equity, intellectual-property, licensingI am negotiating a royalty rate for an IP license, and I want to verify my understanding of how a royalty percentage of revenue translates into effective ownership/equity of the business (non-voting, of course).
Let’s assume the royalty percentage ‘x’ applies to the retail price of the product (though it often will apply to ‘net sales’ instead). So if the product is on the shelf for $100, and x is 3%, then the royalty fee is $3.
Let’s also assume that all company revenue is affected by the royalty rate, and that the profit margin ‘y’ of the company before royalty payments is 25% (may be as low as 10-15% for more established products). Then, it seems that the effective ‘value ownership’ of the company is x/y, since company value is only based on future cash flows. This would imply that the licensor would own 12% or 20% of the company with a 3% or 5% royalty rate, respectively.
For standard profit margin and royalty rates, this seems like a very high number given that the licensor is not actively operating the business or taking any major financial/time risk. Am I missing something here?
I see what you are trying to say. I personally wouldn’t translate the percentage of the profit margin on one product into effective ownership of a company. Yes it kind of translates to that money wise but be aware that if you ever choose to produce a different product or open another service, you do not own the licensor anything. In general it is a good idea to just take the license and develop new products with the revenue which is puring in. At some point you will get rid of the licensing fees because you own your own IP now. So my advice would be, that if you think you can pull of the 25% profit margin to just go for it.
Royalty rates generally have nothing to do with equity. You generally pay cash for the license and the licensor doesn’t get any equity.
It is possible that you could work out a deal where the licensor would get equity in exchange for a lower royalty rate or no royalty at all.
If you need more assistance, please clarify your question, and I’ll try to update my answer.
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