Have an idea for a new product? Early on, spend some time determining what your strategy for bringing it to market will be. Is venturing required, or can you license it instead
Personally, after venturing uniquely shaped guitar picks geared towards fans and licensing many of my ideas, I’d choose the latter every time. That’s because running a small business, even an ultimately successful one, stressed me out. Who wants to worry about cash flow? I much preferred the freedom to keep creating that licensing affords. Primarily because you can get to market faster, licensing to a large company is also one of the best ways of protecting yourself. These are among the many benefits of licensing.
If this is the route you choose, it’s understandable, then, that you might be asking yourself how to get the highest royalty rate possible.
Royalty rates differ across industries. Knowing what’s typical can be extremely helpful when negotiating, so get familiar with the specifics. In my experience, royalty rates for high-volume products are about three percent. Five percent is very average. It’s not out of the ordinary to see seven percent. These figures are typical for simple consumer product ideas.
In an article for The Journal of BioLaw and Business, intellectual property and technology licensing attorney Howard G. Zaharoff describes the 25 percent rule.
“Several decades ago it was suggested that, as an empirical matter, a large percentage of royalty negotiations arrived at a royalty rate that equaled approximately one-quarter to one-third of the licensee’s anticipated pre-tax profits derived from the technology. Of course, most royalties are calculated against net revenues rather than licensee profits, so this rule must be used to yield a rate that will be applied against revenues.
Thus, in industries (such as software) where profit margins have historically been high, royalty rates are comparatively high. For example, if the parties anticipate that the licensee will have profit margins of 80%, the royalty paid to the licensor should be in the range of 20-30% of net revenues (before taxes). In contrast, in fields where profit margins are low (such as the food industry), royalties will be low: For example, if a licensee expects to generate additional profits of 4% by deploying some invention (say, a novel food preservation technology), the royalty should be within the range of 1-1.5% of net revenues earned from deploying that technology.
In many industries — from medical devices to electronics and food — negotiations frequently yield a royalty rate between 5 and 6 percent of net sales.”
Zaharoff notes that the 25 percent rule should not be taken as “non-negotiable gospel.” There are always other factors to take into consideration. It’s a useful starting point to keep in mind.
First, you must do the math. Approximately how many units will the company you’re negotiating with sell based on their current distribution? Create high, medium, and low estimates. This will help you determine what an appropriate royalty rate is.
The most effective negotiators do not view obtaining a signature on the agreement as their ultimate goal. The same goes for trying to get the highest royalty rate. Instead, they view establishing the potential for a lucrative, long-term relationship with the other party as the primary objective of negotiating.
Inventors should make sure to pay attention to the total cost of goods, Warren Tuttle told me. Tuttle is a licensing expert who brings inventors and very large companies like Lifetime Brands (Farberware, KitchenAid) and Techtronic Industries (Ryobi, Ridgid) together.
There are defined retail matrixes into which your licensee must factor your royalty rate. What will the company have to sell your invention for at retail to make a profit and pay you? Tuttle told me products that cost $29.99 sell 67 percent fewer units than similar products that retail for $10 less.
“Volume or margin is always a consideration,” he pointed out. “It’s really important for inventors to understand that higher royalties can sometimes harm their own cause.”
A higher royalty rate could actually result in less income, in other words.
inventRight, the company I cofounded in 1999 with my business partner Andrew Krauss, helps product developers license their ideas. These days David Fedewa, who is now our lead negotiator, reviews a new licensing agreement weekly.
Here are a few things you can do to get a higher royalty rate for your invention.
1. File a non-provisional patent application or have an issued patent. To be clear, I do not recommend this, because you can license simple ideas with a provisional patent application alone. The good news is that if you have a patent, you can leverage it for a higher royalty rate.
2. Establish proof of demand. One example is by running a successful crowdfunding campaign. To avoid attracting unwanted attention from copycats who are capable of beating you to market, stay small. You can leverage as little as $10,000 to secure a licensing agreement. I do not recommend trying to attract a large amount of money. You don’t want to be on anyone’s radar.
3. Pull-through marketing. Have a major buyer at a retailer take a look. What does he or she think? Input from a buyer, like whether they’d be interested in carrying your product, can be hugely beneficial. Most manufacturers show early prototypes and concepts to retail buyers before they commit to production, because the buyer’s reaction helps them gauge interest level as well. Here’s how to do pull-through marketing like a pro.
4. Manufacture and sell the product first. Some of my students begin producing and selling their invention on their own first and thus, have a sales history. This can make getting a licensing deal much easier. After all, you’re in business. I don’t recommend this as a strategy, because it’s not necessary. But if, for example, you have a garage full of inventory you cannot sell….
5. When negotiating, ask the company first instead of throwing out a number. “What’s the typical royalty rate you offer product developers?” It might be higher than you imagine. This is Fedewa’s strategy, and it has worked for him.
6. Having more than one company interested in your product at the same time. If you can walk away from a deal, you’ll be able to cut a better one — always. The power of, “No thanks, I’ll pass” is huge. Licensing attorney Noah Harfouch, who frequently advises my clients, says that it’s appropriate to tell one company that there’s another interested party. (Don’t specify or allude to who the other party is.) This is a delicate situation, but if you approach it tactfully, it can speed up the negotiation process and result in a higher royalty rate. Plus, you’re being honest. You may have to pull out.
7. A provisional patent application that value. Meaning it includes a lot of variations, thereby stopping potential work-around opportunities.
8. Step-up royalty rates. Step-up royalty rates allow the licensee to pay a lower royalty rate early on in the agreement and a higher rate later on that is triggered by certain events (like trade shows, orders, production, etc.) This structure acknowledges the reality of startup costs. You want them to get to market, right? This benefits them while their startup costs are ramping up.
9. Step-down royalty rates. Step-down royalty rates allow the licensee to pay a declining royalty rate as they ramp up production of products that incorporate the licensed technology. So, you receive a higher royalty rate at the beginning but once they stop production, your royalty rate decreases. As sales volumes increase, you make more money. This is a huge incentive for them to market and get behind your product.
10. Sub-licensing opportunities. These can lead to a higher royalty on the primary license agreement. Ask for a very low royalty rate on any sub-licensing opportunities.
An expert who wishes to remain anonymous told me about a surprisingly simple strategy he’s witnessed work. If negotiations are stalling out at say, four percent, you could ask to receive a specific amount, like 40 cents a unit, instead. It doesn’t always work, he said, but it can change the conversation. And as a result, you could end up with closer to a six percent royalty.
Big-picture wise, don’t obsess about your royalty rate. There are other more important considerations, like making sure your contract includes some kind of performance clause. Focus on establishing a good relationship. Be a reasonable partner.
