FUTURUM - Licensing intellectual property(draf)

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Licensing Intellectual Property
(DRAFT)
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Our Background :Royalty Rate Determination
In Essence,
The Royalty
A SHARING OF THE BENEFITS ENJOYED BY THE LICENSEE BY
REASONS OF THE LICENSE

LICENSOR

Thus, ideally (!), the royalty rate is set at one-quarter to one-
half of the expected benefit or anticipated operating profit
(gross, not net) of the licensee. This is sometimes known as
the 25 percent rule. If, for example, this rule was applied in a
situation where the licensee anticipates a gross operating
profit of 16 percent of the sale price of a patented product,
the royalty rate would be 4 percent (16% x .25).
25% Rule

Our Background : DANNY DARUSSALAM
Tax Center
Royalty Rate Determination
Royalty means payments (terjemahan UU PPh : IMBALAN) of any
kind received as a consideration for the use of, or the right to use,
intangible assets/intellectual property. The ownership of the
intangible assets/intellectual property IS NOT TRANSFERRED TO
the party paying the royalty.
In the definition of royalty above, the purpose of the payment is
not explicitly stated, yet, considering that the CONTEXT of the
royalty payment is generally found in the business world, then
there should be a profit-seeking motive in the payment.

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What is Business?
An integrated set of activities and assets conducted and
managed for the purpose of providing:
A return to investors; or Lower costs or other economic
benefits directly and proportionately to policyholders or
participants.
A business generally consists of inputs, processes applied
to those inputs, and resulting outputs that are, or will be,
used to generate revenues.
What is Business?

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What is Business?
1. It is probable (note : the
probability is generally speaking
is more than 50%), that the
economic benefits associated
with the transaction will flow to
the entity.
2. The amount of the revenue can
be measured reliably.
So it is logic to think that royalty
payment is RETURNS TO INVESTOR, for
the use of, or having the right to use
intangible asset/intellectual property.
The use of, the intangible
assets/intellectual property, or the right
to use, is ONE OF the INPUTS TO THE
BUSINESS PROCESS TO GENERATE
IDENTIFIED REVENUE, which means:

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Royalty Calculated
But, in the main and in the long-run, businesspeople base those decisions on a
careful (and correct) evaluation of the potential for earning a return on
investment. Dollars are not committed for idle amusement. They are planted in
order to grow – businesspeople are simply farmers with their own unique seeds
and implements, trying to employ the classic agents of production in their own
way.
(Gordon V. Smith, Russelll L. Parr, Valuation of Intellectual Property and Intangible Assets, third edition,
2000, John Wiley & Sons, USA, halaman X).

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ROYALTY
PROFIT SHARING BETWEEN
LICENSOR AND LICENSEE
RETURN ON AND OF
INVESTMENT TO
LICENSOR/INVESTOR

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Definition
Royalties and License Fee
Cover the exchange of payments and receipts between residents
and non-residents for the authorized use of intangible, non-
produced, non-financial assets and proprietary rights (such as
patents, copyrights, trademark, industrial processes, franchises,
etc.) and with the use, through licensing agreements, of
produced originals or prototypes (such as manuscripts and films).
OECD Statistics on International Trade in Services Volume I, Detailed Tables
by Service Category 2000 – 2008, OECD (2010)

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Royalties and License Fees

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Patent Statistic - USA

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Patent Statistic - USA
Year of
Application
or Grant
Utility Patent
Applications,
U.S. Origin
Utility Patent
Applications,
Foreign
Origin
Utility Patent
Applications,
Foreign Origin
Percent Share
Utility Patent
Applications,
All Origin
Total
Design Patent
Applications
Plant Patent
Applications
Total Patent
Applications
*
Total Patent
Grants
Total Patent
Grants,
Foreign
Origin
Percent Share
*
2010 n/a ** n/a ** n/a ** 490,226 29,059 992 520,277 244,341 50
2009 224,912 231,194 50.7 456,106 25,806 959 482,871 191,927 50
2008 231,588 224,733 49.2 456,321 27,782 1,209 485,312 185,224 50
2007 241,347 214,807 47.1 456,154 27,752 1,049 484,955 182,899 49
2006 221,784 204,183 47.9 425,967 25,515 1,151 452,633 196,405 48
2005 207,867 182,866 46.8 390,733 25,553 1,222 417,508 157,718 48
2004 189,536 167,407 46.9 356,943 23,975 1,221 382,139 181,299 48
2003 188,941 153,5 44.8 342,441 22,602 1 366,043 187,012 47
2002 184,245 150,2 44.9 334,445 20,904 1,144 356,493 184,374 47
2001 177,511 148,997 45.6 326,508 18,28 944 345,732 183,969 46
2000 164,795 131,131 44.3 295,926 18,292 797 315,015 175,979 45

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Intangible Property - OECD 2010
Intangible Property
rights to use
industrial assets such as patents, trademarks, trade
names, designs or models, literary and artistic
property rights, and intellectual property such as
know-how and trade secrets.

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Commercial
Intangible Property
Marketing
Intangible
Trade Intangible
patents, know-how, designs, and models that are used for
the production of a good or the provision of a
service, as well as intangible rights that are themselves
business assets transferred to customers or used in the
operation of business (e.g. computer software)

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Trade
Intangible
Trade intangibles often are created
through risky and costly research and
development (R&D) activities, and the
developer generally tries to recover the
expenditures on these activities and obtain
a return thereon through product sales,
service contracts, or licence agreements.

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Marketing
Intangible
Marketing intangibles include trademarks
and trade names that aid in the
commercial exploitation of a product or
service, customer lists, distribution
channels, and unique names, symbols, or
pictures that have an important
promotional value for the product
concerned.

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Types of Intangibles-OECD
• the reputation and credibility of the trade
name or the trademark fostered by the quality of the
goods and services provided under the name or the
mark in the past,
• the degree of quality control and ongoing R&D,
distribution and availability of the goods or services
being marketed,
• the extent and success of the promotional expenditures
incurred in order to familiarize potential customers with
the goods or services (in particular advertising and
marketing expenditures incurred in order to develop a
network of supporting relationships with distributors,
agents, or other facilitating agencies),
• the value of the market to which the marketing
intangibles will provide access, and
• the nature of any right created in the intangible under
the law.
The value of
marketing
intangibles
depends upon:
Marketing
Intangible

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intangible property associated with commercial activities,
including marketing activities.
Intangible Property
Business Rights
These intangibles are assets that may have considerable value
even though they may have no book value in the company’s
balance sheet. There also may be considerable risks associated
with them (e.g. contract or product liability and environmental
damages).

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NOT ALL research and development expenditures produce a
valuable trade intangible, and
Marketing activities may encompass a wide range of business
activities, such as market research, designing or planning
products suitable to market needs, sales strategies, public
relations, sales, service, and quality control. Some of these
activities may not have an impact beyond the year in which
they are performed, and so would properly be treated as
current expenses rather than as capitalisable expenditures
NOT ALL marketing activities result in the creation of a
marketing intangible

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In some cases, the
costs of marketing
activities and, with
respect to trade
activities, R&D
expenditures
may be sought to be recovered through
the charging for associated goods and
services,
there may have been created intangible
property on which a royalty is separately
charged,
or a combination of the two.

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The differences between trade and marketing intangibles can be seen in a
comparison of patents and trademarks.
Patents are basically
concerned with the
production of goods (which
may be sold or used in
connection with the
provision of services)
trademarks are used in promoting
the sale of goods or services
A patent gives an exclusive
right to its owner to use a
given invention for a limited
period of time
A trademark may continue
indefinitely; its protection will
disappear only under special
circumstances (voluntary
renunciation, no renewal in due
time, cancellation or annulment
following a judicial decision,etc.).

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The differences between trade and marketing intangibles can be
seen in a comparison of patents and trademarks.
A trademark is a unique name, symbol or picture that the
owner or licensee may use to identify special products or
services of a particular manufacturer or dealer and, as a
corollary, to prohibit their use by other parties for similar
purposes under the protection of domestic and
international law.
Trademarks may confer a valuable market status on the
goods or services to which they are attached, whether or
not those goods or services are otherwise unique.
Trade
Intangible

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The differences between trade and marketing intangibles can be
seen in a comparison of patents and trademarks.
Patents may create a monopoly
in certain products or services
trademarks alone do not create monopoty,
because competitors may be able to sell the
same or similar products so long as they use
different distinctive signs.
Patents are usually the result of
risky and costly research and
development and the developer
will try to recover its costs (and
earn a return) through the sale
of products covered by the
patent, licensing others to use
the invention (often a product or
process), or through the outright
sale of the patent.
The legal creation of a new trademark (or one
newly introduced to a given market) is usually
not an expensive matter. In contrast, it will very
often be an expensive business to make it
valuable and to ensure that the value is
maintained (or increased). Intensive and costly
advertising campaigns and other marketing
activities will ordinarily be necessary as will
expenditure on the control of the quality of the
trademarked product

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From the perspective of the
transferor, the arm’s length
principle would examine the
pricing at which a comparable
independent enterprise would
be willing to transfer the
property.
From the perspective of the transferee,
a comparable independent enterprise
may or may not be prepared to pay
such a price, depending on the value
and usefulness of the intangible
property to the transferee in its
business.
The transferee will generally be
prepared to pay this licence fee if the
benefit it reasonably expects to secure
from the use of the intangibles is
satisfactory having regard to other
options realistically available.
the usefulness of the property should be taken into
account when determining comparability.

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Transferring intangible property
an outright sale of the intangible
more commonly, a royalty under a licensing arrangement for rights in
respect of the intangible property
A royalty would ordinarily be a recurrent payment based on the
user’s output, sales, or in some rare circumstances, profits.
When the royalty is based on the licensee’s output or sales, the rate
may vary according to the turnover of the licensee.
There are also instances where changed facts and circumstances
(e.g. new designs, increased advertising of the trademark by the
owner) could lead to a revision of the conditions of remuneration.

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Difficult transfer pricing problems can arise when marketing activities are undertaken
by enterprises that do not own the trademarks or tradenames that they are
promoting (such as a distributor of branded goods).
it is necessary to determine how the marketer should be compensated for those
activities
service provider
Where the distributor actually bears the cost of its
marketing activities (i.e. there is no arrangement for
the owner to reimburse the expenditures)
the extent to which the distributor is able to share in
the potential benefits from those activities
how the return attributable to marketing activities
can be identified
it can be difficult to determine what these xpenditures
have contributed to the success of a product
OR

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In general, in arm’s length transactions the ability of a
party that is not the legal owner of a marketing
intangible to obtain the future benefits of marketing
activities that increase the value of that intangible will
depend principally on the substance of the rights of
that party.
How to share in the potential benefits from
those marketing activities?

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Royalty Rate
How much should the licensee
pay the licensor for the right to
use the licensed property?
Paid-Up Licenses Running Royalty

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Paid-Up Licenses
A “paid-up” license is one wherein the royalty is a fixed sum. It
may be paid in a lump sum or over a period of time in accordance
with an agreed-on payment schedule. Once agreed on, the sum is
independent of the future success of the licensee. Sales by the
licensee may prove high or collapse to virtually nil, but the royalty
remains fixed at the agreed sum.
A critical step in the determination of a paid-up royalty is the
agreement by the licensor and the licensee upon a forecast
of future licensed sales.

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Running Royalty
One way to avoid or minimize disagreements as to future sales is
to base the royalty on actual sales. If the license provides for a
royalty based on actual sales of the licensed product(s)—a
“running royalty”—the need to forecast future sales volumes and
prices is obviated.
Then: How to set up the running royalty rate???

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Licensor Licensee
points to the investment
required to create the
licensed property as
justification for a higher
royalty.
points to the risks it must
accept and the
investment it must make
before any profit can be
realized, as support for a
lower royalty.
“SUNK COST”

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The more significant the licensed
property as a component of the
product in which it is
incorporated
A property for which there are
few or no available substitutes or
for which the substitutes are
unacceptably costly
The closer the licensed product
to the market – greater certainty
The the
royalty it could
command

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As usual,
real life is not
as simple as
theory

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Ingredients of
Royalty Rate
“Laws are like sausages. It’s better not to see them being made.”
Otto von Bismarck

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Then,
HOW TO GET BOTH PARTIES TO AGREE ON THE
ROYALTY RATE?
MAKING REFERENCE TO THE ROYALTY RATES OF
OTHER EXISTING LICENSES

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What happens, in the
case of an allegedly
infringed patent, if the
parties are unable to
reach agreement as to
the reasonable royalty?
Litigation

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In the 1970 case of Georgia-Pacific v. United States
Plywood Corp. (318 F. Supp. 1116),
the U.S. District Court for the Southern District of New York
listed 15 Factors that it considered important for
deriving a reasonable royalty rate

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Georgia-Pacific v. United
States Plywood Corp.
1. The royalties received by the patentee for the licensing of the
patent in suit, proving or tending to prove an established
royalty.
2. The rates paid by the licensee for the use of other patents
comparable to the patent in suit.
3. The nature and scope of the license, as exclusive or
nonexclusive, or as restricted or non-restricted in terms of
territory or with respect to whom the manufactured product
may be sold.
4. The licensor’s established policy and marketing program to
maintain a patent monopoly by not licensing others to use the
invention or by granting licenses under special conditions
designed to preserve that monopoly.

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5. The commercial relationship between the licensor and
licensee, such as whether they are competitors in the same
territory in the same line of business, or whether they are
inventor and promoter.
6. The effect of selling the patented specialty in promoting sales
of other products of the licensee, the existing value of the
invention to the licensor as a generator of sales of non-
patented items, and the extent of such derivative or convoyed
sales.
7. The duration of the patent and the term of the license.
8. The established profitability of the product made under the
patent, its commercial success, and its current popularity.

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9. The utility and advantages of the patent property over the old
modes or devices, if any, that had been used for working out
similar results.
10. The nature of the patented invention, the character of the
commercial embodiment of it as owned and produced by the
licensor, and the benefits to those who have used the
invention.
11. The extent to which the infringer has made use of the
invention and any evidence probative of the value of that use.
12. The portion of the profit or of the selling price that may be
customary in the particular business or in comparable
businesses to allow for the use of the invention or analogous
inventions.

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13.The portion of the realizable profit that should be credited to the
invention as distinguished from non-patented elements, the
manufacturing process, business risks, or significant features or
improvements added by the infringer.
14.The opinion testimony of qualified experts.
15.The amount that a licensor (such as the patentee) and a licensee
(such as the infringer) would have agreed upon (at the time the
infringement began) if both had been reasonably and voluntarily
trying to reach an agreement, that is, the amount obtain a license
to manufacture and sell a particular article embodying the
patented invention—would have been willing to pay as a royalty
and yet be able to make a reasonable profit and which amount
would have been acceptable by a prudent patentee who was
willing to grant a license.

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Company A Company B
Product X
Product X
Process P-1
Process P-2
Patent 7 years
Product Y
Offering Company B to become
the exclusive worldwide licensee
of P-1
Company B wants to
pay 5% running
royalty
Company A doing the
research and said that
the operating margin is
44%, and with 25%
rule, Company b
should pay 11% royalty
Real case in early 1990 between two major petrochemical companies

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Case Problem : Jackpot
Inc.
Jackpot management recently became aware of a new slot machine patent
owned by NewTech that, when incorporated into its gaming machines, could
result in a new product line with significant growth prospects. Jackpot is the
North American market share leader in gaming machines. However, over the
past decade, the company has continued to lose market share to its main
competitor, Slots.
Given (1) the perceived potential for market share gains based on the
expected consumer acceptance of the new product line and (2) the desire to
protect its market share, Jackpot management is interested in negotiating an
exclusive domestic use license from NewTech. Jackpot management
anticipates that the exclusive domestic use license would enable Jackpot to
add a new product line to its portfolio of gaming machines with enough
growth potential to enable Jackpot to increase its market share over the next
few years.
Jackpot management retained IPFA to estimate the fair royalty rate that it
should be willing to pay to NewTech for an exclusive domestic use license of
the slot machine patent.

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Overview the Licensee
Jackpot is a closely held manufacturer of computerized casino gaming products and an operator of wide-area
progressive systems. Since its founding in 1974, Jackpot has primarily served the casino gaming industry in the United
States. The company currently manufactures its products in the United States, China, and Japan. For the fiscal year
ended September 30, 2003, the company reported revenue of over $1.0 billion. The company is headquartered in Reno,
Nevada.
Joseph Jarrod founded Jackpot and is currently president and chief executive officer of the company. As of the
analysis date, Joseph Jarrod owns a controlling interest in Jackpot. The balance of the company ownership is divided
among various Jarrod family members.
The company’s two lines of business include (1) the development, manufacturing, marketing, and distribution of
computerized casino gaming products and systems (traditional gaming machines) and (2) the development, marketing,
and operation of wide-area progressive systems (progressive gaming machines).
The traditional gaming machines line of business consists of spinning reel slot machines and video gaming
machines. In the North American gaming market, Jackpot holds an estimated 55 percent share of the installed base of
casino gaming machines.
The progressive gaming machines line of business is based on gaming machines that generate recurring revenue. In
that line of business, the company participates in the revenue from the machines on either a percentage or a flat-fee
basis. These systems are electronically linked, inter-casino systems that connect gaming machines to a central
computer. This allows the system to build a progressive jackpot with every wager made throughout the system until a
player hits
the top award-winning combination. In the North American gaming market, Jackpot holds an estimated 57 percent
share of the installed base of recurring revenue machines.

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Overview the Licensor
NewTech, founded in 1994, is a publicly traded company located in Portland, Oregon. NewTech was
formed to develop patented technologies that it licenses to companies in a variety of different
industries. NewTech has successfully negotiated three major use licenses for its patented technologies
since its inception.
Jackpot’s primary competitor is Slots, a closely held company with lines of business that are similar
to Jackpot. In 1988, several key members of the Jackpot management team left Jackpot to form Slots.
Since that time, both Jackpot and Slots have reported market share gains primarily through the
acquisition of several smaller competitors. Exhibit 19.1 presents a market share comparison between
the two companies as of 1992 and as of 2002 (based on the most recent available data).
Importance of the Appropriate Royalty Rate

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Comparable Uncontrolled
Transaction Method

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CPM & PSM
Exhi 19.6 Comparable Profit Method
Exhi 19.13 Profit Split Method

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Summary of Royalty Rate

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Discounted Cash Flow Method
Base Case Analysis Discounted
Cash Flow Method
Projected
Financial
Statement
Calculation Of
Net Cash Flow
to Invested
Capital
Present Value of
Net Cash Flow to
Invested Capital
Estimation of a
Present Value
Discount Rate

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Jackpot, Inc

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Present Value of Net Cash
Flow to Invested Capital

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Synthesis and Conclusion
IPFA analysts also used the discounted cash flow method to estimate the maximum
royalty rate that Jackpot could pay to NewTech without impairing the value
of the company

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Case Study IGTMA
Founded in 1984, Independent Golf Tee Manufacturers Association (IGTMA or the
Association) is the largest golf tee manufacturers trade association in the United States.
IGTMA represents over 85 percent of golf tee manufacturers in the United States. IGTMA
provides its members with a variety of services, publica-tions, legal advice, vendor
discounts, and regulatory compliance information. In general, the purpose of the
Association is to present the views of golf tee manufacturers to the golf industry at large
and to the public. In addition, the Association promotes and protects the interests of the
golf tee manufacturing industry. IGTMA is a not-for-profit business, exempt from federal
income taxes under Internal Rev-enue Code Section 501(c)(6).
Endorsed Vendor Royalty Income
For the services provided by IGTMA and IGTMA Services, endorsed vendors pay IGTMA
a royalty based on total endorsed vendor sales to IGTMA members. Histori- cally, total
endorsed vendor royalty income has been allocated equally between IGTMA and
IGTMA Services. Endorsed vendor royalty income compensates (1) IGTMA for endorsed
vendor use of the IGTMA trademarks and (2) IGTMA Services for its marketing-related
services.

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Case Study IGTMA
OBJECTIVE
The objective of our analysis was to provide IGTMA with an independent opinion as
to the arm’s-length allocation of IGTMA royalty income (referred to as “total
endorsed vendor royalty income”) between IGTMA and IGTMA Services. The
effective date of this analysis is December 31, 2002.
1. Company specific analysis:
- Profit Split
- Excess Earnings Method – Asset Basis
2. Industry specific analysis
3. Market Derived Royalty Rate Analysis

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Case Study IGTMA
1.1. Profit Split
The profit split method relates to the amount of profit that the subject trademarks and
trade names generate. The profit split method is based on the share (or split) of the
operating profit margin that a hypothetical licensee would be willing to pay to a
hypothetical licensor for the use of the subject trademarks and trade names.
The typical range of such splits is between 25 and 50 percent as evidenced by the
preponderance of actual arm’s-length, third party intellectual property license
agreements. In the case of IGTMA, we used an equal (i.e., 50/50 percent) split between
the licensor and the licensee.

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Case Study IGTMA

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Case Study IGTMA
1.2. Excess Earnings Method—Asset Basis. The excess earnings method is
based on the excess economic earnings that will be generated by the business
enterprise using the subject trademarks and trade names (i.e., the trademark
licensee).
Step 1: Fair Rate of Return
Step 2: Quantify Economic Income Earned by Licensee (Economic Income =
Cash flow)
Step 3: Determine Excess Income
Step 4: Compare Excess Income to Average Annual Revenues  Royalty rate

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Case Study IGTMA
2. Industry Specific
A common procedure in the analysis of trademark royalty rates is to seek guidance from the
profitability of comparative companies—that is, companies with and without established
trademarks and trade names—in order to estimate the arm’s-length royalty rate for the
subject trademarks. In this section, we discuss the extraction of a trademark royalty rate
from industry and guideline company data.
STEP 1 : Search comparables (SIC codes)
STEP 2: Excess Income

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Case Study IGTMA
3. Market Derived Royalty Analysis (CUT method)

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Case Study IGTMA
Evaluation and Conclusion

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Key Factors Involved in Setting
Royalty Rate
Degnan and Horton in “Royalty Rates for Licensing Intellectual Property, Russell Parr, P. 25, 2007.

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Key Factors Involved in Setting
Royalty Rate
“Utility over old modes” can be interpreted to mean that licensing executives will pay more for significant
enhancements over other technologies than they will for minor enhancements. The more unique
or different a licensed technology is, the higher the royalty rate. Higher royalties are
also associated with exclusivity, which also makes sense. When a licensor gives exclusive rights, they
forego the opportunity to obtain royalty revenue from any other source, so a higher royalty is usually
required from a license. Licensees often want exclusivity, to maintain a proprietary advantage.
Uniqueness over the competition is difficult to obtain. so when exclusivity is desired, a higher royalty is
reasonable.
The only direct evidence of the impact of exclusivity was a deal where DuPont revised a license
agreement where that agreement initially conveyed exclusive rights to a licensed invention. Later, the
agreement was revised to provide DuPont with only non-exclusive rights, and the royalty rate was
reduced. The following story appears in Royalty Rates for Pharmaceuticals and Biotechnology, Sixth
edition

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Use of the 25% Rule in Valuing IP
the Rule was formally developed decades ago by one of the authors, Robert
Goldscheider. Mr. Goldscheider did, in fact, undertake an empirical study of a series of
commercial licenses in the late 1950s.
Illustration
History
It is particularly useful when the IP at issue comprises a significant portion of
product value, and/or the incremental benefits of the IP are otherwise difficult to
measure
It need not be the case that the IP at issue is the only feature driving product value. In
fact, underlying the Rule is the understanding that a variety of factors drive such value.
That is why only a portion of the profits—twentyfive percent—is paid in a license fee,
which is why the appropriate profit split may be much less than twenty-five percent of
product profit.

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25% rule illustration— revenue side

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25% rule illustration— cost side
The Rule, in its pure sense, should be applied to fully-loaded operating profits, not to
already computed incremental benefits

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APPLICATION of the RULE
In Standard Manufacturing and DBP v. United States, the U.S. Court of Claims employed a
two-step approach to determining a reasonable royalty. The first step involved an
estimation of an initial, or “baseline,” rate. The second step entailed an
adjustment upward or downward, depending on the relative bargaining strengths of
the two parties, with respect to each of the fifteen factors described in Georgia-Pacific v.
U.S. Plywood.
The Standard Manufacturing court found application of the Rule to be an appropriate
method for determining the baseline royalty rate.

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the remaining economic life of the property being valued,
which may be shorter than the remaining legal life of any
patents which may be part of the analysis, is estimated;
the operating profit rate expected during each of such
years is projected, and twenty-five percent (or another
rate considered appropriate in accordance with the Rule)
is applied to each of the annual figures;
a discounted cash flow analysis is performed, using an
appropriate discount rate, to convert future flows into a
current year, lump sum amount.
The Rule has
been
Employed as
Follows:

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Fourth
a three-times payback ratio is
common. Such is obtained by a
licensee, retaining seventy-five
percent of the return by investing
twenty-five percent
First
“that’s the way it is.” Numerous
licensors and licensees have
agreed to a twenty-five/seventy-
five split, so it is, according to
Razgaitis, the industry norm
Sixth
The ratio of research and
development costs to profits is
often in the range of twenty-five
to thirty-three percent.
Second
typically seventyfive percent of
the work needed to develop and
commercialize a product must be
done by the licensee.
Third
“he who has the gold makes the
rules.” Licensees have
considerable leverage because of
the numerous investment
alternatives open to them.
Fifth
technology is the first of four
required steps of
commercialization. The others
are making the Justification
product manufacturable, actually
manufacturing and selling it.
Richard Razgaitis, US/Canadian Licensing In 2004: Survey Results”, Les
Nouvelles, (December 2005): 145.

Tax Center
Criticisms Of The Rule
Paul Schaafsma
Arbitrary
Mark Berkman
[The Rule does] not take into account specific circumstances that
will determine the actual value of the patent at issue. No
consideration is given to the number, or value, of economic
alternatives, or the incremental value of using the patented
technology over other viable alternatives
A typical ‘rule of thumb’ . . . is for the licensor to command twenty-five percent of the
profit. While this . . . attempts to link the value of the patent to the profitability of
commercial exploitation, because it does not relate to the value and degree to which the
patent can exclude substitute products, and therefore command a patent profit, it is little
better than [an] ‘industry norm.’ . . . Patented products add to economic profit the patent
profit tied into the ability of the patent to further exclude substitutes. . . . the portion of
the total profit can vary greatly, even within a given industry. Adding these values together,
and multiplying by an arbitrary fraction to derive the value of a patent, is an exercise in
arbitrary business analysis.
“Crude Tool”
“Arbitrary”

Tax Center
Response for Criticisms Of The Rule
Richard Toikka
The Rule, however, is one of many tools. Ultimately, royalty
rates are often higher or lower than twenty-five percent of
fully-loaded product profits, depending upon a host of
quantitative and qualitative factors that can, and should,
affect a negotiation or litigation.

Tax Center
William Lee
the Rule is “indefinite.” That is, should twenty-five percent be
applied to gross profits, operating profits, or some other
measure of profits?
In fact, there is no indefiniteness. The Rule is based on historical observations of the relationships between
royalty rates and operating margins.49 That is, rates often are twenty-five percent of operating margins, and it is
anticipated operating margins, according to the Rule, against which the profit split figure should be applied.
In Procter and Gamble v. Paragon Trade Brands,54 the court cited testimony that the Rule “is not really even
useful as a general guide for deriving an appropriate royalty rate.” In part because of that, the court wrote that it
“will consider the [twenty-five percent] rule of thumb analysis in determining the royalty rate, [but] this approach
will not receive substantial weight.” Nonetheless, in its final royalty analysis, the court did rule that “the [twenty-
five percent] rule of thumb analysis provides an additional confirmation of the reasonableness of a
royalty rate of two percent.”

Tax Center
it has been asserted that the Rule is inappropriate for use in those instances where the IP at issue
represents a small fraction of the product’s resident value
The precise split should be adjusted depending on a host of factors, including the relative
contribution of the IP at issue. Relatively minor IP often should, and does, command a split of
profits that is lower than relatively important IP.
The Flexibility of the Rule
In Procter and Gamble v. Paragon Trade Brands,54 the court cited testimony that the Rule “is not really
even useful as a general guide for deriving an appropriate royalty rate.”55 In part because of that, the court
wrote that it “will consider the [twenty-five percent] rule of thumb analysis in determining the royalty rate,
[but] this approach will not receive substantial weight.”56 Nonetheless, in its final royalty analysis, the
court did rule that “the [twenty-five percent] rule of thumb analysis provides an additional confirmation of
the reasonableness of a royalty rate of two percent.”

Tax Center
Empirical Test of the Rule
Licensed Royalty Rates (Late 1980s-2000)
Russell Parr, “Royalty Rates for Licensing Intellectual Property, 2007, hal.47

Tax Center
Industry Profit Rates (Late 1990-2000)

Tax Center
Licensee Profit (1990-2000)

Tax Center
Royalty Rates and Licensee Profits

Tax Center

Tax Center
Royalty Rates and Successful
Licensee Profits
Russell Parr, “Royalty Rates for Licensing Intellectual Property, 2007, hal..50.

Tax Center
Royalty Rates and Successful
Licensee Profits
Russell Parr, “Royalty Rates for Licensing Intellectual Property, 2007, hal..51

Tax Center
Conclusions
An apportionment of twenty-five percent of a licensee’s expected
profits has become one, of many, useful pricing tools in
IP contexts.
Although the data generally support the Rule, there is quite a variation in
results for specific industries. As this variation makes clear, the Rule is best
used as one pricing tool, and should be considered in conjunction
with other quantitative and qualitative factors that can, and
do, affect royalty rates.

Tax Center
Royalty Rate Guidelines
The following guidance is from Patent to Profit (www.frompatenttoprofit.com), a company
focused on helping inventors turn their ideas into commercial products, generating royalty
income.

Tax Center

Tax Center
Analysis Group, a national economic consulting firm, studied 2,279 license deals, for
fifteen different industries (based on data from RoyaltySource .com).

Tax Center
Royalty Rates for Technology,
Third Edition
Published by Intellectual Property Research Associates (IPRA, Inc.), Royalty Rates for
Technology, Third Edition
The information in the book has been collected from reliable sources, from September
1990 through May 2003, and is considered to represent a comprehensive collection of
technology pricing information. Information in this report is categorized by the following
industries:
The most frequent royalty rates are five and ten percent of net sales

Tax Center
Royalty Rates for Technology,
Third Edition

Tax Center
Royalty Rates for Trademarks
and Copyrights, Third Edition
Also published by IPRA, is Royalty Rates for Trademarks and Copyrights, Third Edition, which
provides a guide to royalty rate information for trademarks and copyrights, based on real-
world transactions. The information in this book represents data collected from reliable
sources, from September 1990 through December 2003, and is considered to represent the
most comprehensive collection of trademark and copyright pricing information. The
information contained in the book is organized by industry, as follows:
Airline
Apparel
Architecture
Art
Automotive & Boats
Celebrities
Communications
Corporate Names
Electronics
Food & Beverage Toys
Franchises
Furniture
General Merchandise
Internet Domain Names
Medical
Movies
Music
Party Goods
Publishing
Restaurants and Hotels
Sports
Toys
University Names

Tax Center
Royalty Rates for Trademarks
and Copyrights, Third Edition

Tax Center
Royalty Rates for Pharmaceuticals
and Biotechnology, Sixth Edition
Royalty Rates for Pharmaceuticals and Biotechnology, Sixth Edition, is also published by IPRA,
and focuses on the royalty rates associated with biotechnology and pharmaceutical
intellectual property transfers. Exhibit 4.5 graphs the royalty rate data, collected between
September 1990 and December 2005, found throughout the “License Agreement” section of
the book.

Tax Center
Business Enterprise Framework
Business Enterprise
Working
Capital
Fixed
Assets
Intangible
Assets
IP

Tax Center
Earnings
Fixed Assets
Intellectual
Property
Working
Capital
Intangible
Assets

Tax Center
Business
Enterprise
Working
Capital
Fixed
Assets
Intangible
Assets and IP
Intellectual Property
• Patents
• Trademark
• Copyrights
• Techno-know
how
• Designs
• Formula
• Trade Secrets
Intangible
• Distribution
Networks
• Supply Contracts
• Licenses
• Customer Lists
• Manufacturing
Practices
• Trained Work Force
• Research
Capabilities

Tax Center
Investment Rates of Return
and Royalty Rates
Total Earnings
(Te)
Working
Capital
Fixed Assets
Intangible
Assets
Intellectual
Property
(WCe)
(FA)
(IA) & (IPe)

Tax Center
Investment Rates of Return and
Royalty Rates
Earnings
(IA) & (IP)
Intangible
Assets
Intellectual
Property
SUBSTRACT
Intangible Assets
Earnings
(IAe)
RESULTS
Earnings Attributed
Technology
(IPe)

Tax Center
Royalty Rates

Tax Center
Royalty Rates
Investment Rate of Return Associated with all Intangible
Assets and Intellectual Property of Example Company, Inc.
Including the Patented Therapeutic Drug
Investment Rate of Return Associated with all Intangible
Assets and Intellectual Property of Surrogate
Pharmaceutical Companies Excluding the Patented
Therapeutic Drug
MINUS
EQUALS
Royalty Rate Associated with
the Patented Technology
Exi. 19.8
Exi. 19.9
Exi. 19.10

Tax Center
Benefits of Investment
Rate-of-Return Analysis
An investment rate-of-
return analysis
enhances royalty rate
determination by:
considering the investment risk associated with the business, and
industry environment in which the licensed technology will be used.
reflecting specific commercialization factors associated with
the licensed technology, as embedded in forecasts associated
with sales, production costs, and operating expenses.
allowing for an investment return to be earned on the fixed
assets used in the business.
allowing for an investment return to be earned on the working
capital assets used in the business.
allowing for an investment return to be earned on the other
intangible assets and IP used in the business, other than the subject
patent.

Tax Center
Discounted Cash Flow
Analysis and Royalty Rate
converts a stream of expected cash flow into a present value. The conversion is accomplished by
using a discount rate, reflecting the risk of the expected cash flow. In addition to the benefits
previously listed, from using an investment rate-of-return analysis, the discounted cash flow analysis
also reflects the
Net cash flow, also called “free cash flow,” is the amount of cash remaining, after
reinvestment in the business, to sustain continued viability of the business
• time period during which economic benefits will be obtained.
• timing and amount of capital expenditure investments.
• timing and amount of working capital investments.
• timing and amount of other investments in intellectual
property and intangible assets not associated with the subject
technology.

Tax Center
Discounted Cash Flow
Analysis and Royalty Rate
NET SALES minus
MANUFACTURING COSTS equals
GROSS PROFITS
GROSS PROFITS minus
MARKETING EXPENSES and
GENERAL OVERHEAD EXPENSES and
ADMINISTRATION EXPENSES and
SELLING EXPENSES equals
OPERATING PROFITS
OPERATING PROFITS minus
INCOME TAXES equals
NET INCOME
NET INCOME plus
DEPRECIATION equals
GROSS CASH FLOW
GROSS CASH FLOW minus
ADDITIONS TO WORKING CAPITAL and
ADDITIONS TO FIXED PLANT INVESTMENT equals
NET CASH FLOW
Exhibit 10.1
Exhibit 10.2
Exhibit 10.3
Exhibit 10.4

Tax Center
Court-Awarded Royalty Rates
Exhi 11.1

Tax Center
Frequency of Rate Awarded

Tax Center
Industry Categorizations
Exhibit 11.3

Tax Center
Infringement Damages Analysis
The Analytical Approach
Expected Profit Margin Normal Profit Margin Royalty Rate
The analytical approach is a profit differential calculation, where the profits
derived from use of the technology are subtracted from the profits that would be
expected without access to the technology. The difference is attributed to the
technology, and is considered by some as an indication of a royalty.

Tax Center
The Analytical Approach – Case Study
In TWM Manufacturing v. Dura Corporation, a royalty for damages was calculated, based on
an analysis of the business plan of the infringer, prepared just prior to the onset of the
infringing activity. The court discovered the profit expected from using the infringed
technology by reviewing internal memorandums, written by top executives of the company.
Internal memorandums showed that company management expected to earn gross profit
margins of almost fifty-three percent from the proposed infringing sales. Operating profit
margins were then calculated by subtracting overhead costs, to yield an expected profit
margin of between thirty-seven and forty two percent.
To find the portion of this profit level that should be provided as a royalty to the plaintiff, the
court considered the standard, normal, profits earned in the industry at the time of
infringement. These profit levels were determined to be between 6.6 and 12.5 percent,
and were considered to represent profit margins that would be acceptable to firms operating
in the industry. The remaining thirty percent of profits were found to represent a reasonable
royalty from which to calculate infringement damages. On appeal, the federal circuit court
affirmed.

Tax Center
Hypothetical Example

Tax Center
General Profit Margins
More data showing the profit differential between
generic and patented drugs can be found in The Risk
Management Association (RMA) Annual Statement
Studies. RMA compiles information about the balance
sheets and income statements of thousands of
companies
Generic Pricing
Considering the price differential between proprietary
drugs (under patent protection) and the same product,
sold as a generic drug (after patent protection expires),
provides additional information that supports a royalty
rate. Generic drugs are the chemical equivalent of brand
name products, for which patents have expired. The
primary difference is the absence of patent protection.
The following information indicates the enormous
value of patent protection.

Tax Center

Tax Center
Profit differentials are just one
way to calculate royalty rates.

Tax Center
Normal Industry Profits
A difficulty with the analytical approach centers on answering the
question, “What is normal?” Many companies in the same
industry, offering the same types of products to the same types of
customers, can show wide swings in profit margins. Presented in
Exhibit 36.1 are the net profit margins for six companies that
compete in the same industry, selling similar products to similar
types of customers. The profit margins range from a low of 0.2% to
a high of 11.4%. The average for the six companies is 6.5%. The
average increases to 9.4% if Beauticontrol Cosmetics and Helene
Curtis are eliminated from the average

Tax Center
Cosmetics Companies
Company Profit Margins
Aloette Cosmetics 8,2%
Avon Products 8,6%
Beuticontrol Cosmetics 0,2%
DEP Corporation 9,4%
Helene Curtis 1,2%
Jean Philip Fragrances 11,4%
Net Profit Margins for Six Cosmetics Companies

Tax Center
Annual Earnings From Different Products
Diversified Company Product Line Profitability
(millions)
Product Offering Annual Sales Total Earnings Profit Margins
Mature Product $ 1,429 $ 86 6%
High Tech Product 516 77 15%
Emerging Product 333 10 3%
Total $ 2,278 $ 173 7.6%

Tax Center
Exhi 36.4

Tax Center
Determining A Royalty Rate An
Example
Financial Review
Information provided by Phazor shows that earnings from commercialization of the
DermaPulse patented process were $42 million (before income taxes) for the year ending
December 31, 2003, on $105 million of net sales. This represents a profit margin of 40%.
After-tax earnings were reported as $25.2 million, representing a profit margin of 24%.
Invested capital associated with the fixed and monetary assets used to commercialize this
product line was reported at $126 million. Return on invested capital was 20%. This
financial performance is slightly better than that attained by the product division in which
the subject intellectual property is grouped. Pretax profit margins for the December 31,
2003, year-end for the total Phazor Basic Products Division (PBP Division) equaled 36%.
After-tax margins equaled 21.6%

Tax Center
Example
Financial Review

Tax Center
Example
DRR-1

Tax Center
Determining A Royalty Rate
An Example

Tax Center
Trademark Licensing
ROYALTY QUANTIFICATION
Assume that we are a marketer of ballpoint pens. We designed our pen some time ago, had it
manufactured to our specifications, and sell it in the northeast United States. We have a registered
trademark, PEN, and have built a nice business by calling on distributors and retailers in the region.
We would like to go national with our product but lack the capital for the extensive advertising
campaign that would be necessary to support such a move.
We are aware of a large, multinational company that manufactures and sells pencils and erasers
under its well-known PENCIL trademark. It agrees to license to us the use of the PENCIL trademark
on our pens, which will greatly facilitate our national rollout. It asks for a royalty of 10% of net
sales. Is that a fair price? We need to analyze the economics of our business before answering.
To illustrate, we will start with PEN’s income statement, given in Exhibit 26.6. We have added a
column to the typical dollar data to show the income statement on a percentage basis. We can
observe that our bottom line, or net income, is 10.2% of net sales. Would a 10% royalty wipe out
profits? No, because royalty expense is a deduction for income tax purposes, and so we must
reflect the payment of a royalty in the model in order to discern its impact, as shown in Exhibit
26.7.

Tax Center
Trademark Licensing
ROYALTY QUANTIFICATION
• Becoming a PENCIL licensee and entering the national market ought to bring in many times
the sales revenue and net income (in terms of dollars) that we now receive.
• We will, however, need to make an additional investment in our business to maintain a larger
inventory, among other things.
• The risk of our business will be increased because we will have to place larger orders with our
suppliers that we will be committed to buy even if sales do not materialize as planned.
• The risk of our business may be decreased because we will be selling to a larger base of
customers.
• In contrast, we ought to be able to negotiate a lower price for PENS and share in the
economies of scale enjoyed by our suppliers. This would increase the rate of our profitability.
• Perhaps PENCIL products sell at higher prices than competitors’ and we could recoup some of
the royalty by increasing the price of our product.
This is a very simplified model for analysis, and there are some additional
considerations:

Tax Center
Trademark Licensing
Discounted Cash
Flow Model
Allocation of
Income Technique
Exi 26.8 Exi 26.9 Exi 26.10

Tax Center
Trademark Licensing
Earnings with
Trademarks
Earnings without
Trademarks
Sales Revenue
Earnings
Attributable to
Trademarks
=Royalty Rate
Earnings Attributable to
Trademarks

Tax Center
Trademark Licensing
USING LICENSING TRANSACTIONS as a ROYALTY RATE SURROGATE. A popular royalty
rate estimation technique is to look to the market for rates that have been negotiated

Tax Center
Trademark Licensing
consor.com
fvgi.com
ipresearch.com
Consulting firms maintain a number of
proprietary licensing transaction databases
that are available for purchase. Most of
these are Web-enabled to some degree.
Some such sources include: recap.com
royaltysource.com
royaltystat.com

Tax Center
Jackpot, Inc, Case
In this case study, Jackpot, Inc. (Jackpot or the company), a major manufacturer of
computerized casino gaming products, has developed a plan to manufacture a line of
slot machines that incorporates a patented technology. Due to the unique nature of this
patented technology, Jackpot anticipates that the new line of slot machines will be a
significant contributor to the future growth of the company.
NewTech, Inc. (NewTech), a publicly traded company that is unrelated to Jackpot,
developed the technology and owns the associated utility patent (the slot machine
patent).
Since Jackpot does not own the slot machine patent, it has entered into negotiations
with NewTech to license the domestic use of the patent. Jackpot will then incorporate
the licensed technology into the new slot machine product line that it will manufacture
and sell.

Tax Center
Jackpot, Inc, Case
During the negotiation process, NewTech management informed Jackpot management
that it is also negotiating with Jackpot’s main competitor, Slots, Inc. (Slots) for a license
to use the patent
Jackpot retained Intellectual Property Financial Advisors (IPFA) to advise man-
agement regarding the contemplated patent license transaction. Specifically, Jackpot
retained IPFA to provide an independent opinion regarding the fair royalty rate that
Jackpot should be willing to pay for the exclusive domestic use of the slot machine
patent.

Tax Center
Jackpot, Inc, Case
NewTech has developed and patented a human recognition technology
for slot machines that addresses both the increased security needs of
casinos and casino management’s desire to improve customer
satisfaction.

Tax Center
Alternative Analytical methods
Considered
IPFA analysts used four methods to estimate the appropriate royalty rate that Jackpot
management would be willing to pay to NewTech to license-in the use of the slot
machine patent. These four methods are as follows:
1. The comparable uncontrolled transaction method
2. The comparable profits method
3. The profit split method
4. The discounted cash flow method
The next section of this case study presents a detailed description of each of the
methods that IPFA analysts used to estimate the royalty rate.
Exhi. 19.2

Tax Center
Alternative Analytical methods
Considered
Based on the data presented in Exhi. 19.2, a summary or the royalty
rates for comparable license transaction is presented as follows:

Tax Center
Comparable Profits Method
Exhi. 19.6
Exhi. 19.7

Tax Center
Profit Split Method
Exhi. 19.8
Exhi. 19.9
Exhi. 19.10
Exhi. 19.11
Exhi. 19.12

Tax Center
Summary of Royalty Rate
Estimation Methods
IPFA analysts developed a range of royalty rates based on the CUT method, the CPM, and the
profit split method, as presented earlier in this case study. A summary of the estimated
royalty rates from these methods is presented in the following table.
Since competitors are also negotiating with NewTech management, knowing the maximum royalty
rate that Jackpot can offer to NewTech will provide Jackpot management with the key information it
needs to successfully outbid them. In addition, knowing the maximum royalty rate that it can
reasonably offer will keep Jackpot management from overpaying for the patent license and, thereby,
impairing the overall value of the company. Therefore, IPFA analysts also used the discounted cash
flow method to estimate the maximum royalty rate that Jackpot should pay to NewTech without
impairing the value of the company.

Tax Center
Discounted Cash Flow Method
Exhi. 19.14
Exhi. 19.15

Tax Center
Synthesis and Conclusion
IPFA analysts developed a range of royalty rates based on the CUT method, the CPM, and the
profit split method. A summary of the estimated royalty rates from these methods is
presented in the table as follows:

Tax Center
Valuing Intangible Assets
The Analyst can predict the most likely response of the
market to the subject intangible asset. In other
words, the market determines value. The
analyst estimates value
MARKET
Analyst
Value

Tax Center
Valuing Intangible Assets
A specific BUNDLE of LEGAL property rights associated
with the existence of any intangible assets
Legal Property
Rights
Economic
Existence
In order for it (intangible) to have existence, the
intangible should be subject to private ownership
and that private ownership should be able to be
transferred to a new owner.
Economic
Economic
Existence
The intangible ‘s economic value dose
not accrue from this tactility, but the
intangible’s economic (and legal)
existence does

Tax Center
Expected
Profit
Margin
Normal
Profit
Margin
Royalty Rate

Tax Center
In TWM Mfg. Co., Inc. v. Dura Corp., 789 F.2d 895, 899 (Fed. Cir. 1986), a royalty rate for damages was
calculated based on an analysis of the business plan of the infringer prepared just prior to the onset of
the infringing activity. The court discovered the profit expectations of the infringer from internal
memorandums written by top executives of the company. Internal memorandums showed that company
management expected to earn gross profit margins of almost 53% from the proposed infringing sales.
Operating profit margins were then calculated by subtracting overhead costs to yield an
expected profit margin of between 37% and 42%. To find the portion of this profit level that
should be provided as a royalty to the plaintiff, the court considered the normal profits earned in the
industry at the time of infringement. These profit levels were determined to be between 6.6% and
12.5%. These normal industry profits were considered to represent profit margins that would be
acceptable to firms operating in the industry. The remaining 30% of profits were found to represent a
reasonable royalty from which to calculate infringement damages. On appeal, the Federal Circuit
affirmed.
An important characteristic of this royalty method, as used by the court for this case, is the emphasis
placed on the profit expectations associated with using the intellectual property at the time of the
infringement. Actual profits realized during infringement were decided to be irrelevant in this case

Tax Center
Normal Industry Approach
A difficulty with the analytical approach centers on answering the question,
“What is normal?” Many companies in the same industry, offering the
same types of products to the same types of customers, can show wide swings
in profit margins. Presented in Exhibit 36.1 are the net profit margins for six
companies that compete in the same industry, selling similar products to
similar types of customers. The profit margins range from a low of 0.2% to a
high of 11.4%. The average for the six companies is 6.5%. The average increases
to 9.4% if Beauticontrol Cosmetics and Helene Curtis are eliminated from the
average.

Tax Center
Normal Industry Approach

Tax Center
Hypotetical Example

Tax Center
Hypotetical Example
Exhi 36.4

Tax Center
Discounted Cash Flow Analysis
Pharmaprod Commodity Corp. Value
Exhi 37.1 dan Exhi 37.2
NEW PHARMAPROD CORP. ROYALTY RATE
What royalty rate should the company pay for use of the new product technology?
The highest amount of royalty the company should be willing to pay for the licensed
technology is shown in Exhibit 37.3. A royalty of 10.9% of the sales associated with
the new product represents a royalty expense to New PharmaProd Corp. and yields a
present value of $10,118,000—the initial value of the company. At this royalty rate,
the company has earned a return on the additional investment required to
commercialize the new product technology and not a penny more. A royalty rate of
less than 10.9% would increase the value of the company by allowing New
PharmaProd Corp. to keep a portion of the excess cash flow generated by the licensed
intellectual property.
Note that a payment greater than a 10.9% royalty rate would cause the value of the
company to drop below the initial $10,118,000. In such a case, the company would be
in a worse value condition than if it had never instituted the new business initiative

Tax Center
Disclaimer
This material was produced by and the opinions expressed are those of FUTURUM as
of the date of writing and are subject to change. The information and analysis
contained in this publication have been compiled or arrived at from sources believed
to be reliable but FUTURUM does not make any representation as to their accuracy or
completeness and does not accept liability for any loss arising from the use hereof.
This material has been prepared for general informational purposes only and is not
intended to be relied upon as accounting, tax, or other professional advice. Please
refer to your advisors for specific advice.
This document may not be reproduced either in whole, or in part, without the written
permission of the authors and FUTURUM. For any questions or comments, please
post it at www.futurumcorfinan.com
© FUTURUM. All Rights Reserved

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