Running Royalty

A running royalty is a periodic payment that is calculated based on the licensee's actual sales or usage of the licensed technology: THE MECHANICS: the licensee reports sales (or unit volumes) to the licensor on a periodic basis (quarterly or annual); the royalty is calculated: royalty rate × royalty base = royalty due; quarterly royalty reports are standard in most licenses; audit rights allow the licensor to verify the accuracy of royalty reports; ROYALTY RATE: expressed as a percentage of net sales (e.g., 3%); or as a fixed amount per unit (e.g., $0.50 per device); or as a percentage of a component's price; ROYALTY BASE: the number that the royalty rate is applied to; most commonly net sales (gross sales minus returns, allowances, discounts, and applicable taxes); sometimes limited to a specific component price rather than the finished product price; KEY ADVANTAGES OF RUNNING ROYALTIES: (a) ALIGNMENT: the licensor participates in the upside if the licensee has strong commercial success; (b) RISK SHARING: the licensor receives less if the product is not commercially successful; (c) LOWER UPFRONT PAYMENT: the licensee doesn't need to pay a large sum on day one; useful for early-stage licensees with uncertain cash flows; KEY DISADVANTAGES OF RUNNING ROYALTIES: (a) REPORTING AND AUDIT BURDEN: the licensor must receive, review, and audit royalty reports; auditing is expensive and creates friction; (b) COLLECTION RISK: if the licensee has financial problems, royalty payments may stop; (c) UNDERPAYMENT RISK: licensees may underreport sales; audit provisions help but are imperfect; MINIMUM ANNUAL ROYALTIES (MAR): many licenses include a MAR provision — the licensee must pay at least X per year regardless of actual sales; MAR protects the licensor if sales are lower than expected; MAR gives the licensee an incentive to actually commercialize the licensed technology.

Royalty rate setting is a combination of valuation methodology, industry norms, and negotiated outcome: GEORGIA-PACIFIC 15-FACTOR FRAMEWORK: the judicial framework for setting reasonable royalty rates; factors most relevant to royalty rate setting: (a) comparable licenses (most probative — what has the licensor charged for similar licenses? What do others in the industry charge for similar technology?); (b) nature of the patented invention and its advantages over prior art; (c) portion of profit attributable to the patent vs. other product features; (d) commercial success of the patented invention; (e) the licensor's established royalty policy; (f) expected profit to the licensee from using the patented invention; HYPOTHETICAL NEGOTIATION: courts calculate damages as the royalty that would have been negotiated between a willing licensor and willing licensee at the time infringement began; INDUSTRY NORMS — APPROXIMATE RANGES: pharmaceutical/biotech drug compound patents: 5-25% (higher for blockbusters, lower for non-core compounds); semiconductor and electronics: 1-5% of product selling price; software patents: 1-5% of the relevant feature or product value; medical devices: 3-10%; consumer electronics: 1-3%; mechanical/industrial: 1-5%; materials science: 2-8%; THESE ARE RANGES, NOT FORMULAS: the actual rate depends heavily on: strength and scope of the patent claims; commercial importance of the patented feature to the product; number of alternative non-infringing approaches; the licensee's profitability; the licensor's licensing history with comparable licensees; STACKING PROBLEM: in complex products (smartphones, cars), many technologies are patented; the aggregate royalty to all patent holders (royalty stack) could exceed the product's profit margin if each patent holder demands a percentage of the entire product; stacking awareness leads to lower individual rates for each patent in a stack.

The royalty base is the revenue figure to which the royalty rate is applied — a critical negotiating point: NET SALES DEFINITION: in most licenses, the royalty base is defined as net sales, which typically means gross revenue minus: returns and allowances; trade discounts (volume discounts); freight and delivery charges; sales and use taxes; WHAT IS INCLUDED IN THE ROYALTY BASE: only revenue from products that practice the licensed patent; if the license covers specific products, only those products' sales; if the license covers a component, the royalty base may be the component price, not the finished good price; ENTIRE MARKET VALUE RULE (EMVR) IN LITIGATION: in litigation, the patent owner may try to use the entire product's price as the royalty base; LaserDynamics v. Quanta Computer (Fed. Cir. 2012): EMVR is a NARROW EXCEPTION — the patented feature must be the BASIS FOR CUSTOMER DEMAND for the entire product; otherwise, the royalty base must be apportioned to the value of the patented technology; SMALLEST SALABLE PATENT-PRACTICING UNIT (SSPPU): the royalty base should be the smallest component that incorporates the patented technology; in a smartphone, the royalty base for a Wi-Fi chip patent would be the Wi-Fi chip price, not the phone's selling price; NEGOTIATED ROYALTY BASE vs. LITIGATION ROYALTY BASE: in voluntary licenses, parties can agree to ANY royalty base; using a higher base with a lower rate is economically equivalent to a lower base with a higher rate; in litigation, courts are more constrained by apportionment principles; PRACTICAL NOTE: the choice of royalty base matters enormously — a 5% royalty on a $10 chip yields $0.50/unit; a 0.5% royalty on a $100 phone also yields $0.50/unit; structuring both royalty rate AND royalty base is the key to accurate deal valuation.

A lump sum license is a one-time payment that fully resolves the royalty obligation for the licensed period — an alternative to running royalties: LUMP SUM DEFINITION: a single upfront payment (or a series of fixed milestone payments) that fully compensates the licensor for all past and future use of the licensed patent; once paid, the licensee owes no further royalties regardless of sales volume; ADVANTAGES OF LUMP SUM FOR THE LICENSOR: immediate cash payment (no collection risk); no reporting or audit burden; no ongoing relationship required; ADVANTAGES OF LUMP SUM FOR THE LICENSEE: no ongoing reporting obligations; no exposure to audits; predictable cost (can be budgeted with certainty); no exposure to royalties increasing if sales exceed projections; LUMP SUM CALCULATION: typically calculated by: estimating projected sales over the license term; applying the royalty rate to projected sales; discounting to present value (NPV); adjusting for litigation risk and patent validity uncertainty; LUMP SUM IN LITIGATION: in damages, courts may award a lump sum if: the nature of the case makes a running royalty impractical; the patent is near expiration; the infringer's specific infringing use can be quantified; Lucent Technologies v. Gateway (Fed. Cir. 2009): court may award lump sum if evidence supports it, even if the parties didn't use that structure; WHICH STRUCTURE IS BETTER: LICENSOR PREFERS RUNNING ROYALTY WHEN: product is early-stage (uncertain sales → may miss out on large sales with lump sum); patent covers a high-growth product; LICENSOR PREFERS LUMP SUM WHEN: licensee's financial health is uncertain; licensor needs immediate capital; patent is near expiration; LICENSEE PREFERS LUMP SUM WHEN: product is expected to have high sales (avoid paying more than a lump sum would cost); licensee wants to avoid audit exposure; HYBRID APPROACH: upfront lump sum (non-refundable advance against future royalties) + running royalty; the advance reduces the running royalty obligation for the first X units/years.

Minimum annual royalties (MAR) and audit provisions are operational provisions that protect the licensor's financial interests throughout the license term: MINIMUM ANNUAL ROYALTIES (MAR): a contractual floor on annual royalty payments; regardless of actual sales, the licensee must pay at least the MAR each year; PURPOSE FOR LICENSOR: protects against negligible commercialization of the licensed technology; ensures some revenue even if the licensee doesn't actively market the product; LICENSEE'S PERSPECTIVE: MAR creates an exit option — if sales are below the MAR threshold, the licensee can evaluate whether to continue the license; some licenses allow the licensee to pay the MAR and maintain the license but reduce exclusivity if sales are below targets; EXCLUSIVE LICENSE PERFORMANCE REQUIREMENTS: exclusive licenses often include more stringent performance milestones: minimum sales targets; minimum marketing expenditure; minimum R&D investment; failure to meet milestones can result in: loss of exclusivity; license termination; conversion to non-exclusive; AUDIT PROVISIONS — LICENSOR RIGHTS: the licensor has the right to audit the licensee's books to verify royalty accuracy; trigger: typically the licensor requests an audit no more than once per year; notice requirement (30-60 days); AUDIT PROCEDURE: independent certified public accountant; access to sales records, royalty calculation records, product records; LICENSEE PROTECTIONS: confidentiality of audit results; licensor pays for audit unless underpayment exceeds threshold (typically 5-10%); licensee pays if significant underpayment is found; AUDIT DISPUTE RESOLUTION: typically a second audit by a jointly selected CPA if the parties dispute results; binding arbitration for unresolved disputes; LIMITATION PERIOD: most licenses require the licensee to challenge royalty reports within 3-5 years; after that period, the reports are deemed accepted; COMMON AUDIT FINDINGS: product classifications excluded from royalty base; foreign sales not included; royalty on sublicensee revenue not passed through.