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Many inventors fail to understand that a royalty percentage does not guarantee a royalty income.
Your royalty percentage is the agreed share of the company's income from your invention that you will receive under the terms of the licensing agreement. But your royalty income depends entirely on sales. You might have negotiated a high royalty percentage but if the company makes no sales, you receive no income.
It is quite possible for a company to acquire a licence from you but not make or sell any product. Your licensing agreement should therefore include a guaranteed minimum income (see later).
It is also possible for an inventor who accepts an extremely small royalty percentage to become much richer than one who negotiates a high royalty percentage. The difference depends on the number of units sold. For example, the inventor of the drinks can ring-pull got only a tiny royalty percentage - but he is reputed to be the world's wealthiest inventor.
The maximum royalty you are likely to get is about 25 per cent of the company's gross profit from sales of your invention.
Gross profit is the company's ‘factory gate' price per unit minus the cost of production and selling, multiplied by the number of units sold per year. You can predict the company's gross profit with reasonable accuracy if you know:
If the company will not or cannot tell you what these are, meaningful negotiation will be almost impossible.
Most companies will not want to give you anywhere near 25 per cent of their gross profit. They will tend to undervalue your invention in order to reduce the royalty percentage payable. For their part, many inventors tend to overvalue their inventions and ask for an unrealistically high royalty percentage.
To help determine a fair value, answer these questions as objectively as you can:
You should also consider gross profit per unit and market size. Simply multiply the gross profit per unit (which you know) by the number of units the company estimates it can sell in a year (which you also know). Then look at the size and sustainability of the market. Will your invention sell well for only a few years, or for many years?
Overall, the bigger the potential gross profit per unit and the bigger and more sustainable the market, the higher the value of the invention.
The story so far is:
You should now have enough data to convert the value of your product into a percentage of net sales price that you can justifiably ask for.
Gross profit is the most accurate way for an inventor to calculate a realistic level of reward. But it is standard business practice to express royalties as a percentage of the product's net sales price - that is, the ‘factory gate' price minus all taxes. The terminology changes but the amounts of money do not.
Converting a percentage of gross profit into a percentage of net sales price is straightforward once you appreciate that one (gross profit) is a percentage of the other (net sales price). For example:
As sales rise, the company's profit margin may fall as large orders are conditional on a lower unit price. It might therefore help your cause to suggest a sliding scale of royalties based on total royalty income. For example: seven per cent up to €20,000 per year of total royalty income, reducing to five per cent between €20-50,000 and to three per cent when your total royalty income exceeds €50,000 per year. This demonstrates your willingness to be flexible in everyone's best interests. Furthermore, by taking a smaller share of higher sales, your licensee has an incentive to sell more products.