In most licensing situations payments have to be made by the licensee to the licensor. The payments represent compensation to the licensor for allowing use of industrial property rights or valuable intellectual property by the licensee and providing necessary technical assistance to enable the licensee to produce as per agreed terms. Generally there is likely to be some financial return for proprietary knowledge or other forms of intellectual property to the licensor. The process by which this return is determined and agreed to by both licensor and licensee, is crucial to the licensing process. It is, however, not an area that is always amenable to the application of scientific rules, since licensing negotiations are subject to human factor, supply and demand conditions in the market and bargaining power of both the partners. In addition, pricing and negotiating in general is subject to the extent of support being available to both buyer and seller.
CATEGORIES OF PAYMENTS
Payments for the technology may be divided into three broad categories, although in practice an agreement may involve a combination of all three : lump sum payment, royalties and fees.
Lump sum Payment : Lump sum payments, by definition, are calculated in advance, though the agreed sum may be paid in instalments. This method maybe appropriate where it is desired to obtain the technology by outright purchase. It may also be a means of obtaining the data on a patented process. Traditional reasons for down payment or lump sum payments are as follows :
- Down payment is a transfer cost representing the specific costs borne by the licensor to prepare a “technology package” for the licensee. Costs could arise from preparing drawings, specification lists, operating manuals, on-site training of personnel etc.
- Down payment acts as a surety, in case licensee defaults on the term royalties, delays in business operations, fails to go into operation after receipt of know-how or undergoes liquidation. By down payment the licensor reduces the risk of surrendering valuable technology.
- It is an advance collection of minimum royalties on estimated turnover of the licensor.
- The licensor may not be in a position to verify licensee’s accounts and thus prefers a onetime transfer fee.
- The licensed product may be sold internally in the enterprise and detailed sales/production records may not be maintained for such sales.
The economic, legal and regulatory environment of the country of the licensee may also influence the collection of lump sum payments. These include stability of national currency or that of exchange rates, regulatory policies of the host country, different levels of taxation etc.
Payments are made for the use of all forms of industrial property rights, the ownership rights of which are established by national statutory law (patent’, trade mark, copyright),’civil law (trade secrets), or international consensus (know-how). As a consequence, payments arise in the licensing of industrial property rights because the licensee derives protected benefits from its use. Royalty can be considered a lease payment, not an outright payment.
Royalties may be paid as a percentage of sales value, whether the technology is in the form of know-how or the use of patented equipment/process of production. The exfactory value of total sale is frequently the basis of calculations. Alternatively, the royalty may be based on the gross value of production.
The rate of royalty may be related to the net value of production. Whether the royalty is based on sales or value added, payments will increase in an inflationary situation, irrespective of the contribution of technology acquired.
Fee for technology which may be remunerated specifically include training, whether in the licensor’s or in the licensee’s works, the position for technical experts required to introduce the technology and fee for expert assistance in the setting up of associated research and development, design and engineering services. Any fees payable for the management of the plant, purchasing of inputs, etc. are a separate matter, to be distinguished from those of technology fees. Fees related to foreign personnel should be calculated on the number of hours of such services which are agreed upon. The three ways of payment are three alternatives. In the end, it is the total, payment to be made by the licensee by whatever means and over whatever period, that matters to both the parties.
Factors Affecting Royalty Rates
In any negotiation for technology transfer, both parties will arrive at their ‘reservation’ price by some assessment of the costs and benefits they both derive from trade, so that the financial benefits are acceptable to each side. This determines the absolute range over which the price can be negotiated. The process of finalising a specific price depends on the bargaining strength of the two parties, as well as their negotiating skills and general attitude towards risk and uncertainty. These factors will depend on the nature of the intellectual property to be exchanged. In Tables 6:1 and 6.2 present the key factors affecting the alternative pricing of intellectual property, first from the point of view of the licensor and second,, from that of the licensee.
From Tables-1 and table-2 it is apparent that various factors on the cost and benefit side of the equation can affect the pricing of a licence and fixing royalty rates. At the outset, the royalty level will be based on an assessment of the respective valuations of both licensor and licensee of these factions. However, that merely sets a maximum and a minimum royalty rate that both would find acceptable. Once it has been established that there is scope for trade, the rest of the pricing decision revolves around the risk preference and bargaining power of, the two parties. Figure-1 illustrates this bargaining range. The essence of this table is again to emphasise the existent of an overlapping range within which other factors play an important role.
Table-1 : Factors Underlying Licensor Royalty Negotiations
Table-2 : Factors Underlying Licensee Royalty Negotiations
Figure-1 : Configuration of Bargaining Ranges
COMMONLY USED INTELLECTUAL PRICING METHODS
Some of the more commonly used royalty rate development models are discussed, highlighting their primary deficiencies
The “25 Per cent” Rule
Under; this method royalty is calculated at 25 per cent of the gross profit, before taxes, from the enterprise operations in which the licensed intellectual property is used. At best this method of royalty determination is crude.
Gross profit based upon “generally accepted accounting principles” concept includes the direct costs of production. These include raw material cost, direct labour, manufacturing expenses and depreciation expenses. All of the costs and expenses associated with conversion of raw materials into a final product or service are included. Since this is most likely to be the area of greatest contribution from intellectual property, consideration of the amount of gross profit in setting a royalty is reasonable but it fails to take into account the final profitability that is ultimately realised with the licensed property. Absent from the analysis are setting, administrative and general overhead expenses.
Intellectual property that is part of a product or service which requires little marketing, advertising and selling effort is far more valuable than a product based upon intellectual property that requires the use of national advertising and a highly compensated sales, personnel. Two patented products may cost the same amount to produce and yield the same amount of gross profit, yet one of the products may require extensive and continuing sales support while the other may not. The added costs of extensive and continuing sales efforts make the first product less profitable to the licensee. While the two products may, have the same gross profit, it is very unlikely that they would command the same royalty.
The 25 per cent rule also fails to consider the other key royalty determinants of risk and fair rates of return on investment. The “25 per cent rule” is not even useful as a general guide upon which to begin negotiations.
The industry norms method focuses upon the rates that others are charging for intellectual property licensed within the same industry. Investment risks, net profits, market size, growth potential and complementary asset requirements are all absent from direct consideration. The use of industry norms-places total reliance upon the ability of others to correctly consider and interpret the many factors affecting royalties.
Changing economic conditions along with changing investment rate of return requirements also are absent from consideration when using industry norms. Even if an industry norms royalty was a fair rate of return at the time it was established, there is no guarantee that it is still valid after some years. Value, economic conditions, rate of return and all of the other factors that derive a fair royalty have dynamic properties. They constantly change and so must their underlying analysis that establishes royalties. Use of established industry norms fails to reflect changing conditions.
Return on R&D Costs
Basing a reasonable royalty on the amount that was spent on development of the intellectual property could be terribly misleading. The amount spent in the development is rarely equal to the value of the property. The millions of rupees spent on research relating atomic energy, space, defence etc. may yield to the Indian Government very little intellectual property.
A proper royalty should provide a fair return on the value of the asset regardless of the costs incurred in its development. The underlying value of intellectual property is founded upon the amount of future economic benefits. Factors that can limit the benefits include the market potential, the sensitivity of profits to production costs, the period of time over which benefits will be enjoyed and the many other economic factors that were discussed. The development costs do not reflect these factors in any form. Basing a royalty on development costs can completely miss the goal of obtaining a fair return on a valuable asset.
Return on Sales
Royalty based upon a percentage of revenues sales has several primary weaknesses. The first difficulty is the determination of the proper allocation of the profits between the licensor and the licensee. Another area of weakness is the lack of consideration for the value of the intellectual property that is invested in the enterprise as well as a lack of consideration for the value of the complementary monetary and tangible assets that are invested. Finally, this method fails to consider the relative investment risk associated with the intellectual property.
There is no rigid formula for determining the price of intellectual property and thus estimates vary from case to case. The price of know-how/intellectual property normally ranges between 2% to 10% of either the plant and equipment cost or projected turnover production of the unit for a period of 5 years. However, the price would depend, on the estimates of opportunity value and “what the market can bear” Besides, the realisation of price could be between lump sum amount and recurring royalty payments. Although it would be in the interest of licensor to realise as much of the price as is possible through lump sum payment, the licensee’s interest would be to pay the price only through recurring royalty based on production. Thus, balance has to be struck between these two components.
TECHNOLOGY TRANSFER AGREEMENTS
A Technology Transfer Agreement is a contract between the licensor and licensee, detailing the scope of services and terms and conditions from both sides. Drafting of this agreement is often a highly complex job requiring considerable skill and experience, since the interests of the two parties may sometimes be conflicting.
However, the obligations of the licensor and licensee may broadly relate to the following:
Obligations of the licensor
a) Supply of the technical means
b) Technical assistance to the staff of the licensee
c) Provision as to the results and consequences of non-satisfaction of the guarantees.
d) Exclusive and non-exclusive rights
e) Preservation of secrecy
f) Title of the licensor
g) Period of agreement
h) Force majore
i) Intellectual property rights
j) Updated technologies and improvements
k) Technical information
m) Help in marketing and exports
n) Settlement of legal disputes
o) Access to R&D
Obligations of the licensee
c) use of the know-how
d) Minimum output
e) Maintaining specified quality or standard
f) Adequate technical and managerial standards and facilities
g) Focal facilities for the experts/staff of the licensor
h) Access to the factory premises as required
i) Legal disputes