Part I: What are the alternatives to the 25% Rule of Thumb?
Previously we discussed the demise of the 25% Rule of Thumb. While the 25% Rule of Thumb won’t be missed, it does pose the “what-now” question: what analytical techniques are available to replace the 25% rule?
If there are any rules of thumb that reflect real world transactions, they would be: no agreement is generic, and no one’s intellectual property is “average.” Just as parent’s of Little Leaguers feel their child is unique and special enough to be the next Mickey Mantle, IP owners believe their properties are special. Yet many IP valuations rely on a simple calculation of sales multiplied by industry “average” royalty rates.
Few, if any, companies enter into a simple agreement, with royalties solely determined by a constant percentage of licensee’s sales. A license agreement is basically a contractual financial agreement between two parties: a promise to pay by the licensee and a promise to perform (financial and non-financial commitments) by the licensor. These financial commitments can and do take many forms. In our quarter century of “Real Life Licensing”, the framework for a license consists of a situation-specific blend of: minimum and maximum guarantees, territorial options, tiered royalty rates, up-front payments, marketing fees, licensor commitments, product content, year-to-year increases, scaled bonuses, tie-in agreements, and more.
License analysis and valuation should mirror the complexity of reality. When analyzing any license agreement or valuing licensing opportunities, one must consider terms and conditions found in real world agreements. The complexity of determining royalty rates was evident in a recent ruling in Lucent Technologies v. Microsoft. The district court was presented three approaches to calculating damages. The one and only approach accepted was premised on situation-based factors; factors specific to the circumstances and situation of the parties in the hypothetical licensing transaction. In other words, the only acceptable approach was to consider and quantify those terms and commitments likely to be found in the hypothetical agreement that the parties would have entered into.
As in real life situations, the parties involved in a negotiation are familiar with their own requirements and bargaining positions, and the correct valuation approach must reflect the knowledge each party has when negotiating.
From CONSOR’s experience, we recently analyzed over 400 agreements, and observed the following complexities found in those licensing agreements:
*Even those “Flat” fee agreements with a constant percentage royalty (the royalty fee % does not change with the licensee’s sales results) contain a mix of additional financial commitments. Again, CONSOR’s own practice validates the concept that licenses are complex, and the valuation of them should be handled as such.
In fact we have observed over 20 different types of structures in our study of real world license agreements. These 20+ structures are some of the agreement components that can be quantified when valuing licensing opportunities and hypothetical agreements. Of course there are non-financial commitments with every agreement that need to be considered as well.
So what are the alternatives to the outmoded and now disgraced 25% royalty rate rule?
As a start, we suggest beginning the analysis using these 20+ structures as building blocks, selecting those structures most appropriate to the type of asset being licensed and the desires, requirements and positions of the parties involved.
Quantifying the impact of the applicable structures on both licensee and licensor allows a more accurate analysis of the licensing opportunity.
In addition to our list of the 20+ structures, we plan to discuss these and other structures, and their application in analyzing intellectual property licenses in a few future articles. Stay tuned . . . .