RoyaltyStat Blog

Royalty Rates Are Great Ratios

Posted by Ednaldo Silva on Feb 29, 2016 10:20:14 AM

In physics, we benefit from the historical development of simple formulae describing basic phenomena, including Newton’s (1687) three laws of motion and the law of universal gravitation. Even the posterior extension of Newton’s second law of motion to accommodate particles moving at high velocities (comparable to the speed of light) has a simple formula. Newton's second law of motion can be interpreted to be a mathematical implementation of an earlier idea attributed to Buridan (1295-1363) that momentum (impetus) is proportional to a particle mass multiplied by its velocity. Buridan's simple definition of momentum finds many analogues in economics, such as the principle that price is proportional to cost, income is proportional to investment, and royalties are proportional to the revenue of the licensee.

Again in economics, we benefit from the historical development of many simple formulae, such as the principle (in addition to those listed above) of markup pricing attributed to Cournot (1838). In contrast, international transfer pricing guidelines are complex, resulting from regulatory overreaching.  E.g, no KIS (keep it simple) principle, aka Occam’s razor or the principle of parsimony found in mathematics and science, is applied in transfer pricing guidelines. As a result, tax controversy abounds about issues that can be resolved with a simple system of safe harbors. To satisfy those infatuated with complexity, we can localize safe harbors by using near-neighbor information and making them subject to periodic adjustments.

Among those who favor simplicity, several important economists (Lawrence Klein, Richard Kosobud, Nicholas Kaldor) have written of “great ratios” and “stylized facts” in which a supposedly unknown magnitude in reality has a known stable value. Evidence from large samples suggests that royalty rates are "great ratios" showing a stable center of gravity; thus, comparability analysis serves to determine: 

     (1)  the error band around 5% central value;

     (2)  if the 5% royalty rate is fixed or tiered; and

     (3)  if additional payments (upfront fees and milestones) exist among the comparable license agreements. 

The chart below shows that royalty rates are stable over time with the mass of the data varying within a range from 3% to 10%, and containing a stable median of 5%.  The sample includes 2,241 license agreements with data retrieved from RoyaltyStat on February 10, 2016.  This sampled license agreements reflect the following criteria: royalty rates are based on net sales; they are not tiered; they contain no additional payments, such as upfront fees and milestones; and they exclude related parties. Deviations from the stable center reflect sparse data.  E.g., the median royalty rates per year without a shadow range reflects less than five observations.

This stability of royalty rates with a center of mass of 5% persists when we examine royalty rates across countries, type of property being licensed (patent, know-how, trademark), and industries. Software and cyberspace (Internet) royalty rates are higher by exception; however, there are indicia that these higher royalty rates are really distributor gross profit margins masquerading as royalty rates.

We conjecture that royalty rates based on net sales (revenue, turnover) can be treated as safe harbors, and thus comparability analysis to support the intercompany transfer of intangibles can be simplified to localizing (in terms of industry and geographic market) the three items listed above.

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Ednaldo Silva (Ph.D.) is founder and managing director at RoyaltyStat. He helped draft the US transfer pricing regulations and developed the comparable profits method called TNNM by the OECD. He can be contacted at: esilva@royaltystat.com

RoyaltyStat provides premier online databases of royalty rates extracted from unredacted agreements, normalized company financials (income statement, balance sheet, cash flow), and annual reports. We provide high-quality data, built-in analytical tools, customer training and attentive technical support.

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Topics: Safe Harbors, Safe Harbours