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Goldscheider 25 Percent Rule
Goldscheider 25 Percent Rule
Rule In Valuing IP
BY ROBERT GOLDSCHEIDER, JOHN JAROSZ AND CARLA MULHERN*
Introduction
s the importance of intellectual property (IP) protection has grown, so has the
sophistication of tools used to value
it. Discounted cash flow,1 capitalization of earnings,2 return on investment,3 Monte Carlo simulation4
and modified Black-Scholes option valuation methods 5 have
been of great value. Nonetheless,
the fairly simple 25 Per Cent
Rule (Rule) is over 40 years old
and its use continues. Richard
Razgaitis has called it the most famous heuristic, or rule of thumb,
for licensing valuation.6
The Rule suggests that the licensee pay a royalty rate equivalent
to 25 per cent of its expected profits for the product that incorporates
the IP at issue. The Rule has been
primarily used in valuing patents,
but has been useful (and applied)
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Figure 1
25 Per Cent Rule Illustration - Revenue Side
No Patent
Revenue
25 Per Cent Rule
Enhancing Patent
$100
$110
Cost of Sales
$40
$40
Gross Margin
$60
$70
Operating Expenses
$30
$30
Operating Profits
$30
$40
Revenues
($40*25%)/
$110=9.1%
Figure 2
25 Per Cent Rule Illustration - Cost Side
No Patent
Cost Reducing
Patent
$100
$100
Cost of Sales
$40
$30
Gross Margin
$60
$70
Operating Expenses
$30
$30
Operating Profits
$30
$40
Revenues
($40*25%)/
$100=10%
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ferent grades of X. P-2 did not involve the need to purchase Y from
B. Rather than simply abandon P-1,
however, A decided to offer B the
opportunity to become the exclusive worldwide licensee of P-1. The
argument was that such a license
could be profitable to B because it
was a basic producer of Y (which A
had been purchasing at a price containing a profit to B), and B could
thus manufacture X on a cost-effective basis. Another attraction of
such a license would be that it could
compensate B for the loss of its sales
of Y to A.
B was interested to take such a license to P-1, and offered to pay a 5
per cent running royalty on its sales
of polymer made in accordance
with P-1. A decided to test the reasonableness of this offer by applying the 25 Per Cent Rule, a good
portion of which analysis could
employ 20-20 hindsight. A understood the market for X, past and
present, and had what it considered
to be realistic projections for the future. A had made such a study because it intended to remain in the
market for X, utilizing P-2. A was
also able to calculate pro-forma
profitability to B by subtracting Bs
margin on its sales of Y to A for use
in P-1.
This analysis revealed that B
should be able to operate as a licensee under As P-1 patent at an operating profit of 44 per cent. A
shared its fully documented analysis with B and asked please tell us
if we are wrong. If not, A would
expect to receive an 11 per cent royalty based on Bs sales of X using
As patented P-1 process, based on
the 25 Per Cent Rule, rather than the
5 per cent that was offered.
Following study of As work
product, B (somewhat surprised
and reluctantly) agreed with As
conclusion. B accepted these terms
because B would still make a 33 per
cent operating profit under the license, which was higher than Bs
normal corporate operating profit
rate. Over the remaining life of its
P-1 patent, this additional 6 per cent
royalty amounted to added profit,
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127
Figure 3
Licensed Royalty Rates (Late 1980s - 2000)
Automotive
Chemicals
Computers
Consumer Goods
Electronics
Energy & Environment
Food
Healthcare Products
Internet
Machine/Tools
Media & Entertainment
Pharma & Biotech
Semiconductors
Software
Telecom
Total
Industry
35
72
1.0%
0.5%
15.0%
25.0%
4.0%
3.6%
68
90
132
86
32
280
47
84
19
328
78
119
63
0.2%
0.0%
0.5%
0.5%
0.3%
0.1%
0.3%
0.5%
2.0%
0.1%
0.0%
0.0%
0.4%
15.0%
17.0%
15.0%
20.0%
7.0%
77.0%
40.0%
25.0%
50.0%
40.0%
30.0%
70.0%
25.0%
4.0%
5.0%
4.0%
5.0%
2.8%
4.8%
7.5%
4.5%
8.0%
5.1%
3.2%
6.8%
4.7%
1,533
0.0%
77.0%
No. of Companies
5.0%
11.1%
Consumer Goods
459
544
6.9%
11.0%
Electronics
425
8.8%
767
240
433
12.2%
7.3%
14.8%
781
174
360
534
207
-13.5%
7.9%
10.6%
16.4%
17.4%
534
627
18.8%
14.2%
6,309
10.4%
Computers
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Median
Royalty
Rate
100
126
Chemicals
128
Maximum
Royalty
Rate
Figure 4
Industry Profit Rates (1990 - 2000)
Automotive
Minimum
Royalty
Rate
No. of
Licenses
Industry
Food
Healthcare Products
Internet
Machine/Tools
Media & Entertainment
Pharma & Biotech
Semiconductors
Software
Telecom
Total
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as follows:
the remaining economic life of
the property being valued, which
may be shorter than the remaining
legal life of any patents that may be
part of the analysis, is estimated;
the operating profit rate expected during each of such years is
projected and 25 per cent (or another rate considered appropriate in
accordance with the Rule) is applied
to each of the annual figures;
a discounted cash flow analysis
is performed, using an appropriate discount rate to convert future
flows into a current year lump
sum amount.
The rationale for this appraisal
methodology is that the plus or minus 25 per cent apportionment is the
price of a reasonable royalty that the
appraising party would be willing
to pay for a license for this property,
at that point in time, assuming that
it did not own it.
The Rule, whether used in litigation or non-litigation settings, provides a fairly rough tool to be
augmented by a more complete royalty analysis. The precise split of
profits should be adjusted up or
down depending on the circumstances of each case and relative
bargaining positions of the two
parties.40 If a licensor comes to the
bargaining table armed with a relatively strong arsenal of assets, it
may be entitled to 25 per cent, or
perhaps more, of the pie. Correspondingly, a weak arsenal of assets supports a lower split. In
determining the appropriate split
of profits, the factors established in
the Georgia-Pacific case are quite
helpful.41 In fact, many of the courts
that have used the Rule in litigation
Figure 5
Licensee Profits (1990 - 2000)
Industry
No. of Companies
Automotive
4
6
6.3%
11.6%
20
23
8.0%
16.2%
Software
30
14
6
80
14
8
3
76
16
19
8.8%
6.6%
7.9%
17.8%
1.0%
9.4%
-304.5%
25.4%
29.3%
33.2%
Telecom
28
14.1%
347
15.9%
Chemicals
Computers
Consumer Goods
Electronics
Energy & Environment
Food
Healthcare Products
Internet
Machine/Tools
Media & Entertainment
Pharma & Biotech
Semiconductors
Total
Figure 6
Royalty Rates and Licensee Profits
Industry
Automotive
Average
Operating
Profits
Royalty
as % of
Profit Rate
6.3%*
11.6%
79.7%
25.9%
2.8%
5.0%
8.0%
16.2%
34.4%
30.8%
Telecom
4.5%
3.5%
2.3%
4.0%
5.0%
3.4%
9.0%
4.5%
2.5%
7.5%
5.0%
8.8%
6.6%
7.9%
17.8%
1.0%
9.4%
-304.5%*
24.5%
29.3%
33.2%
14.1%
51.3%
52.9%
28.7%
22.4%
492.6%
35.8%
-3.0%
17.7%
8.5%
22.6%
35.5%
Total
4.3%
15.9%
26.7%
Computers
Consumer Goods
Electronics
Energy & Environment
Food
Healthcare Products
Internet
Media & Entertainment
Pharma & Biotech
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Median
Royalty
Rate
5.0%
3.0%
Chemicals
Machine/Tools
40. Robert Goldscheider, Litigation Backgrounder for Licensing, 29 les Nouvelles 20, 25
(March 1994).
41. Georgia Pacific v. United States Plywood
Corp., 318 F. Supp. 1116 (S.D.N.Y. 1970)
modified and affd, 446 F.2d (2d Cir. 1971),
the court set forth 15 factors that should be
considered in determining a reasonable
royalty. See also, Stephen A. Degnan, Using
Financial Models to Get Royalty Rates, 33 les
Nouvelles 59, 60 (June 1998).
Semiconductors
Software
December 2002
129
The Rule, based on historical observations, provides useful guidance for how a licensor and licensee
should consider apportioning the
benefits flowing from use of the IP.
Somewhat untenable (and unrealistic) is guidance that either the licensor or licensee is entitled to all
of the returns. No bargain would
be reached. Though a 50:50 starting split has a ring of a win-win
situation, in fact, the evidence suggests otherwise.
Richard Razgaitis has identified 6
reasons for why a 25/75 (starting)
split makes sense.42 First, thats the
way it is. Numerous licensors and
licensees have agreed to a 25/75
split. It is, according to him, the industry norm. Second, typically 75
per cent of the work needed to develop and commercialize a product
must be done by the licensee. Third,
he who has the gold makes the
rules. Licensees have considerable
leverage because of the numerous
investment alternatives open to
them. Fourth, a 3-times payback ratio is common. Such is obtained by
a licensee retaining 75 per cent of
the return by investing 25 per cent.
Fifth, technology is the first of the 4
required steps of commercialization. The others are making the
product manufacturable, actually
manufacturing it and selling it. Finally, the ratio of R&D to profits is
often in the range of 25 to 33 per cent.
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Number of Industries
Figure 7
Distribution of Profit Splits - Licensee Profits
10
9
8
7
6
5
4
3
2
1
0
<0%
0%-20%
21%-40%
41%-60%
61%-80%
>80%
Figure 8
Royalty Rates and Successful Licensee Profits
Median
Royalty
Rate
Industry
Automotive
Average
Operating
Profits
Royalty
as % of
Profit Rate
5.0%
3.0%
11.3%*
12.0%
44.1%
25.0%
Telecom
2.8%
5.0%
4.5%
3.5%
2.3%
4.0%
5.0%
3.4%
9.0%
4.5%
2.5%
7.5%
5.0%
8.3%
18.4%
13.1%
9.2%
14.2%
18.5%
10.4%
9.6%
-13.5%*
25.8%
31.9%
25.1%
14.5%
33.3%
27.1%
34.3%
38.1%
15.8%
21.6%
48.0%
35.0%
-66.7%
17.4%
7.8%
21.4%
34.5%
Total
4.3%
18.8%
26.6%
Chemicals
Computers
Consumer Goods
Electronics
Energy & Environment
Food
Healthcare Products
Internet
Machine/Tools
Media & Entertainment
Pharma & Biotech
Semiconductors
Software
Figure 9
Distribution of Profit Split - Successful Licensee Profits
Number of Industries
10
9
8
7
6
5
4
3
2
1
0
<0%
0%-20%
21%-40%
41%-60%
61%-80%
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Industry Profits
We obtained financial information for the fifteen industries included
Royalty Rates
To obtain information regarding
royalty rates observed in actual
licensing transactions, we used
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Licensee Profits
Because total industry profits are
not a particularly close match to
royalty rates covering a limited
number of companies, for our first
analysis, we examined profitability
data for only those companies that
were identified as licensees in the
licensing transactions database. Figure 5 reports weighted average operating profit margins for each of
the industries.
Conclusions
An apportionment of 25 per cent
of a licensees expected profits has
become one, of many, useful pricing tools in IP contexts.62 And our
empirical analysis provides some
support for its use.
A comparison of royalty rates
with two proxies for expected
long-run product profits (namely,
licensee profits and successful
licensee profits) yields royalty to
profit ratios of 27 per cent and 23
per cent, respectively.
Although the data support the
Rule generally, there is quite a variation in results for specific industries.
As this variation makes clear, the
Rule is best used as one pricing tool
and should be considered in conjunction with other (quantitative
and qualitative) factors that can and
do affect royalty rates.
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