’s technology. At the same time, the manager will analyze the institution’s alternatives should the licensee say no.

In a free market, all participants can decide what they think a product is worth and communicate this to others. From this process, the technology transfer manager should be able to learn relevant facts that may cause the price to be reassessed. It should be remembered that participants in a free market do not consider themselves compelled to communicate what is good or undervalued about what the institution has to offer. In most instances, a technology transfer manager will only hear (or primarily hear) the bad news related to a product; some of it may be true, and some may even be relevant.

Negotiating strategy is also important. Although this subject is outside the scope of this chapter, two pricing negotiation-strategy poles illustrate the significance of negotiating strategy:

• fixed-price seller: The seller has made a best effort at determining a value that represents what it believes is a fair value to both parties. This price is its bottom line, and it offers the product to all prospective buyers as a here-it-is, here-is-what-it-costs, take-it-or-leave-it proposition.
• price maximizing seller: The seller seeks to identify only those prospective buyers who express interest in the opportunity, which is initially priced at or near the maximum reasonably conceivable value because it is expected to be adjusted downward, perhaps substantially, due to the back and forth of what are likely to be extensive negotiations.

There is, of course, a continuum of perspectives between these polar positions. The fixed price approach (as an idealization), has the appeal of deal simplicity and speed, but may have as its result (a) no buyers and therefore no deal or (b) a deal with a buyer who would have been readily willing to pay more had it just been asked. The price-maximizing approach is really about a seller offering some flexibility on price and deal elements to attract potential buyers to engage in a negotiation that leads to mutual learning. In some respects this second approach could be better described as the deal-probability-maximizing approach because it offers an adjustability of pricing and deal elements not available in the fixed-price approach. However, the initial pricing of this second approach has to be within a range that buyers can conceivably find reasonable; otherwise buyers can be dissuaded from even initiating due diligence. The most important point to remember is that pricing is a process, not a one-time event.

4. Cost as a Basis for Price

Cost is a very poor basis for pricing, although it is sometimes used. To get a sense of using cost of development as the deal price, consider the following: suppose an institution and its sponsors have invested $10 million in a particular technology that at long last has been determined not to work well enough to be used commercially. What are the chances of going out into the world of commerce and saying: Have I got a bargain. Because this technology doesn’t really work, we are not going to ask for any profit. It is yours for only the $10 million we have sunk into it. The market will not value what the institution paid to develop the technology, not because it is unsympathetic to the institution’s investment (and plight), but because what is important to the market (the buyer) is the value of the product, not the costs of development. If the product does not work, it has no value. What the institution has invested in its development is gone.

Consider the other extreme: An individual buys a lottery ticket for $1. It turns out to be the sole winning ticket in a $10-million lottery. Now, someone shows up and says: I’ll give you $2 for your winning ticket, which will double your money. Is this a good deal? Again, the cost of the lottery ticket is irrelevant in this example. Rather, its worth after selection is what some willing party would pay to gain the benefits of ownership. For all the losing tickets together, no rational buyer would pay even a dime. For the one winning ticket, in this example, a rational buyer would offer millions of dollars, but not more than $10 million.

In the world of manufactured-commodity goods, costs and price are often closely related. Historically, pricing in such circumstances was determined by multiplying the costs of manufacture by an industry-standard multiplier. A typical historic multiplier was simply the factor 2, so the price would be double the cost of manufacture.⁶

But in the case of high-cerebral content products, such as intellectual property, cost is an inappropriate basis. If Picasso was alive and you approached him to buy a painting, would you ask: What did it cost you to make this painting? Consider another example. The late Sammy Cahn received (it is believed) approximately US$40,000 for granting the producers of the movie, Die Hard II, the right to play his song “Let it Snow” in the movie’s opening scenes to set the mood for the holiday season. Cahn had sold rights to “Let It Snow” many times. Cahn did not write any new music for the movie; he probably did not even provide the producers a copy of the sheet music. So what did the producers get for their $40,000? They bought merely the right to use something already existing. How was the $40,000 determined? That is what the two parties dealing at arm’s length said it was worth, not an amount based on a person-hours of labor calculation as Cahn’s appropriate value for the rights to use the song.

The market pays for value, not cost. In retail software sales, the actual cost of the CD, the manual (if not on the CD), and the packaging is typically less than 10% of the price. Why are software companies seeking and able to sell their products for more than 10 times their costs? The answer again is that it is value, not cost, that the market buys.

Cost, however, does come into play when considering a prospective licensee’s alternatives to entering into an agreement. A prospective licensee could seek to develop its own technology by inventing around the institution’s protection to accomplish the same purpose. If the prospective licensee was convinced that it could do so in a very short period of time with a parity outcome for, say, $1 million, then the licensee would reasonably determine that the institution’s technology was not worth much over $1 million, which is what its costs would be to get what the institution has without buying what the institution is selling.⁷

When it comes to cost, it is the costs for the prospective licensee that are considered. Whether the seller’s costs for developing the technology were $10 or $10 million is basically irrelevant. Another important, usually misunderstood, point is how to determine the seller’s costs. In the lottery ticket example, the costs are easily known—it is printed on the ticket. But in the case of technology development, such costs are very difficult to estimate. Consider the variety and range of questions to be answered: Have we collected all the direct costs back to the very beginning of the development? Do we even know how to define the beginning? Did we include the value of all the contributions made to the project by products, services, insights, intellectual property, and so on, that were contributed at no recorded cost to the project? Have we excluded costs associated with development efforts that are not being offered to prospective licensees? Have we deducted “bad judgement” costs (which no reasonable R&D program should have spent)? Or should such “misspent” costs be recognized as a natural part of R&D? When parties talk about the seller’s costs, they are usually talking about a number residing in some seller cost account used to track certain kinds of investments, and not the result of a carefully considered analysis of all the activities and value invested by the seller.

5. Pricing Methods

If cost is not a good way to determine price, what is? Sections 5.1–5.6 of this chapter consider methodologies for answering this question. These methodologies include:

• Method I: The Use of Industry Standards
• Method II: The Rating/Ranking Method
• Method III: Rules of Thumb, such as the 25% Rule (and Other Rules)

• Method IV: Use of Discounted Cash-Flow Analysis with Risk-Adjusted Hurdle Rates
• Method V: Advanced Tools
• Method VI: Auctions

The goal of these following discussions is to develop tools and thinking. Producing an “answer,” to the question posed at the beginning of this section is not the goal of this discussion, because the world of technology rights makes it impossible to determine a price in the abstract.

5.1 The Use of Industry Standards Method

Having dismissed cost as a basis for pricing, the next most logical approach is to use industry standards; the reason for this is that such an approach serves decision makers well in many other areas of experience.

Suppose you want to rent office space. The coin of that realm is commonly expressed as dollars per square foot per year (DSFY). Ranges for DSFY in the United States are from about US$1 to more than US$50. However, when consideration is restricted to a particular city and a region within that city (downtown/prime, downtown/ periphery, outer belt, suburbs, inner-city warehouse district, and so on), the DSFY range will shrink remarkably, say to US$6 to $12. Then, when one further specifies level of amenities (Bigelow^®carpets versus linoleum), and what is included in the rate (utilities, janitorial services, parking, security, partitioned office layout versus open and bare) the range narrows even further, say US$10.25 to $11. So it is with many other goods and services, from haircuts to paper clips.

Why can’t this approach work for rights to early-stage technology? The problem is primarily the absence of a track record for comparable products bought and sold under known (or knowable) terms. In the office space example, there are many properties, many buyers (lessees), and many sellers (lessors). This results in many transactions of relatively standardizable terms agreed to by parties that had numerous alternatives to entering into the agreement, which were considered and evaluated before signing. It is the tangibility of what is purchased, the frequency of purchases, and the public knowledge of the purchase that makes it possible to apply industry standards.

In the case of early-stage technology licensing, it is often unclear what products can or will be ultimately introduced. The number of similar transactions on which to determine price are too few, and frequently it is impossible (or difficult) to know what price other licensees/licensors have paid in similar deals. Nonetheless, there does exist some public and private data on early-stage-technology licensing and in many instances something useful can be learned from it.

One example of published financial data for licensing agreements is that obtained by surveying. Among the more famous examples are tables published based upon transactions between a Japanese company and a non-Japanese company. Prior to liberalization of Japanese foreign exchange regulations in the 1980s, foreign parties licensing technology to Japanese parties were required to receive government approval of licensing terms. The Japanese government published annual statistics related to licensing. A typical table is shown in Table 2. In some respects, this table is more complete than most since it includes upfront payments and minimum royalties. As is typical of such tables, there is a frequency of occurrence entry for selected royalty-rate ranges for each of several categories of technology licensed. The best way to assess how useful such a table might be is to think about how its existence would lead a technology transfer manager to reach some decision about the price of something.

Consider the pricing of a medical device such as a blood glucose monitor. Reviewing Table 2, the closest category is probably electrical, but is this really what was meant by electrical? What does this table reflect for upfront payments? Half of the agreements contained a provision for up-front payments, and half did not.⁹ Now what? What guidance does this table give about whether to have such a payment and its amount? What is the modal (most common) value for running royalties? None! Now what? Should the royalty be priced at zero? The percentage of cases the royalty was negotiated within the shown ranges can also be determined using Table 2, but where does the institution’s product fit? Finally, look at the minimums row. What can a technology transfer manager do with this information?

The problem is actually even worse. The agreements that comprise the table each included a whole panoply of exchanges, only some of which were summarized in Table 2. How can a technology transfer manager shrink all of these different considerations down to just one number, a royalty rate, and compare the institution’s opportunity with these published outcomes? Further, there can be instances of royalty base ambiguity. Staying with the hypothetical medical-device example and our bold assumption that “electrical” data may have some relevant teaching, we can envision instances where the entire device being sold is covered by the licensed subject matter, whereas in other cases the license could be about a limited feature or function within a much more extensive device. In such cases, how was the royalty-rate data used by the parties? Did they agree in both of these cases to use the selling price of the complete medical device, or did they in the second instance agree to use as the royalty base some smaller amount than the full selling price of the device because of the limited application to a single feature or function? There is no way to tell from the table. There are also other concerns about this table. It is limited to technology transferred into Japan in the early/mid-1970s. And what relevance would these rates have for licensing technology to be used in the U.S.?

A more recent industry standard survey is available, which also offers more distinguishing categories.¹⁰ One of the tables is shown in Table 3—does it provide the technology office manager more useful information?

Again, use the test. How would this data help a technology transfer manager make a decision? Consider the categories of pharmaceuticals, general manufacturing, and other. Each royalty-range category has an entry for each of these. Unfortunately, all that can be discerned is that most royalties are in the range of 0%–10% and that pharmaceuticals are generally higher than manufacturing. One wonders about the category of telecommunications. Does this mean that all royalties for this industry fall in the range of 10%–15%? (No, as it turns out: there was only one survey respondent.) The paper from which Table 2 has been prepared contains a lot of good information, but a technology transfer manager should recognize its limitations as a guide for setting a royalty.

None of this discussion is intended to disparage the efforts of those gathering and publishing this data. Determining effective ways of

valuing (pricing) technology is extremely difficult, and this author cherishes every scrap of information found. Everyone’s efforts to extricate and publish anything that might help technology professionals in this valuation process are applauded. The goal here is simply to caution the reader about the limitations of using industry standards for setting royalties and other license considerations.

Let us now consider, as examples, other sources of financial information about license agreements. The references that follow should not be taken as recommended norms or standards, but illustrations of information that can be found by investigation.

Lita Nelsen of M.I.T. has published a table of standards that is an example of more useful data than the above broad Japanese license agreements. The table below represents a narrower class of licensors (M.I.T. and similar universities) and provides a narrower distinction of categories as well as a narrower range of typical royalties. A recast version of data she has published is shown in Table 4.

Clearly Nelsen’s data covers wide ranges in royalty rates, from 0.1% to 20%, a factor of 200. Even within one category, the range between the high and low ends can be a factor of five or more. Further, it is likely that there exist “outliers” from such ranges that M.I.T. would license at rates below the bottom end of the range and perhaps, for major breakthroughs and extensive IP portfolios, may expect values above the top of the range. The data illustrates another trend that appears in other examples: those products and industries with traditionally high operating margins (profits), such as pharmaceuticals and software tend to exhibit higher royalty rates compared with, say, the materials industry.

Other authors have published tables of royalties for the purpose of establishing reasonable expectations of both licensors and licensees. Table 5 is a table published by Corey and Kahn for the medical industry.¹²

The table’s context is well defined (early-stage technologies out of research labs), the categories are comparatively precise (diagnostics in vivo), and it includes guidelines on up fronts and minimums. However, note that there is an important economic difference between the ends of the royalty ranges given: 1% versus 3% or 2% versus 10%, and so on. Unless the technology transfer manager understands where the institution’s opportunity fits in the range identified, it is difficult to know where to begin. Further, not every opportunity falls within even these broad ranges. Some opportunities will have only negligible value; others could be unusually valuable opportunities.

Tom Kiley has published another medical industry table that deals with exclusivity granted (Table 6).¹⁴

Kiley appears to suggest that for nonexclusive rights, the royalty should be about half of the exclusive royalty. (See section 6.3.2 for more on the 50% rule.) According to Kiley, inventions in support of a pharmaceutical (drug) warrant higher royalties (7%–15%, as his generalization) than drug delivery, diagnostic and therapeutic monoclonal antibodies (2%–7%), perhaps reflecting another two-to-one ratio.

Published price lists are another source of industry standards for pricing. Sometimes a company simply announces its royalties. One example, shown in Table 7, was published by one licensor for nonexclusive licenses for its LCD display patent.

Another example of such published rates is, or was, IBM’s licensing terms. In the 1980s and early 1990s, IBM established a licensing practice—essentially a price list—that offered to license essentially all of its 34,000 patents worldwide for a 1% royalty each for computer uses (patents only, nonexclusive only), up to a maximum of 5% for all 34,000.¹⁷ This practice does not establish 1% as a minimum per patent royalty; rather it reflects IBM’s practice at one time that a licensee can choose any one from IBM’s massive portfolio for a rate of 1%, any two for 2%, and so on. Further, because IBM does not make public its license agreements it is unknown what payment structure or amount was finally agreed to with licensees.

The main point about the LCD and IBM examples is that such published lists can lead to-expectations and, to the degree that the opportunity the technology transfer manager is pricing fits any published examples, this may influence the thinking of prospective licensees. In some cases, such proposed pricing can create a widely accepted norm in the respective industry, making it difficult for the seller to price above such a norm if the subject matter is perceived to be in a similar category. Licensees, like licensors, look to this method of industry standards (or norms or comparables). However, they may look to a different population of examples such as their own internal catalog of extensive deals that they have completed in the past to establish their expectations for financial terms.

Yet another source of industry standards are court determinations of reasonable royalties awarded in patent infringement lawsuits. Table 8 offers a summary from a paper by Mike Carpenter who analyzed a series of judgments.¹⁸

The main limitations of such data are that the result is very specific to the litigated subject. In addition, the maturity state of the technology is normally far beyond what may be considered as early-stage technology. Further, adjudicated reasonable royalty rates are almost

always unrepresentative of arm’s-length rates, as they represent royalties for patents known to be valid and infringed—conditions not typical of early-stage technologies. This litigation-particular outcome example is also quite dated, but datedness is a factor here in all of the prior examples as well, and is innate to any historical collection of data.²⁰ Still, a court case usually contains a wealth of information about how such rates were determined, and of course, the information is in the public record. Einhorn has published a much more current summary of reasonable royalty determinations by a court.²¹ One can also search LEXIS^® for even more current data. The key is to find a comparable technology, stage of development, market impact, and so on. When something comparable exists and is published, this can be very helpful.

The most valuable tool for determining industry standards for this method are published agreements for similar technologies licensed by similar institutions. As Ashley Stevens explains, publicly-traded companies will file license agreements that may have a significant economic impact on the value of the company with the U.S. Securities and Exchange Commission (SEC).²² The Internet now enables very effective searching of disclosures made by publicly-traded companies.

Several organizations offer, as a service, summaries of categories of such filings and copies of specific agreements. An example, taken from a talk by Mark Edwards, is shown in Figure 1.²³

These data are unusual in that they show many of the forms of upfront consideration received by universities for having licensed their biotechnology. Underneath such summaries, however, are specific agreements now numbering in the thousands, copies of which can be found with some research. It is from such published agreements that one can gain a better understanding of what was agreed to, at least once, by two parties for something similar to what is being offered.²⁴

One example of such a specific agreement is the license between the University of Houston (UH) and DuPont for the so-called 1-2-3 superconductors developed by Professor Wu of UH. The State of Texas required that this agreement be placed in the public domain. The agreement details the payments DuPont agreed to make to gain rights to UH’s superconductor technology: US$1.5 million in cash upon execution of the agreement, an additional US$1.5 million upon issuance of the U.S. patent, and a third US$1.5 million upon the second anniversary of the U.S. patent. The agreement has many other interesting details, and it would be wise to study this agreement and learn as much as possible about its background and current status.

To sum up, using this industry standards method of setting prices has both positive and negative aspects:

Positive aspects of the industry-standards method include:

• The values used as the basis are based on the market.
• No calculations are required (beyond perhaps taking averages and medians or other statistical methods).
• One has some confidence of being in the range of some believed-to-be comparable reference points.

Potential negative aspects include:

• Published information is inevitably dated, and such datedness could have a material effect on the present value of a similar deal.
• The segmentation provided by surveys is normally too coarse (electrical, mechanical, telecommunications, and so on).

• The values published normally do not provide sufficient information to determine what IP rights were provided, or to determine their significance or their strength.
• The royalty basis (or base) is not always explicitly defined.
• The connection of the license to the size and margins of the buyer’s market opportunity is not explicitly known.
• A wide range of royalties is reported for each classification, with no clear means of discerning why some opportunities were higher valued and some lower.
• Often no information on upfront payments, minimums, or due-diligence provisions is available, all of which can be important components of value.
• The licenses often contain other provisions that directly affect the total value of the deal and are reflected in the royalty rate.
• One cannot uncover a historical agreement for exactly the same technology as that of current interest, between comparable parties, at a comparable stage of development. So one is commonly performing some interpretation of available data to apply to one’s present situation.

The industry standard method works best when one deals in one technology/industry segment, especially when there are a significant number of deals involving multiple buyers and competitive sellers, much as in the real-estate rental market discussed above. The examples given here are not intended to provide representative technology values but to illustrate some of data sources that exist.

In summary, price is a very tricky idea. It occurs “between the ears” of the technology transfer manager, as well as between the ears of prospective licensees. As you can see, it is affected by all the other things that affect a person’s judgment. For those who doubt this, an experiment has been published that illustrates this point.²⁵ Two groups of students were asked to review identical notebooks containing descriptions of seven consumer products. They were each asked to respond to each product by specifying what they would be willing to pay for the item. A summary of the findings is shown in Table 9.

Everything was identical in the two settings (A and B), except for one small thing. In setting B, there were Mastercard^® logos left lying on the table. Even though all the participants understood that they were not buying the items in the book,

and there was no discussion as to how such items could or should be paid for, the mere presence of the logos influenced the group B students significantly.

The point of relating this experiment is that everything about the technology transfer manager, the institution, the inventors, and so on, are potential influences on what a licensee will conclude is a fair price.

Consider these two different settings for the same invention. In setting A, the prospective licensee goes to Nowheresville, has to drive four hours because there is no air service, steps in cow dung as he gets out of his car, meets the inventor who has no front teeth and exhibits an annoying habit of scratching his underarms, and discusses the invention in the Greasy Spoon Cafe. In setting B, the prospective licensee goes to Mostfamousuniversity, where he is introduced to the distinguished inventor (who has previously won a Nobel Prize) at the exclusive faculty club and a well-known, well-respected, high-ranking public official stops buy and says hello during lunch.

Remember, in this thought experiment the institution is selling the same invention in both settings. Even though the prospective licensee is not a student and is not buying consumer products as in the example above, the principles are the same. The licensee will likely be influenced by the setting and circumstances, which may be completely unrelated to the underlying value of the opportunity.

In the first act of a wonderful play by Arthur Miller called The Price, the owner of a house full of furniture is frustrated when the dealer he has invited to bid on all of it delays giving him a price. Instead, the dealer spends a lot of time understanding the context of the sale (and learns that the building is about to be demolished and that the seller has no time or patience to sell the items piece by piece). He intermittently (and politely) points out certain blemishes in objects that would otherwise have been perceived as very valuable. When the seller finally demands to hear the price, the very old man who plays the buyer simply says, “Because the price of used furniture is nothing but a viewpoint, if you don’t understand the viewpoint, it is impossible to understand the price. ” The view from the buyer’s position always affects the price he is willing to pay.

One other point needs to be made about price. It is often the lever used in negotiations. Often each party to a negotiation uses price as a lever to get other things. There is a wonderful ancient saying on how buyers tend to negotiate, “Bad, bad says the buyer, but then he goes his way, then he boasts.”

5.2 The rating/ranking method

This method applies the elements of any definition: the specification of a genus plus the distinction of a differentiator.

First, the technology transfer manager must find the genus (or family) for the institution’s technology that he or she is seeking to price. Places to look include the published agreements discussed earlier, friends in the network of the Association of University Technology Managers (AUTM) and the Licensing Executives Society (LES), consultants, and the institution’s files of negotiated deals. Ideally, a technology transfer manager should find at least one or possibly two or three comparable deals from such a search.

Second, this method uses some form of rating table to score (differentiate) the deal that is now being priced based on the known price of the comparable deal(s). To do this, a technology transfer manager must select a list of relevant factors. Tom Arnold and Tim Headley published a useful, extensive list of 100 possible factors in an article in Les Nouvelles.²⁷ One hundred factors, however, are far too many to evaluate, which is perhaps why the most well-known enumeration is the Georgia Pacific factors, so called because the factors were annunciated in a lawsuit involving the Georgia Pacific company and have since been widely cited with respect to litigation matters. The results of a survey published by LES asked respondents which of the primary Georgia Pacific factors they used to assess an opportunity when either licensing in or licensing out. Table 10 gives a summary of these findings.

Other approaches may use only three or four factors to simplify the analysis, such as (1) comprehensiveness of the IP protection, (2) the stage of development (or, conversely, the magnitude of licensee investment) to bring the technology to the market, (3) the size and value of the market that is expected to be won by the licensee, and (4) the sustainability of the innovation wrought by the subject technology in view of competitive alternatives both present and anticipated.

Once one has chosen the key factors, the technology transfer manager, or preferably a commercial assessment team, scores the subject opportunity compared to the reference agreement found above for each factor selected on some scale. This can be done by employing a 1 to 5 scale, with a 3 as being indistinguishable to the comparable agreements, 4 meaning the subject opportunity is better (more valuable) with regard to this particular factor, 5 meaning much better, and so on. It is usually a good idea to also include a weighting factor so that each consideration is not treated equally. This is illustrated in Table 11.

The result is a weight-averaged score. Anything greater than 3.0 would suggest that the subject opportunity is better than the examples being considered as a standard, anything less than 3.0 suggests it is worse. If a technology transfer manager has two or three standards available, it may be possible to use this method to bracket the opportunity.

Although this method is straightforward, there are some important limitations. What is a true comparable? Each agreement is a snapshot in time, no two technologies are really identical, the market is almost never the same, and the negotiators and organizations will likely be

different. In addition, there are many tradeoffs and exchanges in every agreement; a technology transfer manager cannot simply compare one single aspect, such as a royalty rate, and look at it without considering what else was in the agreement. What about the differentiating factors selected? Does a technology transfer manager really know what the important ones are for this opportunity? What does a 4 really mean in economic terms? Finally, what does a technology transfer manager do with the result? Suppose the technology transfer manager determines that the institution’s opportunity scores a 3.8 compared to the standard. Now what? Does the technology transfer manager set expectations for the royalty at 27% better than the standard, as determined by ((3.8–3.0)/3.0)? Is the up front now 127 instead of 100? Are the minimums 64 instead of 50? Does the diligence requirement provide that the licensee must be on the market in 31 months instead of 40 months? Is the premium on late payments 3.8% instead of 3%? There are no simple answers to any of these questions. Still, performing this ranking against multiple standards and thinking through the results generally allows one to better understand

the helpfulness of this rating/ranking method in a specific circumstance.

The approach also yields at least two other benefits. First, it prepares the technology transfer manager for marketing, negotiating, and sharpening his or her thinking about what the important economic factors are relating to the opportunity. It gives the manager a greater self-awareness. A second benefit is that it provides a way of dialoguing with the internal stakeholders and beneficially incorporating some of their insights.

The rating/ranking method can also be used for selecting a commercialization path. When developing a commercialization strategy, there are countless possibilities: exclusive versus nonexclusive licenses, licensing versus equity in a new start-up, going with a company in industry A as the exclusive licensee or in industry B, commitment to the industry leader versus a small company who seeks to upset the industry, and so on. The rating/ranking method can help a manager sort out the advantages and disadvantages of each of the alternatives. It can also be used with respect to different potential licensees/partners by taking into account the particular benefit(s) of the technology to such licensee; the method can help a seller differentiate among multiple potential candidates to identify those who would appear to have the most to gain from the license and would therefore be the likeliest to enter an agreement and possibly pay the most. These and other criteria can help a technology transfer manager decide upon the best commercialization path.

5.3 Rules of thumb, such as the 25% rule (and other rules)

5.3.1 The 25% rule

One of the most widely cited tools of valuation is the 25% rule. It has various manifestations, but when most managers invoke it they usually mean either of the following:

1. The royalty in dollars should be one fourth of the savings in dollars to the licensee by the use of the license subject matter.
2. The royalty in percent of the net sales price should be one fourth of the profit, before taxes, enjoyed by the licensee as a result of selling products incorporating the licensed subject matter.

Although this looks simple, it is not. One of the key issues is the degree to which the licensed subject matter accomplishes the savings or produces the profit. For example, an invention incorporated into a process may produce a savings of $1 a unit. However, when one examines in detail how such savings are attained, it may be that several other technologies developed and possessed by the licensee need to be exploited in order to realize the full $1. In such a case, does the licensor deserve 25 cents, or should the savings be discounted in some way before the one-fourth fraction is computed? The issue seems to hinge on whether the invention opens the door to an otherwise locked room called: I can save you $1, or whether the invention is a link in a multilink chain that together combine to save $1.²⁹

In the second (profit) manifestation of the rule, things get even more complicated. Although net sales is generally a straightforward term to apply, profit before tax is subject to many interpretations. Normally, the royalty rate is applied to the royalty basis defined by net sales as follows: net sales price is the gross invoice price charged minus allowances for returns, and minus cash and other discounts granted, charges for packaging and shipping, and sales and excise taxes.³⁰

For the purposes of this rule, there is no comparable generally accepted definition of profit before tax. Indeed, one of the basic problems is determining what an appropriate income statement should look like. Typically, they have the following categories:

The trouble usually starts below the gross-margin calculation. What overheads should be attributable to this opportunity? Should all the overhead costs currently being experienced by the licensee be included in the calculation, even though including these may reward the licensee’s inefficiencies? Will the cost-of-sales allocation, which is across many products now being sold, overcharge the appropriate sales allocation for the subject opportunity? What is “other,” and why is it being used to draw down the profitably before the application of the royalty? And finally, what constitutes R&D, and should it draw down profits as calculated for determining a reasonable royalty?

Underneath these questions is the difficulty of obtaining reasonable estimates for each of the numbers. Annual reports from companies that sell products like the one the institution is licensing are good places to start. Table 12 shows summaries of two large materials companies, one U.S. company and one European company, based on their income statements published in annual reports. Although the numbers reflected in Table 12 represent real data, for the purposes of this illustration, the company names have been noted as U.S. Co. and Europe Co., respectively.

As discussed earlier, one of the issues in applying the 25% rule is where to apply it. If it is applied to the EBIT line ($18,352,000, in the United States company example), it is asserted that the deductions above that line (COGS, SD&A, and R&D) are appropriate for determining the true profitability associated with the commercialization of the new opportunity being licensed.

Consider whether it is appropriate to subtract R&D from available profit. If it is not subtracted, we would get, by this rule, one fourth of 12% (11+1) or a 3% royalty. This is a lot better for the licensor, since it is 12 times the 0.25% one gets by using what remains after R&D is subtracted. But should R&D be included in the subtraction? The argument for including it is that R&D is a necessary business expense for the enterprise; without such investments, the licensee would not have the high-value, competitive products it needs to sustain its operations, and, by implication, would be unable to successfully commercialize the subject opportunity.

On the other hand, these expenses are investments for future payoffs to the company for which the licensor may not enjoy the benefits. Suppose the U.S. company had elected, in the year reported, to increase its R&D investment by $18,351,000 to pursue an antigravity invention. This would have left the grand sum of $1,000 on the EBIT line, corresponding to one-ten-thousandth of a percentage point (of sales). Why should a licensor’s fair share of profits depend on the company’s management pushing an R&D project to develop an antigravity material or, for that matter, any other product?

Above or below the EBIT line are even more subjective costs. If they are associated with the company’s core operations, they may be appropriate. But what if they are associated with buying that new hunting lodge in Montana? Or buying up Brazilian rain forests? What about restructuring, which may be synonymous for the present cost of past folly? Again the same kinds of arguments exist on both sides. And again, what about that favorite term in accounting statements: “other.” Other than what?

If the licensor agrees that all of the expenses shown are appropriate allocations against earnings, it leads in this particular year to a negative number. Now what? Does the institution pay the licensee a royalty to commercialize the institution’s product? The point of this discussion is that each cost below the sales line should be analyzed in the context of the subject technology to determine if the EBIT percentage shown reasonably predicts the licensee’s profitability in the present case. If not, adjustments to such costs should be made to correct the base on which the rule is applied.

The second example in Table 12 (European Co.) presents other problems. For competitive reasons, many companies conceal details in their statements. They may also use different terminology. In Europe, sales is normally called turnover, interest can be finance charges, and so on. This example shows a gain from investments.³² Should the licensor receive the benefit of a higher royalty because the Europe-based company made money in one year on a good investment? Probably not. But if the company had lost money on investments, wouldn’t the licensee argue that such loss should be subtracted as an appropriate business expense? So, what about the gain?

Another way to obtain income statements is to use Ibbotson and Associates³³ and Robert Morris Associates (RMA) publications.³⁴ RMA, for example, annually publishes income statements of categories of companies by Standard Industrial Classification (SIC) code. Continuing with our two materials company examples, Table 13 shows the data available from the 1991 edition for SIC #2395.

In the first two columns are shown summaries for 11 smaller companies and 17 larger companies, based on assets. The right three columns provide three years of data for all of the companies in the database. Even when focusing on just the operating profit row, this gives five choices on which to apply the one-fourth rule: 4.1%, 4.7%,

7.8%, 8.4%, and 10.4%. How does a technology transfer manager choose? Taking an average yields about 1.5% as the royalty. Is this fair? Unlikely.

The root problem is getting good numbers for the profitability associated with the subject opportunity. A prospective licensee will almost surely make such a calculation. Yet a licensor will find it very difficult to get access to such information. The problem with published numbers of business enterprises—such as annual reports, 10Ks, RMA publications, Ibbotson, and other sources—is that the numbers are “smeared” over many different products, each with widely varying profitability. And once a product has been introduced, a company is inclined to keep it in the marketplace as long as it contributes to overhead, meaning it at least covers its cost of goods sold (COGS). In short, dogs in the company’s profit portfolio bring down the returns of the stars. Basing a valuation on such numbers will therefore always be a very tricky business. It also ignores a company’s willingness to pay more for a new opportunity, such as licensing a particular technology from which new products can be made. As a technology transfer manager becomes more experienced in various business sectors, he or she will better understand the economics of such variables—especially the company’s interest in the opportunity of a new technology—allowing for better valuations (see Method IV: Discounted Cash-Flow Analysis with Risk-Adjusted Hurdle, section 5.4).

One possible remedy to these difficulties is to request that the licensee provide a pro forma (predictive) income statement for the subject opportunity. In many cases, the licensee will refuse on

Table 13: Another Example Application of the 25% Rule³⁵

the grounds that such information is trade-secret information and that providing it, even under confidentiality terms, is forbidden. In other cases, the licensee may provide it. If so, it is a virtual certainty that what will be provided is the lower range of possible outcomes. Also, such pro forma statements may have certain cost allocations incorporated by rule or custom that may be arguable (either way) for getting to a figure to which the parties will apply the 25% rule.

Licensors sometimes call the 25% rule the “one-third rule.” Licensees, on the other hand, sometimes argue that claiming even one-fourth of the profit is overreaching, given such issues as the technology’s early stage of development, weak patent protection, high market risks, the extraordinary value of intangible assets to be applied by the licensee, and so on. Clearly, the many numerous factors that go into value (summarized earlier) must always be considered when applying rules of thumb. Perhaps the high risk associated with commercializing a specific opportunity means that only one-tenth is fair. And if the technology is only a small part of a very complex whole, with many other patents and proprietary technologies required of the licensee and a royalty base on the selling price of such a complex whole product, then a value much less than one-tenth can be reasonable. This last point relates to the always-relevant discussion of the royalty base that is being used with the royalty rate to determine the royalty payment. If the licensor’s technology enables substantially the entire product, then the selling price of the entire product is normally the base. If the licensor’s technology is only part of the entire product, then the parties may elect to still use the selling price of the entire product, but discount the royalty rate in recognition of that fact. Returning to the issue of whether 25% is the appropriate apportionment, if the commercial introduction of a well-developed, whole technology package for an attractive market opportunity is certain, then a value higher than 25% may be appropriate.

Despite these complexities, the 25% rule is well known and widely cited. One example is a citation by the court in Gore vs. Internal Medical Prosthetics where the judge stated, “As a general rule of thumb, a royalty of 25 percent of net profits is used in license negotiations. ”³⁶ However, in the famous case of Polaroid vs. Kodak, the judge awarded a reasonable royalty that amounted to slightly more than 60% of the infringer’s anticipated profits. The “Ten Sources of Value” (Table 1) and the rating/ranking factors must always be kept in mind, as should the overwhelming significance of differing risk perceptions of the same opportunity. If the licensee sees an opportunity as extraordinarily risky, then 25% of the profits will appear far too high. If the licensor sees it as picking the low-hanging fruit of something that can be readily commercialized by a license, 33% or more will seem reasonable. So, one should not take this “rule” suggesting there is a universal agreement that the value of “25%” covers all situations.

For more information, a summary of the history of the 25% rule is included in William (Bill) Lee’s paper.³⁷ Our observations relating to the use of this rule are summarized below:

Positive aspects of the 25% rule method:

• Has a “feel-right” tug in certain circumstances
• Can be the basis (principle) of early agreement
• Appropriately tied to profitability
• Widely accepted (at least in the sense that lots of people have heard of it)

Difficulties with the 25% rule method:

• The lower you go below the top line of an income statement or model, the more subjective (that is, inauditable and arguable) it gets, for example, what is appropriate overhead? What are appropriate sales costs?
• The calculation, depending on how it is performed, can have the effect of rewarding licensee business inefficiency.
• Very difficult to get good income statement numbers that are not smeared over many businesses and products.
• The licensed subject matter (normally) represents only a part of the sales price; complex considerations are needed to decide whether to discount or not.
• There can be significant year-to-year variability in available income statement numbers.
• No help on upfront fees.
• There is no inherent assessment of the potential importance of third party IP and technology to a licensee’s use of the subject technology.

One key piece of advice: If you use the 25% (or one-third) rule, use it only to develop the calculation of the royalty rate to be based on sales—never permit the royalty to be calculated on an as-you-go basis as a percentage of earnings before tax.

5.3.2 The 50% rule

Duke Leahey has outlined a 50% rule that is related to the 25% rule:³⁸

• At the point of product introduction, about 50% of the total risk of product failure remains.
• If the inventing organization brings the technology to the state of product introduction, it is entitled to 50% of the total reward (profit).
• If the commercializing organization participates in premarket development costs and risks, it is entitled to more than 50% of the total reward.

From this perspective, the 25% rule represents a 50:50 participation in premarket risk. Accordingly, the 50% rule suggests that to determine a fair apportionment of profit one should assess the extent to which the premarket risks and costs will have been borne by the licensor and licensee when the product finally gets marketed. Unfortunately, this is not easy to do.

When did the invention begin? In most cases, the inventing organization and individual inventors endured a long, costly gestation that was the essential primordial ooze from which the invention emerged. It is therefore unfair to the licensor to add a $5,000 patent application and a $10,000 project that fleshed out a few numbers and contend such expenditures are equivalent to the $1 million required cost asserted by a licensee to bring the technology to the market as the basis for determining the relative, premarket contributions of licensor and licensee.

A second version of the 50% rule appears to be applied primarily in the area of software and reflects the very significant pre- and post-commercial involvement by university and R&D organizations in certain situations. When software is commercialized, many activities can be the responsibility of either the licensee or licensor. These include: performing all the bug fixes and compatibility tests of the original code, developing user interfaces, creating software manuals, making copies for distribution, packaging, finding customers, delivering copies, hot-line help for routine questions, resources for in-depth questions, new bug fixes, updates and improvements, product advertising, sales and distribution, more bug fixes, and so on. In some instances, the licensee and licensor will divide these responsibilities so that when credit for cost/risk of creating the product is ascribed to the licensor, then the resulting split is 50:50.

But there is no simple way of saying how such a split in responsibilities warrants 50:50. At one extreme, for example, the owner/developer of the software product could do everything required for commercial use, including advertising and other promotional activities, and elect to hire marketers purely on a commission basis to assist in direct sales. (This is commonly necessary when selling software that costs in excess of several thousand dollars). In such a case, the marketer is playing only a limited role in the commercial process, basically as a manufacturer’s rep and may be paid a commission, ranging from 10%–20%. Taking a figure of 15%, this means the revenues from sales have been effectively split 85:15 taken as a percentage of sales in this example of a different rule of thumb.

At the other extreme, the creating organization can enter a license at an early stage in development and turn over a hard drive containing code that works but is not yet complete as a product. In this case, the licensee has to finish the code; develop all the user-friendly tools; introduce the product to the market; perform all the promotions, sales, and distribution; handle the customer; and so forth. Here, the licensee may agree to pay a royalty in the range of 10%–25% (or even much less). Taking again a figure of 15%, this means that the revenues from sales have been split 15:85.

By using the 50% rule, or a 50:50 split of revenues, a licensor agrees to perform an additional 35% share more of services than in the 15:85 example (or the commercial partner is doing an additional 35% share more of services than in the manufacturer’s rep example of 85:15). As you can see, it is unhelpful to rely too heavily on such numbers. Indeed, like any other type of licensing, once a technology transfer manager has gone through a significant number of deals, he or she will be able to recognize what deserves a 50:50 split, as well as the appropriate split for the level of involvement in particular cases.

5.4 Discounted cash-flow analysis with hurdle rates

Method III introduced the concept of apportioning profit by examining each party’s contributions and risks incurred in creating such profit. Method IV is a more sophisticated way of performing such considerations. This method consists of determining future cash flows, then discounting these cash flows by accounting for the time over which those amounts are to be received and by the associated risk of receiving such cash flows. For this reason, this method is sometimes known as the discounted cash flow (DCF) method. When all such cash flows have been discounted, they can be added to determine net present value (NPV). The key to this method is the application of the risk-adjusted hurdle rate (hereafter designated by k) or the factor based upon perceived risk that is used to discount the future cash flows and will be referred to here as the “risk-adjusted hurdle rate” (RAHR). In effect, k is used to determine how the profits (or cash) resulting from the commercialization of the subject opportunity should be apportioned.

5.4.1 Defining risk

First, let us consider what is meant by risk. There are technical risks, market risks, and the infamous other risks, such as market erosion or the changing tastes of consumers. What are some technical risks? Although it may not be obvious, a key technical risk has to do with whether the technology works. For many reasons, a lot of inventions simply do not work. Sometimes the invention works, but only under very carefully controlled, glacially slow procedures with tiny quantities in clean rooms carried out by very experienced scientists using technicians with dexterity and intelligence that is hard and very costly to duplicate. If a product needs to be made in high volumes at low cost, there is a huge risk in taking something that works in the cleanest of clean-rooms and getting it to work in a factory.

In the category of market risk, a competitor may develop a superior product based on another technology. Customer requirements can also change dramatically. Tastes can change, and anticipated profit margins can erode or disappear. And customers, despite all the market assessment, can simply decide not to like a product. Remember New Coke? Remember Corfam? Sinclair and Commodore computers? An appetite-suppressing candy with the unfortunate name of Ayds?

Finally, all sorts of external events can sink an enterprise. Some raw material that the licensee needs to use or a product that it plans to sell can become illegal or so constrained by regulation that there is no cost-effective way to use it or sell it. Other industries can undergo upheaval to the mortal detriment of a licensee. Remember the oil embargo? The shortage of DRAM chips? Nuclear power? A key trade secret could be stolen. The patent office could deny patentability or grant broad rights to a blocking patent owned by a third party.

5.4.2 Developing a risk-reward model

Investors use a risk-reward model to guide their investment decision making. It is commonly expressed in some form of a graph such as the one shown in Figure 2, where increased risk demands an increased required rate of return (k), also known as the hurdle rate. The job of a businessperson is to convert the investments made in the company into returns that equal or exceed the rates of return expected by such investors. So the floor for a businessperson’s expected returns is normally the company-specific, average cost of capital (a combination of debt and equity). What makes a particular project investment good or bad at the stage of making the investment is the perception of whether the returns will be attractive in relation to its risks, the latter of which are determined by the company’s prescribed reward-risk relationship.

From the point of view of the prospective licensee, one of the basic value questions is the degree of risk that has been eliminated by the licensor’s R&D and other activities. The greater the risk reduction, the greater the perceived value (or, in other words, it is less likely that a discount will be applied to the perceived potential value of the license). From the perspective of the licensor and, particularly, the professor-inventor, this suggests that additional R&D will increase both the likelihood and the economic value of a license. But this is only true if the licensor’s R&D activities are successfully applied to commercial risk-reducing activities. Investment in R&D that is directed toward improved scientific understanding and publication of an invention may or may not reduce risks associated with commercializing a product of interest to a licensee.³⁹ Not all motion is progress. This is yet another reason why costs are irrelevant in assessing value. Figure 3 summarizes the key steps of this method.