Options and Royalty Rates

The Real Options Approach to Accurate Licensing Rates
by: Fernando Torres, M.Sc.
Picture the situation. The company has spent millions developing a new technology, the patent has been issued, and the Intellectual Property holding company (IPH) is ready to leverage the innovation by licensing to various subsidiaries. At what rate should the licenses be structured? What about compliance? The transfer pricing specialists are called, and they come back with: “There are no close comparables!” It seems the new technology is truly innovative and conventional methods to determine transfer prices break down. What now?
The Question
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 under-serve 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 high-enough 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 earth-shattering 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 in-house. Financial options have been valued in different ways, but the most solid methods are derivations from the famous “Black-Scholes” model.[3]

The Model
Arguably one of the key conceptual advantages of the Black-Scholes 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 time-value of money (risk-free 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 Risk-free interest rate.

Fairly Valued Rates
Recall the rate-setting 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 risk-adjusted profit expectation of the licensor and the licensee. That is how an objectively-determined 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 option-pricing 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 cross-border 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 risk-free 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.

_______________

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 real-world 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 three-month 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 Black-Scholes model. See: F. Russell Denton and Paul J. Heald, “Random Walks, Non-Cooperative Games, and the Complex Mathematics of Patent Pricing,” 55 Rutgers Law Review 1175-1288 (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.

Advertisements

One thought on “Options and Royalty Rates”

  1. You the man! The article is brilliant…. cutting edge stuff. I will be calling you shortly to discuss how your firm can assist me in my patent litigation practice. Keep up the good work!

Leave a Reply

Please log in using one of these methods to post your comment:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s