Royalties

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.

Royalty percentages

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:

• The company's sales forecast for your product.
• Its proposed selling price.

If the company will not or cannot tell you what these are, meaningful negotiation will be almost impossible.

The value of your invention

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:

• What is your contribution to the product? If you have given the company a highly developed product, that may justify a royalty of 15 per cent or more. But if the company has done all the redesign and development, a fair royalty percentage may be 5 per cent or less.

• Who is taking the risk? If the company is investing heavily in production and marketing resources for an invention that is unproven in the market, it may be difficult to justify a large royalty if your own exposure to risk is small by comparison.

• How special is the product? If there is no close competition and the company can charge a high price, you deserve a high royalty. But if competition will keep profits low, your royalty percentage will also be low.

• In what quantity will the product sell? The more units sold, the lower will be your royalty percentage. Profit margins shrink as customers place larger orders but insist on lower prices. However, even at a lower percentage your income may increase dramatically if sales increase.

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.

Bidding for a percentage of gross profit

The story so far is:

• You know that 25 per cent of gross profit is probably your maximum royalty percentage, and that a company will almost certainly want to give you far less.
• You know what 25 per cent of gross profit ought to be worth in money.
• You know the relative value of your invention - low, medium or high.

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.

Converting gross profit into net sales price

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: 

• Your figures show that the company will make 40 per cent gross profit on sales of your product in one year.

• Based on your valuation of your invention, you decide that you want 15 per cent of gross profit as your royalty.

• That now becomes 15 per cent of 40 per cent...

• ...which is 6 per cent of net sales price - a smaller figure but exactly the same money as 15 per cent of gross profit.

Renegotiation of royalties

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.

Traps to avoid

• Your royalty should apply to all sales, so never let a company stop paying you royalties if sales exceed a certain level. (A possible exception is if you accept a royalty ‘ceiling' in exchange for a substantial guaranteed minimum royalty income.)

• Never agree to royalties based solely on net profit, as sales figures can easily be manipulated to show no profit at all. For example, it may be claimed that manufacturing and distribution costs and promotional discounts negate any net profit.

• Some companies may try to reduce your royalty income by selling product at an artificially low price to an associate company. To avoid this risk, insist in your final agreement on royalties based on arm's length transactions - in effect, on a fair market price.