Applied Royalties     Applied Royalties In The High-Tech Industry     By Alan G. Leal     Abstract/Introduction           ...
Applied Royaltiesto achieve shared risk and return—crucial to the                   royalties can mitigate such risk by el...
Applied Royalties     of superior technology, products, or methods).     For simplicity in illustrating the comparative   ...
Applied RoyaltiesCaveats:                                                                 take the form of an assessed pre...
Applied Royalties     increased risk to the licensee of overpayment risk and           as the actual net sales price for t...
Applied Royaltiesroyalty discount vis-à-vis the projected price erosion               carried by the licensee through the ...
Applied Royalties     adjusted, as the royalty model is typically established                        and expansion for the...
Applied Royaltiesning per-license payments to the licensor, with the          volatile markets. In practice, because net s...
Applied Royalties     cost—and the licensor’s resulting license revenue.          technology is highly dependent upon its ...
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Applied Royalties In The High Tech Industry (Les Nouvelles March2011 Final Publ)


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A short treatise on the basis and strategy of the most prevalent applied royalty models encountered in the high-tech industry.

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Applied Royalties In The High Tech Industry (Les Nouvelles March2011 Final Publ)

  1. 1. Applied Royalties Applied Royalties In The High-Tech Industry By Alan G. Leal Abstract/Introduction instrument in allocating both risk and return among Prior discussions of the treatment of royalty com- licensors and licensees in the field of intellectual pensation among technology license arrangements property rights. Royalties often are preestablished typically address valuation methods or fixed method- as a structured payment of a percentage of income ologies to determine how much is paid for a given (whether actual or forecasted) that is to result from technology type or category. This article addresses a licensee’s commercialization of the owner’s rights the more critical aspect of how such royalties are in the property, method, or asset. structured under varying scenarios, with emphasis Price Versus Royalty—What’s the Difference? on the associated market risk inherent in the various Simple terms such as “price” and “cost” which technology royalty models presented below. The au- have their origins in centuries of commodity trade thor’s focus is to distinguish the most prevalent royalty (i.e., bulk or fungible physical goods), do not address models encountered in today’s high-tech industry, the complexities of shared compensation and risk addressing the actual allocation of risk versus return inherent in technology arrangements. Commodity between licensor and licensee. buying or selling inherently does not comprehend This article covers the basis and strategy of the the nonexclusive or contemporaneous use of an asset most prevalent technology royalty models applied apart from actual sole ownership or possession. As across a typical technology product life cycle – from such, transactions involving commodities—whether “growth,” to “saturation,” to final “decline” phase. As corn, bricks, or DRAM memory circuits—allocate risk such, actual valuation or pricing of various products by transferring title and possession of goods and the or technology (i.e., how much) is outside the scope risks associated with taking ownership. of this article. Apart from the fundamentals of commodity trade, For purposes of discussion, this article centers on risk in technology licensing transactions the key asset be- and return of various royalty models from the licensee’s ing traded is divisible rights in intellectual property. perspective, typical organizations seeking to productize To maximize the commercialization of technology the licensed technology and enter commerce. invention, such divisible rights are often granted between the owner and multiple licensees; hence, Concept of Royalty R linear terms of purchase for ownership do not apply oyalties have been applied in the western world to such transactions. since colonial times, stemming from a gradu- Royalty—Rationale ated system of payment for a specific right to use or access a given resource, asset, or methodology. The ultimate success of a commercialized technol- Technically, a royalty may be defined as: ogy is in its monetization, the return on investment of which may be measured in terms of incremental profit Royalty: payment to the property holder/author for or other efficiencies gained in time, deployment of de- the right to use property (intellectual or other), such velopment resources, capital expenses, or opportunity as a license, patent, copyrighted material, or even costs from ventures foregone. Licensees, operating natural resources. as distributors of technology, often face unknown The concept of royalty is believed to have originated market volatility in preparing various market channels with royal franchises granted by the British Crown to merchandise and distribute the target technology. to individuals for the exploitation of territories or Conversely, Licensors or “sellers” of rights in technol- natural resources. The franchisee paid a royalty, or ogy are concerned with recouping applied investment share of the proceeds, to the Crown for the advantage inherent in the development and productization of derived from the royal concession. At the same time, the target technology. Often, early-stage or emerg- the royalty was a token of the recipient’s express ac- ing technology markets face frequent market- and ceptance of the Crown’s continued sovereignty over technology-disruption events, forecasted revenue the territory or property being exploited. provides little guarantee of commercial return. The The general concept of limited use versus title and application of structured royalty models, dependent ownership of an asset expanded heavily during the upon the market circumstances and relative position- Industrial Age and has been carried over as a central ing of licensee and licensor, provides a methodology60 les Nouvelles
  2. 2. Applied Royaltiesto achieve shared risk and return—crucial to the royalties can mitigate such risk by eliminating,sustainability of any long-term technology venture. for example, volume- or prepaid-revenue com-From a shared market perspective, the rationale for mitments for licensed technology.the general application of royalties is straightforward: • Market risk (volatility)—likelihood of a li-as the market for a product goes up, both share in the censee’s margin erosion due to net price (marketprofit; as the market declines, both share the loss. price) declining more rapidly than the related Conversely, commodity-oriented pricing and pay- license royalty to licensor. Such risk can bement models such as flat-fee or fixed per-unit struc- hedged by implementation of either pure run-tures often create an “all-or-nothing” approach to ning royalties (e.g., net-based per-unit royalties)allocation of return between merchants: one party or automatic time-functioned discounts at arisks potential overpayment and therefore margin declination rate equal to or exceeding projectedrisk ahead of realizing actual market performance, market price decli-while the other risks undervaluation or opportunity nation rate. ■ Alan Leal,cost of commercialization of its technology in the • Unsystematicevent market performance exceeds prior forecasts. Hewlett-Packard Company, risk—likelihood ofFrom the licensee’s perspective, assuming a fixed- or unrecoverable up- Enterprise Business,flat-fee pricing model regardless of the technology’s front investment Technology Licensingmarket performance often serves to insulate the due to nonrecurring Roseville, CA USAowner of the technology from market volatility, often initial costs paid to E-mail: alan.leal@at the buyer’s expense, potentially jeopardizing the licensor. Such risk hp.comdesolapate.combusiness association between owner and licensee as can be minimizedmarket conditions deviate. by the avoidance ofWhy Do Royalties Matter? upfront credits, prepaid royalties, or other artifi- Critical revenue-generating deals (i.e., product ini- cial commitments often sought by the licensor.tiatives representing significant impact on profitability Unsystematic costs rapidly increase overpaymentand revenue) and key technology deals (i.e., technol- risk for the licensee.ogy development or licensing initiatives with signifi- Technology Product Life Cycle andcant impact to an organization’s design ability and Profitability Phasesintellectual asset portfolio) require the preservation For purposes of the current discussion, assumeof profit and competitive position throughout the life a typical commercialized technology product lifecycle of commercialized technologies. Successfully cycle where a given technology’s market price peaksapplied royalties are essential to the commercial suc- shortly after product introduction (where t = 0), andcess of any licensed technology market introduction. follows a nonlinear decline over time due to market- Sustainable new business—whether new or suc- and technology-displacing events (i.e., weakeningcessor technology to current markets—hinges upon demand for mature technology with the introductionsuccessfully applied royalties serving as themost effective hedge against market volatil- Figure 1: Technology Product Life Cycle–ity and margin risk inherent in technology Profitability Phasesmonetization. Minimizing market, margin,and upfront, or unsystematic risk generates adecisive advantage for the combined objectivesof technology alliances seeking to productizeand deliver technologies to targeted markets. ListProblems of Poorly Structured Royalties Growth price Problems most frequently encountered from phasepoorly-structured technology royalties can besummarized as follows: Saturation phase Price • Margin risk—likelihood of incurring Actual Decline license or material costs that are either phase sales price unprofitable initially or become so over (ASP) time due to a combination of inflated li- Time cense costs and declining net sales. Applied March 2011 61
  3. 3. Applied Royalties of superior technology, products, or methods). For simplicity in illustrating the comparative Figure 2: Paid-Up or Lump-Sum Royalty effects upon margin (versus profit) of the most commonly-applied royalty structures, also as- sume sales volume remains constant (linear) Effect of a paid-up or lump with time and unit volume directly proportional sum royalty amortized over product life cycle throughout the product life cycle. The profitability phases of the typical technol- List ogy life cycle represented above are: price Growth phase—the ascending path of ini- tially successful commercialized technologies; Break-even point for the lesser the slope, the greater the profitability paid-up royalty over and period of commercial relevance. product life cycle Price Actual Saturation phase—the path of established sales License cost (royalty) or mature technologies; the flatness of the price curve depends on the relative strength of the (ASP) technology against competitive forces. Time Decline phase—inherent with continuing technology innovation, this phase represents • Note: the graphs in the Figures presented a mature technology’s inevitable loss of commercial assume sales performance / volume of licenses viability as a result of displacing or disruptive com- sold to be cumulative over time; thus, the x-axis peting technologies (e.g., floppy disks v. CD’s v. USB represents time and volume cooperatively. flash storage). • Note 2: the dotted curve in Figure (2) illus- Applied Royalty Models trates the high initial royalty cost resulting from Technology royalties can be structured under mul- a licensee’s upfront payment of all the combined tiple models; from upfront lump-sum payments to royalty costs of all projected future license sales running per-unit fees, and including numerous hybrid during the license period. models. The following are, in order of descending risk • Note 3: if the licensee’s sales volumes continue to the licensee, the most commonly applied technol- sufficiently during the paid-up royalty period, the ogy royalty models with a comparative evaluation of effective amortized per-license royalty cost reach- the strengths and weaknesses of each: es a break-even point (i.e., the licensee’s material • Paid-up or lump-sum royalty margin reaches 0 percent), with the licensee’s • Minimum royalty margin inflection point eventually surpassed as • Fixed per-license royalty additional product sales realize a positive material • Volume- or revenue-based discounted royalty margin as sales volume accumulates during the • List-based royalty (LBR) paid-up royalty period. • Net-based royalty (NBR) In determining paid-up or lump-sum royalty models, central among consideration is the duration of the Paid-Up or Lump-Sum Royalty paid-up royalty period for which the lump-sum royalty Application: payment covers the licensee’s sale and distribution Paid-up or lump-sum royalties are most commonly of the licensor’s technology. formulated upon the total perceived commercial Advantages: value of the technology as monetized by the licensee, Opposed to a minimum royalty (see below), a paid- payable either as a preestablished single payment up or lump-sum royalty serves as an “all-you-can-eat” upfront or in fixed installments (e.g., quarterly). The payment entitling a licensee to sell unlimited subli- effect upon the licensee of such upfront royalties is the immediate negative impact upon product gross censes or units of the technology during the covered margin performance with the licensee’s overpayment licensing period. The potential advantage to the or margin risk being overcome only if the licensee’s licensee is the potential to amortize the per-license sustained unit sales volume and market price even- royalty cost over a larger-than-expected sales volume, tually exceed the initial cost burden of the paid-up thereby effectively reducing the average license cost license (see Figure 2). as sales volume increases.62 les Nouvelles
  4. 4. Applied RoyaltiesCaveats: take the form of an assessed prepaid fixed minimum For the licensee, paid-up royalties are among the payment, independent of actual market performanceriskiest of royalty models in that such are least related or sales factors, which is then credited against suc-to the licensee’s actual sales performance of the li- ceeding license sales by the licensee.censed technology. Such royalties often include the A crucial element for the licensee in avoiding over-presumption of anticipated future license sales over payment risk in determining an applied minimumthe paid-up sales period; thus, the forecast assump- royalty is whether the licensee possesses superiortion is central to the negotiation of such royalties. market knowledge of the total value of the prospec-As opposed to per-license royalty models discussed tive technology over the product life cycle.below, the difficulty inherent with such lump-sum • Note: the dotted curve in Figure (3) illustratesroyalties is in consolidating the entire royalty discus- the high initial royalty cost resulting from thesion to a single value, amplifying the licensor’s and licensee’s accelerated royalty payment againstlicensee’s competing interests in establishing the a portion of projected, but unrecognized futureroyalty amount. license revenue during the license period. In effect, such royalties impose the ominous obliga- • Note 2: the amount of the applied minimumtion of reducing the basis of the licensee’s royalty costs royalty, the length of time available to the li-to a single guess as to total future market performance censee for royalty recovery, and the accuracy ofof the end technology or product; often generating a the licensee’s market data (e.g., volume forecast,significant overpayment risk to the licensee as it ad- actual net price, progressive price erosion, costdresses competitive pricing pressure and potentially of sales) are critical factors in driving profit per-disruptive market events. Both parties are relegated formance under such a royalty agreeing to in effect a single calculated number • Note 3: if the licensee’s sales volumes increaseupon which both licensor and licensee face either an sufficiently during the royalty period, the effec-overpayment risk in the case of the licensee, or an tive amortized per-license royalty cost reachesopportunity cost in the case of the licensor. a break-even point (i.e., the licensee’s materialMinimum Royalty margin reaches 0 percent), with additional prod-Application: uct sales eventually realizing an increased true Minimum royalties require a guaranteed payment material margin typically through the remainderpayable either upfront at the beginning of the technol- of the royalty period.ogy transaction or with the commencement of each Advantages:successive reporting period (e.g., month, quarter) The distinction of minimum royalties from lump-for which royalties are due. Similar to paid-up or sum models is that ostensibly only a portion oflump-sum royalties, minimum royalty models typically the licensee’s total perceived value of the licensed technology is required by the upfront pay- ment. Apart from the accuracy of the applied Figure 3: Minimum Royalty royalty rate, minimum royalties represent a slightly-mitigated risk versus total paid-up or lump-sum royalties calculated to represent Effect of minimum royalty the entire value of the licensed technology amortized over product life over the expected commercial life cycle of the cycle intended product. Caveats: List price A minimum royalty provides significantly lim- ited protection to the licensee against market volatility. The central risk in assuming minimum Break-even point for minimum royalty over royalties is that otherwise variable royalty costs product life cycle (i.e., royalties which scale as a portion of actual Price Actual revenue) are converted to an accelerated fixed sales License cost (royalty) price cost irrespective of actual sales performance. (ASP) Especially in the case with emerging technolo- Time gies, such risks often become difficult to predict resulting in wide-fluctuating returns; hence the March 2011 63
  5. 5. Applied Royalties increased risk to the licensee of overpayment risk and as the actual net sales price for the technology loss of profitability. In such cases, minimum royalty declines. models operate as “credit” or prepaid royalties, the Advantages: result of which is to generate a fixed unrecoverable Fixed per-unit royalties offer an incremental expo- royalty cost absorbed by the licensee in the event of sure to the licensee for incurred royalty costs. Effec- minimal or no sales performance. tively, royalties accrue as actual sales are made and Fixed Per-License Royalty in proportion to the volume of sales realized. Such Application: simplified royalty models may be appropriate in cases A fixed per-license royalty is a running per-unit pay- of mature, more static product markets (e.g., market ment, the rate of which remains fixed over a given oligopolies such as the sublicensing of predominant period. A key distinction of fixed per-license royalties O/S platforms) where the licensee benefits from is that royalties are payable in increments typically highly-accurate market and historical data in forecast- tied to the licensee’s actual sales of licenses or units ing future sales performance. of the technology, versus lump sums otherwise re- Caveats: quired under paid-up models. The established royalty Fixed per-unit royalties are among the highest-risk rate under a pure fixed per-license royalty (as opposed running royalties encountered by technology licens- to models discussed below) remains constant for ees. The primary challenge to licensees in considering each unit or license sold and is independent of sales, pure fixed per-license royalties is that no relief is pro- performance, market, or other competitive factors vided to mitigate progressive price erosion over time. incurred by the licensee in the commercialization of Given that the profitability of nearly all technologies the technology. bears the effects of declining market relevance over Similar to the royalty models discussed above, a time (see Figure 1), under such royalty models, mar- key consideration for the licensee in determining a gin retention becomes a significant challenge for the fixed per-license royalty is whether the licensee pos- licensee, with the bulk of associated start-up costs to sesses superior market knowledge of the total value commercialize and distribute the resulting product of the technology over the technology’s product life absorbed upfront. Consequently, fixed per-unit royal- cycle, with particular scrutiny given to anticipated ties offer no protection of margin retention in volatile price erosion during the expected product life cycle. or declining markets. Figure (4) below represents the margin risk inherent Volume- or Revenue-Based Discounted Royalty with fixed per-license royalty models. Application: • Note: the fixed royalty cost in Figure (4) is il- A volume- or revenue-based discounted royalty is lustrated by the lateral dotted line representing a running per-license royalty which remains fixed a constant royalty cost applied against all tech- over time, subject to adjustment of the applied roy- nology sales during the royalty period. Note also alty rate contingent upon preestablished volume or that when a fixed royalty model is imposed, the revenue targets being met by the licensee’s sales or licensee’s resulting royalty margin deteriorates distribution volume of the licensed technology. Volume- or revenue-based discounted royalties Figure 4: Fixed Per-Unit Royalty offer limited margin retention for licensees, the effect of which is that royalty cost relief is real- ized only after and until a prolonged period of static royalty cost is applied against successive technology sales until a preestablished sales or Material List volume milestone is reached. The effect is a price margin compression of the licensee’s resulting license decreases or material margin which continues until the over time given sales or volume performance threshold is reached. Price Actual Key factors in determining a volume- or License cost (royalty) sales revenue-based discounted royalty are deter- price (ASP) mination of the initial royalty rate, the viability Time of the preestablished performance milestones to be reached, and the comparative rate of the64 les Nouvelles
  6. 6. Applied Royaltiesroyalty discount vis-à-vis the projected price erosion carried by the licensee through the technology lifeof the commercialized technology over time. As illus- cycle. Discounted royalties may be appropriate fortrated in Figures (5) and (6) below, such discounted licensees with strong or exceptional sustained salesroyalty models can generate wide-ranging results upon performance within a target technology market. Suchlicensee royalty margin. metrics are most often accurately forecasted within • Note: the progressive-tiered discounted royalty mature or static markets. structure illustrated above represents the effects Additionally, the discounted royalty model can be of a constant royalty subject to periodic royalty inversely applied as a regressively-tiered royalty. Re- rate reductions upon specific sales milestones. versing the initial allocation of margin risk between The effect of such a royalty model is a step-func- licensee and licensor, a regressively-tiered royalty tioned royalty cost curve with successive margin provides the licensee with the more favorable position compression and expansion for the licensee of an initial lowest per-license royalty as an incen- throughout the technology life cycle. tive to induce distribution and sales momentum as aAdvantages: market channel in an effort to proliferate the licensed Discounted royalty models can provide limited but technology.non-proportional scale to the royalty cost burden Caveats: Discounted royalties are often sought by licensors as a hedge against unknown sales Figure 5: Volume- or Revenue-Based competency or marketing efficiency of new li- Discounted Royalty–High Volume censees and the volatility of emerging markets, allowing the licensor to gain a disproportion- ately higher return from the licensee’s initial sales cycle, the effect of which imposes margin License cost pressure on the licensee to accelerate sales (royalty) List volume in order to recover profit by achieving price royalty cost adjustment. A primary caution for Material margin more highly sustained the licensee in considering discounted royalty structures is the net effect such royalties im- pose when entering technology markets exhib- Price Actual iting significantly volatile or declining markets. Royalty discounts occur upon exceeding sales Because such royalties are tied to cumulative set volume or revenue milestones price sales or volume activity and not actual price (ASP) Time or profit performance, discounted royalties provide licensees with little protection against market volatility (e.g., progressive price ero- sion, displacing market or technology events). Under such conditions, the licensee faces Figure 6: Volume- or Revenue-Based continually decreasing margins and reduced Discounted Royalty–Low Volume ability to counter competitive market pricing pressures. The result is that the licensee must either continue to sell the technology at the expense of profit or else withdraw from po- License cost List tentially strategic markets, conceding market (royalty) price share to advancing competition. Material margin severely impacted List-Based Royalty (LBR) Application: A list-based royalty (LBR) is a running per- Price Actual license payment, the rate of which is variable Royalty discounts occur upon exceeding sales typically in the form of a percentage of a refer- set volume or revenue milestones price (ASP) ence or list per-license price for the productized Time technology to be licensed. An LBR’s variability is contingent upon the reference list price being March 2011 65
  7. 7. Applied Royalties adjusted, as the royalty model is typically established and expansion for the licensee throughout the as a percentage of the list price. LBR royalties are dis- technology life cycle. tinguished from volume- or revenue-based discounted • Note 2: LBR models are often sought by licen- royalty models in that LBR’s are variable solely upon sors to alleviate concerns over potential sacrificial the associated reference list price. In theory, for so discounting by licensees. LBR’s are most often long as the associated list price remains static, so too successfully applied with mature technologies does the per-unit license or royalty cost to be paid exhibiting stable market performance (i.e., price by the licensee. Thus, in the event of an unchanged declination behavior and competitive markets are or infrequently-adjusted reference list price, LBR’s well-known). may in practice operate as a fixed per-license royalty, Advantages: remaining constant for each unit or license sold, An LBR offers licensees limited protection against independent of sales, performance, market, or other market volatility, allowing for improved margin reten- competitive factors the licensee faces in commercial- tion over fixed per-license royalties and performance- izing the technology. based discounted royalty models. LBR royalty models Key considerations in the application of list-based can provide limited but non-proportional scale to the royalties are the establishment and control of the royalty cost burden carried by the licensee through reference list price from which the resulting LBR the technology life cycle. LBR royalties may be appro- royalty is to be calculated (i.e., whether the refer- priate for licensees with strong sustained sales per- ence list price is that of the licensee’s, licensor’s, a formance within stable, mature technology markets. third-party’s, or other market-derived reference). Cal- Given that the applied royalty adjusts concurrently culation of LBR royalties would be therefore derived with changes to the associated reference list price, from the number of licenses sold times the applied LBR’s can provide periodic royalty cost relief if the percentage of the then-current applicable reference associated reference list price remains proportionate list price for the trading period. Thus, superior market to then-current market prices. knowledge of the target market’s anticipated price Caveats: erosion over the expected product life cycle and the Problems inherent with LBR models occur with di- ability to adjust a technology’s associated reference vergence between the applied reference list price from price are critical in preserving the licensee’s profit- which the royalty is calculated, and the actual street ability from productizing the licensed technology. or net sales price of the commercialized technology. • Note: the list-based royalty model illustrated Such disparity often results from applied discounts above represents a constant royalty subject to that licensees must often absorb to sustain unit sales periodic royalty rate reductions based upon ad- and distribution performance. Thus, a key factor in justments in the associated reference list price applying LBR royalty models is the degree to which for the given technology. The effect of such a the applied reference list price scales to actual net royalty model is a step-functioned royalty cost sales prices over time. The greater the divergence be- curve exhibiting successive margin compression tween the reference list price and actual street price, the greater the licensee’s effective per-license Figure 7: List-Based Royalty (LBR) royalty cost becomes, resulting in increased margin risk and decreasing margin over time. Acceptable material margin Assuming an LBR’s reference list price is controlled by the licensee, some margin Material margin declines relief can be gained by the licensee effect- List ing a reduction in the list price. In practice, price however, administrative limitations often limit Potential for negative material margin the frequency of such list price adjustments. as actual net (street) price declines Consequently, price declination may occur with License cost every point-of-sale transaction, whereas the (royalty) associated reference list price may be adjusted Price Actual only infrequently. sales Material cost adjusted in-step functioned phases price Net-Based Royalty (NBR) (ASP) Application: Time A net-based royalty (NBR) consists of run-66 les Nouvelles
  8. 8. Applied Royaltiesning per-license payments to the licensor, with the volatile markets. In practice, because net sales priceamount of such payments based on a percentage of performance can fluctuate with every point-of-salethe actual net sales revenue received by the licensee transaction, an NBR provides margin retention byfrom sublicensing the licensor’s technology. Calcula- adjusting the licensee’s royalty cost burden continu-tion of NBR payments is typically made periodically ously in constant proportion with each license sale(i.e., monthly or quarterly) with the application of the as market performance varies throughout the tech-agreed royalty rate percentage or basis applied to the nology’s life cycle. Subsequently, in cases where theaggregate net sales by the licensee over the period licensee must absorb increasing price discounts in or-reported, resulting in the royalty sum payment made der to sustain unit sales and distribution performance,to the licensor. an NBR offers the licensee a significant hedge against An NBR is a prime example of a “pure” applied unforeseen market volatility and price declination. Inroyalty, with the main determinant being tied to ac- short, as the licensee’s revenue increases, so does thetual net sales performance precluding any additional licensor’s: as the licensee’s revenue declines, so toopayments apart from the per-license running royalty. proportionally does the licensor’s.As such, additional payments such as support pay- Caveats:ments, maintenance fees, or unsystematic costs such Since applied NBR royalty returns are largely aas NRE payments may be avoided by negotiating the proportion of a licensee’s actual net sales, NBR’sfactoring of such costs of the licensing arrangement effectively present unlimited upside and downsideinto the agreed running royalty percentage for the potential to the licensor. Consequently, while per-applied NBR royalty. license margin performance is preserved under NBR Given an NBR’s static applied royalty rate, an NBR’s models, a primary concern for licensors in consideringvariability is wholly contingent upon the actual street pure NBR’s is the effect of unforeseen price erosionprice performance for the technology being licensed upon profit. Under an NBR model, technologiesand its unit sales performance given the licensee’s licensed in significantly volatile or declining marketsmarketing efficiencies against extrinsic market forces will generate the greatest variance upon net revenue(e.g., competitive pricing pressures, disruptive tech- and resulting profit for both licensee and licensor.nologies). As such, NBR royalties are distinct from Additionally, licensor concerns may arise overLBR royalty models in that the variability of return “sacrificial discounting”—a product pricing tacticgenerated by NBR royalties is solely dependent sometimes encountered when sales of the licensedupon the licensee’s actual net, or street revenue. technology are sold in combination or “bundled”Under such an applied model, both the licensor and with other of the licensee’s marketed products. Inlicensee may realize theoretically unlimited upside instances where the licensed technology may beand downside potential in the monetization of the sold within a combined or overall solution sale atlicensed technology. a disproportionately higher applied discount, the Because no arbitrary factors such as fixed royalty effect can be to increase the licensee’s resultingcosts, reference pricing, or preestablished volume or overall margin while reducing the licensee’s licenserevenue requirements are ordinarily avoided inapplied NBR royalty models, the key consider- Figure 8: Net-Based Royalty (NBR)ation of NBR models is the applied royalty rate.Negotiation of this item becomes the principaldeterminant of the resulting license margin ofboth the licensor and licensee. The illustrationin Figure (8) below represents how an applied ListNBR model can preserve license margin for priceboth licensor and licensee throughout a tech- Material margin sustainednology’s life cycle, including fluctuations in over product life cyclestreet price performance.Advantages: License cost Price (royalty) Actual Net-based royalties are among the most struc- salesturally advantaged royalty models for preserving price (ASP)sustained margins for licensed technologies, Timeespecially when engaging emerging or highly- March 2011 67
  9. 9. Applied Royalties cost—and the licensor’s resulting license revenue. technology is highly dependent upon its implementa- Such concerns over potential sacrificial discounting tion of applied royalties that sustain profitability while can be alleviated when the licensed technology is to perpetuating commercial relevance. An organization’s be sold as a stand-alone product by the licensee, as development of a central intellectual property strat- the licensee’s revenue will be proportionally impacted egy that discerns the advantages—and risks—inher- by any decline in the final sales price of licenses sold. ent among the technology royalties encountered Sacrificial discounting concerns are also minimized in today’s high-tech arena is the cornerstone for in cases where the licensed technology is a predomi- successful commercialization—and avoidance of the nant portion of the licensee’s product portfolio or often catastrophic pitfalls encountered from poorly- represents a significant portion of the licensee’s total structured technology deals. expected revenue. With the implementation of a disciplined, struc- In arrangements where concerns over sacrificial tured approach to the monetization of strategic discounting remain high, hybrid royalty models such technologies, an organization can expand its asset as NBR’s with floor pricing and other more elaborate potential by maximizing investment efficiency and models (e.g., industry standard method, discounted leverage, balancing product portfolio risk, maintain- cash-flow (NPV) method, Monte Carlo analysis, Black- ing competitive positioning, and ultimately, estab- Sholes options pricing), may enter discussion. Such lishing sustained exceptional financial performance. advanced (and administratively more costly royalty An understanding of the basis and strategy of the methodologies) are beyond the intended scope of industry’s most prevalent technology royalty models the current royalty treatise. and their implications is key in mastering the pro- Conclusion ductization and delivery of relevant technologies to The crux of an organization’s success in monetizing targeted markets. ■68 les Nouvelles