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 an approach is very simplistic and fails to take into consideration important factors that affect 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. Increasing sales volume enables the licensee to increase the royalties payable to the licenser while preserving its required rate of return. This point is totally overlooked by the "Industry-Standard Approach" and, moreover, contradicts a commonly used practice to reduce the royalty rates with the increase in sales.

JEL Classification: L15, L31, G30, G31, G32, L65