Patent Baristas

Among the most frequently asked questions I get from start-up companies is: How much should I pay for licensing in a technology? Answer: As little as possible. Kidding aside, this is really a very complicated question that cannot be answered without a lot of homework. While most companies seem to use a valuation method I like to call “pulling a number out of the air,” there are three primary methods used by licensing professionals to assess the value of IP assets. These are the Cost Method, Market Method and Income Method. With all of these methods, good data and data projection are critical in determining the appropriate numbers.

In the Cost Method, the value is the cost incurred in developing or purchasing the relevant technology or intellectual property. But what if, as a result of changing markets or new information, you determine that the present value of the total revenues/return expected from this technology is less that the cost?

In the Market Method, the method for determining value is to learn what comparable technologies have licensed for recently. Of course, to do this you’ll need to (a) determine what transactions are comparable and (b) obtain current, reliable data. Usually, this is through compiled data reports.

In the Income Method, value is the estimated revenues the technology is likely to produce (and savings it is likely to generate) and comparing this to the estimated cost to generate the same revenues or savings from other sources, that is, total annual returns. Basically, it’s a method of determining what you can afford (or not afford) to pay in the end.

This issue came up while I was on a panel discussion at the BioOhio conference last week (although I was in pain from my broken shoulder). It did provide some interesting insights in the need for obtaining information relating to royalty rates.

One audience member stated that he felt universities or research institutions collaborate and share licensing information, essentially leaving a potential licensee at a disadvantage with little or no information as to what the “proper” royalty rate should be for a given technology. The audience member thus posed the question: Are there sources of royalty data available to a licensee to figure out the “appropriate” royalty amount to pay (i.e., the Market Method)?

The short answer is “Yes” but I find such royalty rate sources particularly unhelpful. We didn’t have time to get into details at the time but I think that finding out the range of average royalty rates for particular products is interesting in the sense of providing a general “ballpark” range — but not really helpful for your particular product and agreement.

Organizations like the Association of University Technology Managers (AUTM) and the Licensing Executives Society (LES) publish lists and statistical analyses of royalty rates (many industries use about 5% of the selling price as a typical rate) but rates can vary from 0.1 to 25% or more and depend on the industry.

Often, such royalty guides provide some range of royalty rates for certain technologies, e.g., a rate of 4%-12% for technologies related to therapeutic products. I would argue: So, what? What does that tell you about your therapeutic? Should it be 12%? Or only 4%? Or do you split the baby and call it 8%?

Granted, using an established royalty rate shown in certain guides sounds good since these are derived from prior actual licenses for comparable products. The rates in the guides come from negotiation and paid by a sufficient number of licenses. As with reasonable royalty, an established royalty rate derives from the outcomes of willing parties licensing without the threat of a suit, or resultant from litigation. These rates are reflective of the profitability of industry segments. Correspondingly, what might pass muster for an established royalty depends upon the definition of a market segment. Commodity items tend to garner a relatively low royalty rate, just shy of 3%, consumer goods 5%, while software garners around 7-8%. But generalities don’t tell you anything about your particular deal.

Very often, universities rely on the 25% Rule. It’s often accepted (as a rule of thumb) that a royalty rate equalling about one-quarter of the licensee’s anticipated pre-tax profits derived from the technology is a fair rate. Of course, one needs to then determine net profits. Thus, the rates depend on the market forces of each particular product. For example, if the licensee will have profit margins of 80%, the royalty paid to the licensor should be about 20% of pre-tax, net revenues. Conversely, if profits of 4% are expected, the royalty should be within the range of 1-1.5% of net revenues earned.

Note, however, that this rule-of-thumb doesn’t take into account specific circumstances determining the value of your particular technology. Therefore, the 25% Rule is only a starting number before looking at many other factors that should be taken into account in the final determination of value/rate. One needs to consider: Is the technology a breakthrough or core product? Is it merely an ancillary product or minor improvement? Is the intellectual property (patents, copyrights, etc.) strong enough to make the final product unique and valuable? Is the technology ready to be used immediately or will it require substantial R&D or regulatory clearance to be commercialized? Is there a high risk of failure? Can you maintain a high profit margin or will others eat your lunch? Therefore, royalties for pharmaceuticals in the pre-clinical stage may be from 0-5%, while royalties in Phase I may be 5-10% and royalties for launched products may top 20%. Again, guidebooks and rules-of-thumb will only get you so far.

If you want to strike a deal in which the licensor thinks the price is too low, you need to provide a basis for your numbers. I recommend to clients that, if necessary, they show their business plan to the licensor under a nondisclosure agreement. That often helps the other side understand that the offer is dictated by the business model and not just an offer to get the lowest royalty rate in order to keep more of the profits for itself. For example, substantiate an expected profit percentage by preparing a manufacturing cost estimate and then apply percentages customary in the specific industry for overhead items like R&D, engineering, marketing and sales, etc. Then the total cost per unit is deducted from the expected selling price per unit to establish a gross profit.

What is more difficult is deciding how much, if any, the royalty rate should be discounted based on risk factors. It is not impossible for discount factors to be in the 25-35%/year range. To determine the ultimate reasonable royalty rate, you need to consider extraneous factors (e.g., how soon until you will be ready to sell a product and gain revenue, the exclusionary position of the patents, the competitive products, market share, etc.).

I say that the “correct” royalty rate is the maximum royalty rate that the licensee is willing to pay that meets the minimum royalty rate the licensor is willing to accept. If you are only willing to pay 3% and the university will only accept 6%, then you’ll have no deal (and I’d argue you shouldn’t!). Why front your capital on a business venture that you can’t afford to pursue?

A reasonable royalty rate is often based on economic sense by utilizing a financial model which relates the investment required to develop a therapeutic technology to the income generated by such technology. What does that mean? It means you have to have a good business plan in place before you can talk turkey on royalty rates. And I don’t mean those wildly inflated fluffy business plans that companies create showing revenue in colorful logarithmic growth charts to impress potential investors. No, I mean a real, down-to-earth, cold shower type of business plan that takes into account all of the pain and suffering that could be encountered along the way.

For example, with a novel early-stage therapeutic technology that is licensed by a university to a commercial company, one has to look at the development of such technology. Entrepreneurs who intend to market a new drug must go through a very complex and expensive process. Bringing a new drug to market can take a company 10-15 years at a cost of over $800 million.

The first step in obtaining FDA approval for a new drug is to submit an Investigational New Drug (IND) application to the FDA that contains preclinical information including animal pharmacology and toxicology data. When the FDA has cleared the IND application, the drug manufacturer can conduct clinical trials in three phases:

Phase I: Study of the drug in 20 to 80 healthy human volunteers for up to one year to provide information on the drug’s toxicity and potential side effects.

Phase II: This type of study is conducted on patients with the targeted disease that the drug is intended to treat over two years to test the drug’s safety and efficacy.

Phase III: This is the most comprehensive of the investigational studies focusing on a large number of patients for approximately two to four years, depending on the drug and the patient population.

Once you have successfully completed three phases of clinical studies on an investigational drug, you submit the information as part of a New Drug Application (NDA). The submission is reviewed by the FDA. If the drug is granted NDA approval, the FDA may require that the company engage in a Phase IV clinical study.

At each step in the path, there is a substantial risk that the drug will fail. Even drugs that complete Phase III clinical trials will go on to gain FDA approval about half the time. And, after clearing all of these hurdles, sales may increase gradually and not reach full scale until many years after marketing approval. The total cost of production, marketing, selling, etc., (excluding royalty payments) may be 80-90% of sales value. Keep in mind, depending upon when patents were filed, a licensee may have only 10-12 years of patent-protected sales in which to recoup investment expenses.

Drug development (or other high-tech product development) is a high-risk venture and such risk should be reflected in the company’s required rate of return. In any event, the rates of returns will depend to a large extent on the maximum royalty rate, payable to the university, which will enable the company to achieve its desired rate of return.

A university will often push for a higher royalty rate based on the appeal of the technology (cutting-edge technologies deserve higher royalty rate), its proximity to human trials and the extent of the patent coverage, etc. The company usually bases its royalty rate by considering the amount of investment required for the development and the extent of patent coverage.

The expected sales volume is often a key determinant of the economically reasonable royalty rates. Thus, the factors that determine the expected sales volume such as the potential market, possible competition, the expected product price and the geographical coverage of the patents should be seriously considered while determining such rates.

Considering that the total investment required for the development can be hundreds of millions of dollars, in many cases only a small royalty rate is economically reasonable depending upon the expected sales volume. If the expected sales volume doubles, the reasonable royalty rate payable will likewise increase. However, as the amount of investment capital increases, the maximum royalty rate payable to the university will decrease. In that case, the range of reasonable royalty rates can easily vary from 1%-12% (or even well outside this range) depending upon the expected sales.

In light of this, guide books of reasonable royalty rates don’t seem all that helpful.