The Economic Sense of Royalty Rates

Abstract

Academic institutions, involved in technology transfer to industry, are always concerned about the "fairness" of the royalty rate payable to them. The common method used by practitioners is the "Industry-Standard Approach" which is based mainly on past experience. However such approach is very simplistic and fails to take into account importnat factors that effect royalty rate calculations. By using a simple financial model, the article demonstrates that expected sales volume of the end product is a key determinant of royalty rates. Higher expected sales volume enables the licensee to pay higher royalties to the licensor, while keeping its required rate of return unchanged. This point is totally overlooked by the "Industry-Standard Approach" and moreover it contradicts a commonly used practice to reduce the royalty rates with the increase in sales.