When an industry’s royalty rate ranges are wide, say from 3% to 10%, or the industry or relevant markets themselves are nearly impossible to pin down, what additional analysis is required to properly set fairly valued licensing rates? Conventional “Relief from Royalty” methods cannot be applied with confidence and, worst of all, guessing begins.
If the license (or royalty) rates are set too low, the IPH would underserve its purpose to take advantage of tax and liability arbitrage. If the rates are set too high, the subsidiaries’ financials will suffer, and external (potential) licensing opportunities will likely be lost. So the question is, is there a licensing rate that, given the projected profits from the innovation, or other intellectual property, will cover both parties against these risks?
This article presents an alternative approach that can support IP owners, and their advisors in achieving their goals in this area.
The Background
As intellectual assets have become one of the most, if not the most, important portion of the value of the global economy’s leading enterprises, issues such as transfer pricing, valuation, and leverage have come to the forefront of business decisions.
Similarly, the tools used by specialists and other practitioners have to evolve to continue supporting that decision making process. Yet the most common method still being applied in the field is taking simplified Net Present Value (NPV) calculations applied to royalty income streams calculated on the basis of “representative” royalty rates. These rates are typically derived from transactions that are supposedly (but rarely) “comparable,” according to certain established criteria. This, in essence, is what the preferred IRS method (Comparable Uncontrolled Transaction methodology or “CUT”) does.
Obviously, the greatest obstacle in relying on the CUT method is finding past transactions involving unrelated parties with a highenough degree of similarity. Questions that must be asked to select the “comparable” transactions include whether, or not:
 the patents, or technologies, are similar
 the parties involved are independent from each other
 the market characteristics are similar
 the investment commitments are similar to the case under consideration
 the terms and conditions are comparable (e.g. territory, duration, exclusivity)
While in many trademark, copyright, and even technology licensing cases suitable comparables can be found, it is the nature of patents, in particular, and true innovations, in general, that such transactions will not be easy to identify. That is the main reason new approaches are derived.
The basic alternative to (outside) comparables is making full use of the (internal) information regarding the patent or other item of intellectual property [1] being licensed. In other words, if your company’s transfer pricing analysts cannot find outside comparables, it may be time to look inward.
The Premise
Patent licensing shares at least one attribute with all other relevant business decisions: it involves risk. While this may not be earthshattering news for most, it does point us in the direction of where an alternative approach can begin.
Where decisions involving financial risk are concerned, sound management principles suggest considering ways and vehicles to hedge that risk. Consider the prospective licensee of our truly innovative technology, wouldn’t it be ideal if the contract commitments could be altered as actual investment, production, and/or sales figures began to be known? Business life does not work like that, so decision makers have a clear incentive to bid for the license in such a way that they are protected from the risk of over investing and spending, as well as from under performing in terms of sales.
One of the central vehicles to hedge risk in modern finance is an “Option.” A financial option on a stock, for instance, is simply the right to buy the stock for a predetermined price (the “strike” price) before the option expires, but it does not entail any obligation to buy.[2] Consequently, the holder of the option will only exercise this right if it becomes profitable to do so, and will not exercise that right if the future market price of the stock does not surpass the strike price.
Suppose our licensing executive could structure an agreement in such a way that a royalty is payable if, and only if, the project involving the innovative patent turns out to be profitable. Naturally, the patent holder (the IPH in our example) would not find such a contract very attractive in real life. Nevertheless, there are financial methods to determine how much such an option would be worth to the licensee and, conversely, what the corresponding value would be for the Licensor to sell the technology if it is unprofitable to develop it inhouse. Financial options have been valued in different ways, but the most solid methods are derivations from the famous “BlackScholes” model.[3]
The Model
Arguably one of the key conceptual advantages of the BlackScholes model[4] is the precise isolation of the factors (all “current” values) that determine the price for the option:[5]

The time to expiration

The risk of the underlying asset

The timevalue of money (riskfree interest rate)[6]

The current and strike prices of the asset
Drawing the parallel with our patent, as the underlying asset in the option analogy, it certainly has a finite lifespan, the risk of the industry (or industries) where it is to be implemented can be ascertained, and the prices refer to the expected profit streams from its implementation. The equation that synthesizes the model is quite daunting, and an experienced valuation consulting firm can greatly add value to our licensing executive by thoroughly reviewing the details of the licensing deal and properly using the formula to arrive at the corresponding royalty rate.[7]
The Formula
Where: RR is the Royalty Rate as a proportion of sales, PR is the Profit Ratio or margin on sales, N(∙) is the Normal Distribution Function, σ is the standard deviation of the market, T is the life span of the patent, and r is the Riskfree interest rate.
Fairly Valued Rates
Recall the ratesetting situation we started with. In the course of actual negotiations, each side could have a different insight into the future profitability of the technology, and their own actions will affect it as well. Consequently, negotiated rates may reflect the extent of the disclosures and the thoroughness of the due diligence, rather than the (ideal) fair values for the licensing rates (or transfer prices) corresponding to the inherent risk of the project. Applying the objective valuation method introduced above, in contrast, what we can calculate are fairly valued royalty rates. That is, given the risk and economic life of the patented technology as well as general economic conditions, the fairly valued royalty rate will balance the riskadjusted profit expectation of the licensor and the licensee. That is how an objectivelydetermined fair value for the license is obtained.[8]
A Case in Point
A recent case where we applied this methodology dealt with finding the fair value for the royalty rates to be charged by the IPH to the manufacturing subsidiary for the patented formulation of a major nutraceutical product. The range of royalties in the nutraceutical market is extremely wide, from 1% to 12% and of little value as a reference.
The patents involved had relatively short lives left, newer patents were about to become available, and the industry has experienced relatively high volatility. The rates the optionpricing model allowed us to determine narrowed the range to 1.8% plus or minus 0.4% and served as a basis for a realistic valuation of the internal transfer of the patent assets, which enabled the client achieve important goals of their crossborder tax strategy.
Case Study
In this case: The Royalty Rate as a proportion of sales is 1.8%,
the Profit Ratio or margin on sales is 17.7%, the standard deviation of the market is 13.7%,
the remaining life of the patent is 7.5 years, and the riskfree interest rate is 3.9%.
Take Away
Intellectual property is a significant component of enterprise value, and the proper leverage of the increasing corporate investments in patents, trademarks, etc. needs to be based on sound analytical support. When dealing with innovative products, technologies, or business models conventional “comparables” are not available, almost by definition. Modern, sophisticated analytical methods are available to incorporate the information internal to the innovation and develop objective and fair licensing fees. Seeking advice from intellectual property specialists who can support innovative companies achieve their IP pricing objectives, internal and for external negotiations, is the most effective strategy.
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Footnotes:
[1] Although the method discussed may be applicable in other types of property, its characteristics can be better explained in the case of patents. Consequently, this article will focus on patents.
[2] This is a simple description of a “call” option, while the right to sell at a predetermined price is called a “put” option. There is a specific relationship between “calls” and “puts” that allows our analysis to be substantially the same in either case.
[3] This model, published in 1973, was derived by Fischer Black and Myron Scholes, based on previous research by Paul Samuelson and Robert Merton. The 1997 Nobel Prize in Economics was awarded to Merton and Scholes, Black having died a couple of years before.
[4] See e.g., Dixit, A. and Pindyck, R. Investment under Uncertainty , Princeton University Press, 1994; Anson, Mark, The Handbook of Alternative Assets, Wiley, 2002; and Anson, Mark, et al, Credit Derivatives: Instruments, Applications, and Pricing, Wiley, 2004.
[5] Like any model, this simplification of a realworld problem inevitably requires assumptions. Space prohibits a thorough discussion of them, but there is a general consensus that the model is sound. A detailed treatment can be found in For an overview of these approaches, see R. Pitkethly, “The valuation of patents: a review of patent valuation methods with consideration of option based methods and the potential for further research,” and M. Reitzig, “Valuing Patents and Patent Portfolios from a Corporate Perspective,” in: UNECE, Intellectual Assets: Valuation and Capitalization, United Nations, Geneva and New York, 2003.
[6] Conventionally this is the yield on threemonth U.S. Treasury Bills.
[7] Although typically the model is expressed in terms of prices, an algebraic equivalent can express the solution in terms of a royalty rate, as a proportion of the price. Furthermore, as Denton & Heald correctly argue, in this case the market and strike prices of the “real option” must be equal, thus simplifying the formula from the original BlackScholes model. See: F. Russell Denton and Paul J. Heald, “Random Walks, NonCooperative Games, and the Complex Mathematics of Patent Pricing,” 55 Rutgers Law Review 11751288 (2003).
[8] Obviously, the model’s formulas can be extended to incorporate different royalty structures, adjust for exclusivity and territorial restrictions, and other key specifics of the license agreement involved.
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