How do you know if the rate you’re considering is too high or too low? Espie Angelica A. de Leon unpacks fair, reasonable and non-discriminatory principles, valuation models and licensing strategies to guide fair, innovative-driven royalty rate setting. 

Royalties – an indelible part of any licensing contract. They reflect product value, contribute to the bottom line and boost the business growth of both licensor and licensee. 

“From a legal standpoint, a licensing royalty rate is an essential element of the licence as it constitutes the cause or consideration for entering into the licence agreement,” said Patricia Bunye, a senior partner at Cruz Marcelo & Tenefrancia in Manila and past president of the Licensing Executives Society International (LESI). 

How should royalty rates be determined by licensors and licensees? 

First, they must be based on FRAND (fair, reasonable and non-discriminatory) terms to make it a win-win situation for both parties.  

“In licensing agreements, royalty rates tend to be defined as a percentage of sales, a payment per unit or a percentage of the gross or net revenues obtained from the use of the property. However, they can also be negotiated on a case-by-case basis according to the wishes of both parties,” said Aixi Li, a researcher at Jin Mao Law Firm in Beijing. 

Generally, a more established brand commands a higher rate than a less established one. 

More specifically, it depends on the intellectual property asset covered by the licence. “A licensor with unique IP, remarkable innovation or multiple interested licensees may command higher rates,” explained Li, “while a licensee with strong market presence or alternative options may negotiate lower rates.”  

For example, if a patent constitutes a core technology embedded in a product such that it is irreplaceable, the royalty rate may be higher. But if the technology is not yet fully developed or may be easily replaced, then the amount must be lower. The ability to drive sales is key. 

Exclusive licences also generally yield higher royalty rates as these reduce competition. Research and development (R&D) costs, geographical scope and duration of the licence are also factors in determining the rates. 

How do you know if the rate you’re considering is too high or too low? 

“Ultimately, what is too high or too low will depend on the subjective assessment of the contracting parties of all the relevant factors, as well as the amount of resources at their disposal,” said Bunye. “A fundamental principle during negotiation in determining the appropriate royalty rate is the need to strike a balance between the licensor’s capacity to profit from the protected asset and the licensee’s potential to receive reasonable returns during commercialization. Setting royalty rates too high may stifle innovation and competition by discouraging potential licensees from commercializing the asset and rendering the licensed products non-competitive. Conversely, setting the royalty rates too low will deprive the licensor of revenue which may harm its financial stability and discourage future innovation.” 

Zunxia Li, a partner at IP March in Beijing, said that practices such as bundling unrelated patents and tying arrangements result in excessively high royalty rates in China. Meanwhile, a licensee who intentionally delays negotiations is typically aiming for a low rate. Holding off the talks is the licensee’s way of pressuring the patent holder to give his nod to the rate, despite the fact it’s excessively low to avoid litigation costs. This is just one such instance where unreasonably lower rates are wont to be offered by one party to a licensing contract.   

FRAND, technology adoption and innovation 

How can licensors and licensees ensure the rates comply with FRAND principles? In the case of patents, how can they ensure the rates are anchored on FRAND terms and, at the same time, make sure the technology is widely accessible and promotes innovation? Here are some strategies to achieve these: 

Know industry standards and market conditions. “Conduct market research to understand the benchmark or norm in the market,” said Nont Horayangura, a partner at Baker McKenzie in Bangkok. Analyze market conditions related to IP rights. These include demand, competition, industry standards or trends, potential income generated by the IP and existing regulations in the jurisdiction.  

For example, China’s Standards of Copyright License Fee for Copying Musical Works sets out royalty fees for the use of music works to produce recordings in CDs and cassettes based on the formula: wholesale unit price × edition tax rate (6 percent for the first time, 3.5 percent for the other) × the number of recordings. For digital products such as MP3, the royalty is Rmb0.12 (US$0.017) for each piece of music × number of copies. 

For book royalties, the country’s Measures for Payment of Remuneration for the Use of Written Works standardizes royalty rates at 3 to 10 percent for original works and 1 to 7 percent for deductive works. 

In terms of franchise royalties, the rates are usually at 4 to 12 percent. These rates are generally agreed by both parties as Chinese law has no special provision on franchise royalties, according to Aixi Li. 

In the case of patents, she cited the China National Intellectual Property Administration’s (CNIPA) Guidelines for Estimation of Patent Open License Fee (Trial). “[It] proposed that the determination of patent royalty can refer to the same industry or international general licence rate – 25 percent of product profit or 5 percent of product sales – as the negotiation benchmark. In 2021, Chongqing No. 1 Intermediate People’s Court gave a judgment on the case of OPPO v. Nokia’s standard-essential patent royalties dispute and confirmed that Nokia’s 5G SEP portfolios were globally set at 4.341 to 5.273 percent so as to comply with the principle of FRAND,” she related. 

Licensors and licensees may also refer to historical licensing agreements involving similar technologies.  

Valuable benchmark data may also be gleaned from surveys. For example, the Licensing Executives Society (LES) U.S. and Canada reported that average royalty rates for high-technology fields, such as aerospace, software, communications, semiconductors, electronics and the like, range from 4.8 to 10.7 percent. Similar benchmark data are available for the life sciences sector which covers pharmaceuticals, biotechnology and medical devices. The same applies to the physical sciences sector which includes chemicals, energy, environmental and materials sciences.  

All these will serve as reference points for both parties to agree on FRAND-based rates for their licensing contracts. 

“Still and all, it does not rule out that higher prices may be worthwhile under special circumstances,” reminded Aixi Li.  

Have a value-oriented licensing model. Instead of calculating royalty rates solely as a percentage of the product’s total sales revenue, determine the rates based on value. How valuable is the IP? What are its selling points? What are their advantages? How strong is brand recognition? What is its market position? Is it a frontrunner in the industry? Or does it lag behind the competition? 

“The value of the license of a pending patent application is different from the value of the licence of a registered patent,” Bunye pointed out. “There may be scenarios that a pending patent application may not result in the complete grant of the claims relied on by the licensee for its business activities at the time of the negotiation. In other instances, the patent application may not even proceed to grant at all,” she warned. “Thus, it is prudent for the licensee to perform due diligence on the IP subject of the licence grant.”  

Being more value oriented will incentivize further innovation. 

Consider a multi-tiered licensing model. Offer standard licensing schemes for general licensees. For strategic partnerships, set up tailored agreements. “Encourage patent pools and collective licensing by facilitating patent pools or industry alliances to streamline licensing processes, reduce transaction costs and promote technology dissemination,” added Zunxia Li. 

Set up flexible licensing structures. Do this by offering lump-sum payments, royalties based on sales or performance which includes market share and customer satisfaction, apart from sales volume. “[Performance-based royalty] can also make the interests of both sides consistent and distribute profits fairly, ensuring a fair distribution of profits,” said Aixi Li. 

Include minimum guarantees to allow the licensor to receive a predetermined amount of royalty payments regardless of the licensee’s performance. “This safeguard provides a level of stability and helps mitigate potential risks associated with underperforming products or markets,” she said. 

“For example, Disney’s trademark licensing empire is a testament to the power of strategic royalty structures while Nike’s licensing strategy includes partnerships with manufacturers and retailers who produce and sell products bearing its swoosh logo. These agreements often involve modest base royalty rates complemented by revenue-sharing arrangements that increase as sales grow,” Aixi Li said. 

Apart from engaging in revenue-sharing schemes, the licensor and licensee may also undertake cross-licensing. These will translate to technological benefits for both parties, lower costs involved in transactions and enhance innovation returns. 

“Set different pricing structures based on the types and sizes of licensees, with a clear price list. Tailor the licensing terms and conditions to suit different business models,” Horayangura said, underscoring the need to offer a range of licensing schemes to cater to the varying needs of different business enterprises. 

Incentivize. To encourage technology adoption, provide incentives for early adopters and startups. Preferential rates or deferred payment options are only a few of these incentives. Startups with limited resources will particularly benefit from these.  

Have shorter licensing periods. “Shorter licensing periods with the option to renegotiate can provide flexibility and allow for adjustments based on market changes or the success of the IP,” explained Aixi Li.  

Put in place licensing mechanisms that are transparent and predictable. Standardized and transparent licensing terms will ensure fairness for both licensors and licensees.  

Avoid market dominance abuse and anti-competitive behaviour. As licensors, do not use your market position to impose excessive fees on licensees. On the other hand, licensees should not also use their position to unduly suppress royalty rates. “To prevent ‘Patent Hold-Up’ and ‘Patent Evasion,’ licensors should not use refusal-to-license tactics to demand unreasonably high fees, while licensees should not deliberately delay negotiations to evade fair payments,” explained Zunxia Li. 

However, Bunye reminded patent owners are required to offer a licence on FRAND terms only with respect to technology or inventions which are widely available. One example is a technology that is incorporated as part of an open standard or standard essential patents (SEP). “In fact, for licensors of patented technology or inventions which are incorporated in an open standard or SEP, the offer of a licence on FRAND terms to all is a matter of obligation,” Bunye stressed. 

She proceeded to mention standard-development organizations (SDOs) or standard-setting organizations (SSOs) such as the International Organization for Standardization, the International Electrotechnical Commission, the International Telecommunication Union and the European Telecommunications Standards Institute. These organizations develop standards for various fields of technology. These standards ensure that each product manufactured in these technology areas is built using a common design which makes compatibility and interoperability among products and systems possible. Compatibility and interoperability, in turn, allow more people to access and adopt these new technologies. At the same time, the SDO or SSO ensures fair compensation for the patent owner.  

“To this end, SDOs or SSOs require participating patent owners to disclose SEPs and undertake the commitment to license to any person or entity wishing to implement the technology on FRAND terms,” Bunye said. “The rationale behind this requirement is that SEP owners must not be allowed to enjoin the use of such standard for the innovation and development of several products which would require such technology. Neither are they allowed to use their position as the owners of the SEPs and the threat of litigation to impose exorbitant rates beyond market value. Thus, to prevent abuse and misuse by the SEP owner, offering its technology to all at FRAND rates is an obligation.” 

In connection with this, an implementer may use a patent owner’s violation of a FRAND undertaking as a defence in an infringement action. Meanwhile, patent owners who do not own SEP-protected technologies are not obliged to make the technologies widely available under the FRAND principle. “Thus, owners of patents that are not included in a standard may license their technology or invention to anyone in accordance with the terms agreed upon by the parties,” noted Bunye, “including the royalty rates.” 

Fairness for all licensees 

How can an IP owner ensure a level playing field for all its licensees? 

First of all, there must be information disclosure and transparency. The licensor must make sure the licensee fully understands all the information contained in the licence agreement. This includes the scope of the license, duration, fees and others. The royalty structures must be clear. Understanding the contract reduces unfair competition. 

The licensor must ensure that the licensing contract is carried out with all applicable standard terms and conditions uniformly applied to all licensees. “Avoid discriminatory licensing by ensuring that licensees in similar market positions are not subjected to significantly different licensing terms without reasonable justification,” Zunxia Li said. 

However, Bunye reminded that the final agreement still depends on the negotiations between the parties. “IP owners may offer standard terms to all its licensees who are similarly situated to ensure that no favour is given to one over the other. Nevertheless, the terms governing the licensing of an IP will ultimately depend on those agreed upon by the parties,” she noted. 

The licensor should also comply with the anti-monopoly law and avoid abusing IP rights to exclude or restrict competition. “For example, the licensor of IP rights should not engage in acts such as restricting transactions, tying and attaching unreasonable trading conditions during the licensing process to ensure fair competition in the market,” Aixi Li explained. 

She noted that trademark licensors are expected to report the licensing contract to the trademark office for filing and announcement. This will not only enhance the contract’s legal effect; it will also let potential partners or consumers know about the use of the trademarks and help prevent unfair competition. 

As royalty rates are an essential component of licensing contracts, it is therefore imperative to make the right decision when determining the amount. Bunye summed it up best: “The imposition of licensing royalty rates is an effective mechanism for incentivizing licensors to continue improving technology, which involves a substantial investment in research and development, while ensuring market access for the benefit of society at large. In turn, this fosters market competition and innovation, which not only results in technological advancement but also the promotion of consumer welfare and economic growth.”