As a business model, licensing has always appealed to me. I enjoy being creative. I like working with my hands. If one of my inventions delighted a consumer, if it brought a smile to their face — I felt like I’d won the lottery. That was what gratified me. Other aspects of product development, like manufacturing, marketing, and distribution? Not so much. So when I discovered I didn’t have to start my own business to get my creations in front of people who would want to buy them, I leapt at the opportunity. Companies that licensed an idea from me would take care of all the heavy lifting? How fantastic. For me, it was an ideal partnership.
I look at licensing the same way today: As a partnership. I encourage my students tofind a home for their ideas. A question I receive often is, “What’s a fair royalty rate?” The truth is: There’s no such thing. When I reply, “Typically, rates hover between 3 and 5 percent,” some entrepreneurs are aghast. How can I promote a business model that offers inventors so little, they want to know. That’s just not right, they decry. They’ve done so much work, after all. And now someone else is going to profit from it? Like so much does, I think it comes down to perspective. If you’ve spent years and thousands and thousands of dollars developing a concept, I can understand why 3 percent seems paltry. But if you’ve done just enough to sell a potential licensee on the idea and established perceived ownership, which I recommend, you might feel differently.
First though, do the math. That’s really the only way to determine what will work for you. Know that potential licensees are going to ask you about royalty rates early on. They’re trying to weed out unreasonable people — people who are going to be difficult to work with. If you throw out a figure that’s too high, the company might walk away then and there.
So, what should you say? It isn’t an easy question to answer. What you need is data. With the right insight, you’ll be able to provide the company with a concrete answer. Without it, you’re just guessing. You need to know how many stores they envision will carry the product and what they estimate the wholesale price will be.
Later on when you’re negotiating, the company will be more reluctant to give you this information. You can use it against them to advocate for minimum guarantees, which I strongly recommend. (In fact, I think minimum guarantees are more crucial than royalty rates.) So do your best to get these figures early on. If you aren’t able to get this information from them, do research on your own.
Every licensing agreement is different, which is why there’s no such thing as a “standard” royalty rate. But I can tell you what I’ve experienced and negotiated, which is this: Most royalty rates are between 3 and 7 percent. More than 10 percent is extremely rare. Years ago, I became a Disney licensee so I could sell guitar picks with images of Mickey Mouse on them. I paid Disney slightly more than a 10 percent royalty rate. I had an exclusive, and in their opinion, compared to other licensees, I would be selling low volumes. At the time, I was told that when Disney licenses out in a large consumable category, such as beverages, the royalty rate is much closer to 4 percent. The popularity of a property is also influential. We all know how much brand recognition Disney brings to the table.
I’ve seen a few other royalty rates around 10 percent. It’s fairly unusual. If your product has proven sales, manufacturing in place, and/or intellectual property — that might warrant a higher rate. You’ve done a lot of the work already, after all. In some cases, a licensee will pay an inventor a higher royalty rate up to a certain figure (say 10 percent) so he or she can recoup some costs. Later on, the royalty rate is reduced to, say 5 percent, for ongoing net sales. If you invent a high-ticket item predicted to have low sales volumes, your royalty rate could be 10 percent. But again, it’s uncommon.
The royalty rate for most of my licensing agreements has been around 5 percent, which in my mind is a very reasonable number. In some cases, you might need to split a royalty. When I created the Michael Jordan Wall Ball and licensed it to Ohio Art, my royalty rate was 2.5 percent. In that case, Michael Jordan was also paid a royalty.
Some licensing agreements set sliding royalty rates. The more they sell, the lower your royalty rate goes, which is great incentive for them to sell more and lower the retail price, or have a higher profit margin.
You can also negotiate to tie your royalty rate to your intellectual property, a strategy I wrote about in-depth here and in Sell Your Ideas With or Without a Patent. For example, if your patent issues, the licensee will pay you 7 percent. During the patent pending phase, they’ll pay you just 3 to 5 percent. And if no intellectual property issues, they’ll pay you 1 to 2 percent.
If your invention is part of a larger product, determining an appropriate royalty rate is more difficult. Because your invention is part of a larger project, your royalty rate will be smaller.
So please, before you spit out a rate, do the math. Estimate sales for one week per store. How much will you make if your royalty rate is 3 percent? What about 5? If sales are voluminous, you might be extremely happy with 2 percent.
Once you do the math, it’s much easier to determine what’s ‘fair’. Maybe licensing isn’t for you after all. Maybe you’d rather venture your idea and experience all the high highs and low lows that avenue brings. The point is: Do you know what can you live with? You should.
Originally published on Inc.com January 8th 2016.
