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Licensing 101: Royalty Rate and Basis Part 1

15 December 2014

At the core of the licensing agreement are the payment mechanism and terms. Remember, the basic premise is that the licensor ‘rents’ its Intellectual Property (I.P.) to the licensee in exchange for a share of the sales.

The royalty rate can vary by market, by product category, by type of I.P., by the basis at which the royalty is taken, and by lots of other variables – but an approximate starting point is 10% of Net Wholesale.

Let’s look at basis first. The royalty can be calculated based on a couple of different points on the supply chain. It can be taken at FOB, at Net Wholesale, or at retail. It is in licensor’s interest to take the royalty as close to the consumer as possible, hence, since most licensees are manufacturers/distributors/suppliers, the royalty will be on the price the licensee sells the product to the retailer. If the product is on consignment, as is the case in much of Asia, the Wholesale price is the selling price, less the retailer margin.

If the license agreement is with a retailer, then it is possible to take the royalty on retail price (and as something of an anomaly, almost all deals in Japan are written based on retail price). There is a “halving” formula which still sort of holds whereby if the wholesale royalty rate is 10%, the retail royalty rate would be 5%, but retailer mark ups now vary significantly from department store to hypermarket so it pays to know what is the retailer’s expected mark up so as to anticipate if the royalty rate expectation may be above or below 5%.

On the other hand, you may be a worldwide or pan regional licensee, and you’ll be shipping out FOB to 3rd party distributors, in which case it would be very valid to make the point that you wouldn’t necessarily have visibility on your distributors’ wholesale prices to retailers, and thus argue that a royalty rate based on your FOB shipping price makes the most sense. And, in much the same way, there is a “double up” formula whereby if the royalty rate is 10% of wholesale, for FOB it should be 20%, but I’ve seen it range between 18% to about 24%.

In this latter case, if you’re a licensor, and you’ve agreed to an FOB based royalty rate, and the licensee is shipping to its own owned and operated distributors, watch out for transfer price tricks that deflate the ‘true’ FOB price.

More on royalty rates next time.