We find little empirical work in academia about the determinants of royalty rates covering intellectual property (IP) licensing transactions. Beyond the exchange of intellectual property itself, licensing transactions play an important role to market practitioners. Market practitioners benchmark their own pricing terms based on prior royalty rates transactions. Royalty rates are also important for those analyzing IP for transfer pricing and patent litigation, where comparable transactions are recognized by tax authorities and courts as benchmarks of value.
This post explains recent work we’ve done using a surplus bargaining framework to explain royalty rates, and the effect of contract redaction on royalties. Redacted contracts have dramatically lower royalty rates relative to publicly disclosed contracts. We argue that the parties’ bargaining power and whether the contract was redacted are important value-relevant characteristics that should be considered when conducting comparables analysis for IP valuation for IP litigation or transfer pricing.
There are three key issues of selecting comparables. First, are they technologically comparable? Second, what is the role of non-technological factors (at the contract or company level)? Third, do we know all relevant comparables? The first issue is not the focus of this post – deciding what is “comparable” requires subjective judgement and is a tall task we leave for future research. Instead, we tackle the second and third issues. They are questions made exigent by recent judicial developments, and are heavily discussed among legal scholars today.
Using RoyaltyStat®’s leading database of licensing agreements, we obtained about four thousand agreements that pass our basic sample filters of referring to a US publicly traded company, not between related parties, involving IP and not commodity rights, and not assessed on a per-unit-of-sale basis but rather on a per-sales basis. Linking to a publicly traded company gives us incredible detail on the company and its financial health and size, while RoyaltyStat’s database provides details about contract terms, including royalty rates. We consider both redacted and unredacted license agreements, allowing us to compare how confidential transactions differ from publicly known ones. Because the redactions remain confidential for at least 10 years or the life of the contract, this provides a reasonable analogy to the overall “dark” market for intellectual property as the redacting parties were reasonably confident their transaction would remain confidential for its useful life.
Using a standard but robust statistical methodology, we study the factors that determine royalty rates. This approach allows us to estimate how different contract terms and company and technology characteristics, controlling for each other factor. To understand how contractual terms affect pricing (i.e., royalty rates), it is necessary to use an economic framework. Gregory Sidak (“Bargaining Power and Patent Damages,” Stanford Technology Law Review (2015)), argues that because IP is not perfectly competitive and grants monopoly power, licensors and licensees are bargaining over economic surplus. The surplus is likely divided according to who has more bargaining power. Thus, we construct several measures of the characteristics of participants in a licensing deal to see if the data attest to Sidak’s conjecture.
We find that it does. Company characteristics that convey market power, technological differentiation (or strong financial position) appear to do well in explaining the variation in royalty rates. For example, firms whose patent composition is highly correlated with those of other competitors earn lower royalty rates, reflecting the high degree of substitutability of their technologies.
Moreover, companies appear to demand repayment for losing the power to commercialize their IP in future situations, such as when conceding exclusivity. Because redaction (undisclosed financial consideration or other key contract terms) conceals the price a company negotiated at, we find that licensors charge lower royalty rates when redacting. This is likely because licensing managers of companies choose not to reveal the price they are willing to bargain at to other potential licensees. Consistent with this conjecture, we find no such statistical relation when contracts are exclusive as there are no longer any potential future licensees. Thus, in these cases redaction is likely motivated by the need to shroud the firm’s product market action rather than its bargaining position over the surplus. This result is robust considering patent citations as (the best available) measure for a patent’s market potential.
Here is a summary of our findings. Holding all else equal:
(1) Exclusive contracts earn higher royalty rates, particularly when licensing companies face more competitors;
(2) A premium is demanded for exchanging “know-how”;
(3) Not for profit licensors earn lower royalty rates;
(4) Redacted contracts earn lower royalty rates; and
(5) Redacted contracts which are exclusive have rates which are statistically indistinguishable from unredacted exclusive contracts.
The magnitudes of these generalizations are large. For example, a redacted contract is 2.5% lower relative to the now-defunct royalty rule-of-thumb of 25%, or the 6% median rate in our sample. This means that almost half the royalty can be explained by redaction. These results are robust to many statistical methods we tried, including various choices of fixed effects, standard error clustering, and joint estimation of the determinants of rates and fees through a generalized method of moments (GMM) approach.
These findings are especially important because at the present juncture courts and legal scholars find themselves in a vigorous debate about the selection of appropriate comparable IP licenses in the determination of reasonable royalty damages. As just mentioned, courts previously accepted 25% as a rule of thumb for reasonable royalties; however, this precedent was thrown out by the federal court decision in Uniloc USA, Inc. v. Microsoft Corp., in favor of a sounder economic logic in selecting comparable transactions. Further, in VirnetX, Inc. v. Cisco Systems, Inc., courts frowned upon the naïve use of the Nash bargaining principle to argue in favor of an even division of economic surplus between the two contending parties. Our findings can thus provide an economically sound guide for the selection and adjustment of appropriate comparables in these applications.
For any questions, please contact Gaurav and Alan at: firstname.lastname@example.org.
Alan Kwan, PhD is an assistant professor of financial economics at the University of Hong Kong. Gaurav Kankanhalli is a doctoral candidate at the Johnson School of Management, Cornell University, where Alan obtained his doctorate.۾
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: email@example.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.