Tech royalty setting: 5 common blindspots

As technology has become a crucial value driver in many industries, there is a growing need to price tech royalties for licensing negotiations, transfer pricing and valuation. A commonly used method of estimating IP royalties is by comparison to arm’s length royalties for assets deemed to be ‘comparable’ (referred to as the Comparable Uncontrolled Pricing method, or CUP).

Royalties are a profit sharing mechanism between IP owners and licensees. It follows that royalty determination should consider the drivers of tech earnings, and how a license apportions value between licensor and licensee.

Tech IP is extremely complex. Finding comparable royalties is difficult. This increases the importance of careful – rather than superficial – analysis. Here are 5 common benchmarking blindspots that can lead to royalties that deviate from commercial reality:

Blindspot #1: Differences in tech utility

Even a crude assessment of comparability is likely to differentiate between tech duds and blockbusters. However, a common blind spot is how functional differentiation can magnify the earnings capability of technology.

Analysts often assume that an industry’s inter-quartile range of reported royalties adequately reflects the range of tech utility. ‘Inter-quartile blinkers’ create utility-blindspots that can result in uncommercial conclusions:

  • No amount of statistical analysis compensate for a bad dataset
  • Royalty databases exclude technology which is not good enough to be licensed. This happens to be the vast majority of patents, and a large proportion of software and data assets. As a result, the median of published royalties is higher than that of the IP population as a whole
  • Within industries the strongest technologies typically command far higher royalties than the upper-quartile. The selection of the upper quartile royalty of, say, 8% of revenue is not commercially logical if truly comparable IP commands royalties closer to 20%.
Blindspot #2: Differences in legal rights

Within an industry, not all tech assets enjoy similar legal protection. Obviously, a technology protected by a single provisional patent is not comparable to one protected by a portfolio of granted patents and associated trade secrets. More subtle differences can compromise comparability, for instance, with patented technology, relative questions include:

  • Do patent claims cover the end-product or a manufacturing process?
  • Do the claims cover commercially important features of the technology?
  • How easy is it to design around the claims?
  • How easy is to identify and prove patent infringement?

For unpatented software, copyright protects the expression of the code rather than the underlying functionality, so differences in the level of protection include access control to key algorithms. Contractual protection and the complexity of developing an equivalent asset.

Once an appropriate royalty is found for a particular technology, it is important to remember that this might require adjustment by jurisdiction, depending on the local status of patents and designs.

Blindspot #3: Different place, different circumstances

It is no surprise that competitive forces and profitability can vary significantly between sectors, between geographic markets, and over time. Yet royalty benchmarking are often silent on these factors. Due to the rate of tech evolution, the passage of time is particularly relevant to the royalty potential of a technology. Between regions, royalties can vary depending on levels of industry maturity, competitive forces and the availability of assets that contribute to the profitability of a technology.

Blindspot #4: Differences in royalty pricing mechanisms

In addition to an ongoing royalty, the pricing of IP licenses can include upfront fees and milestone payments. A $100 million upfront fee clearly influences the rate of an ongoing royalty, so it should be carefully considered in a benchmarking exercise.

In most industries, a percentage of revenue is a common royalty mechanism, but benchmarking can require adjustment to reflect differences arising from revenue at different points in the value chain (for instance, wholesale or retail revenue). In some circumstances, other royalty mechanisms better meet the characteristics of the asset or transaction.

Blindspot #5: Differences in licensing terms

The terms of licences vary according to the commercial circumstances and negotiating strength of the respective parties. Pricing is just one component of a licensing agreement, and arm’s length royalties can be influenced by clauses relating to exclusivity, R&D rights and duration.

This gets back to royalties being a profit sharing mechanism. To the extent that licensing terms influence the rights and obligations of the parties, they also influence the appropriate share of profits.

Conclusion

Technology assets are complex. Without informed comparability analysis, royalty opinions can become detached from commercial reality. Sometimes, the absence of appropriate comparables makes royalty benchmarking an inappropriate method, other times it necessitates the use of corroborating analysis.
In the context of related party transactions, OECD Transfer Pricing Guidelines specify comparability factors that should be considered. However, even if a thorough CUP analysis is undertaken, tax authorities may in future wish to apply a more complex profit split method to deal with the complexities of intangible assets.

Royalty determination that reflects a 360˚ assessment of IP assets is part of Deloitte’s IP Advantage capability.


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