[Jim’s four-part series tells entrepreneurs and investors what they need to know about licensing a product through a discussion of the terms that drive the license’s value. In today’s post, Jim shows entrepreneurs how they can negotiate the best royalty rate possible.]
2. Royalty—Sometimes Lower is Higher
One of the most important aspects of a license is the royalty rate. This is the percentage that the licensee agrees to pay you for the rights to the patent and product. Inventors naturally want to negotiate the highest possible royalty. But a high royalty isn’t always to the inventor’s benefit.
When negotiating a royalty rate there are several factors to consider. The first is the manufacturer’s suggested retail price. This is what the finished product will sell for to the end user. Ask the licensee what price points they want to hit at the retail level. They should be open with this information. From the manufacturer’s suggested retail price, you can determine the approximate wholesale price by knowing what channels the product will be distributed in. For example, a product sold through mass retail channels will typically have a wholesale price of 35% to 65% of the retail price. That is the retailer’s discounted price. Again, ask the licensee what channels they plan to distribute through and what the typical discounts are in those channels. Also, some manufacturers use distributors which require a piece of the pie.
Let’s look at an example I recently encountered. A product, let’s call it “Hitchy,” was going to be sold in the automotive aftermarket channel. In this case the manufacturer sold through a distributor to automotive retail chains, so the channel included a 35/35 mark up structure. The target retail price was $19.99. So the retailer would buy the product from the distributor at $13 and the manufacturer would sell to the distributor at $8.45.
Let’s look at two scenarios which illustrate why the royalty rate is important, but should be examined in terms of volume. Assume the manufacturer’s cost of goods is $5.00. That means the manufacturer’s gross profit is $3.45, before the royalty. Let’s say in the example above, you drive a hard bargain with the manufacturer and demand a 10% royalty. That means the royalty is 10% x $8.45 or $0.845 per unit. And let’s assume the manufacturer’s minimum required net margin is 35%. This deal won’t work! The manufacturer’s net margin is only $2.60 ($8.45-$0.845-$5.00) or 30% ($2.80/$8.45).
Even if the manufacturer decides to go forward with the product they will have to raise the price to meet their minimum net margin, which will put the product over the magic price of $19.99. What will happen? The manufacturer will sell fewer units per year. Why? If you raise the price of any product, fewer consumers will by the product. This effect, often called price elasticity by economists, has been proven again and again. So perhaps the manufacturer only sells 100,000 units per year at the higher price. So your total payoff is 100,000 units x $0.845 per unit = $84,500 per year.
But what if you had been more flexible with the royalty rate? Let’s say you were willing to lower your royalty rate to 6% to allow the manufacturer to meet its minimum allowable margin while keeping the retail price at $19.99. Your royalty now is $0.507 per unit. And the manufacturer’s net margin is 35%. Let’s now assume that the lower price results in an increase in unit sales to 175,000 units per year. Now your total payoff is 175,000 units x $0.507 per unit = $88,725 per year. Your royalty rate went down 40%, but your total payoff went up 5%!
In the third installment next weekend, I move on to what entrepreneurs need to consider when negotiating performance requirements, which are part of every licensing agreement.