The economic sense of royalty rates.
University's licensing managers are often engaged
with the issue of how to determine a reasonable royalty rate for
the technology they license. In a previous article in this magazine
(How to successfully negotiate reasonable royalty rate for
licensing bioproducts, George D. Corey and Edward Kahn, Genetic
Engineering News, September 1, 1995) the authors argue that the
Industry-standard approach is the preferable method to
determine reasonable royalty rates. According to their experience,
Mr. Corey and Mr. Kahn attribute a range of 4%-12% royalty rates
to technologies related to therapeutic products.
This article tries to base the reasonable royalty
rate on economic sense by utilizing a simple financial model which
relates the investment required to develop a therapeutic technology
to the income generated by such technology. Mr. Corey and Mr.
Kahn refer to this method as the simple investment theory approach,
but dismiss it as impractical. My analysis shows that using such
simple models sheds light on various economic aspects of the reasonable
royalty rates that are totally overlooked by the Industry-standard
approach.
The financial model used for the following calculations is based on the assumption that a novel early-stage therapeutic technology is licensed by a university to a commercial company. Two scenarios for the investment schedules required for the development of such technology are analyzed in Table 1 and Table 2:
Table 1: Total investment of $100M
| Phase |
|
|
| Pre-clinical research | ||
| Toxicology and IND submission | ||
| Phase I | ||
| Phase II | ||
| Phase III | ||
| NDA approval and preparation for marketing | ||
| Total |
Table 2: Total investment of $150M
| Phase |
|
|
| Pre-clinical research | ||
| Toxicology and IND submission | ||
| Phase I | ||
| Phase II | ||
| Phase III | ||
| NDA approval and preparation for marketing | ||
| Total |
The following additional assumptions were used in the financial
model:
Translating these assumptions to a simple financial model enables
the calculation of the royalty rate that the company can afford
to pay and still be able to achieve the rate of return it requires
for its investment. The rate of return is defined as the Internal
Rate of Return (IRR) in real terms (meaning that expected inflation
rate should be added to the computed IRR in order to calculate
the nominal rate of return). Drug development is a high risk venture
and such risk should be reflected in the company's required rate
of return. The following analysis uses three rates of returns
as benchmarks: 15%, 20% and 25%. For each such rate I have calculated
the maximal royalty rate, payable to the university, that will
enable the company to achieve its desired rate of return. The
results of these calculations are shown in Table 3 and Table
4:
Table 3: Maximal royalty rate (total investment $100M)
| |||
Table 4: Maximal royalty rate (total investment $150M)
| |||
Tables 3 and 4 clearly demonstrate that the maximal royalty rate,
payable to the university, while ensuring to the company its required
rate of return, is increasing with the increase in sales volume.
Moreover, this result is robust and does not depend on the assumptions
of the model. This point is completely overlooked by the simple
industry-standard approach.
Assuming that the total investment required for the development
is $100M and the rate of return required by the company is 20%
(Table 3), a 1% royalty rate is economically reasonable when the
expected sales volume is $400M; however should the sales volume
double to $800M the reasonable royalty rate will increase to 10%.
Not surprisingly the required investment for the development of
the technology is significant too. Thus, if such investment rises
to $150M and the required rate of return remains 20% (Table 4),
1% royalty rate is adequate if expected sales volume is $600M,
however an increase in expected sales volume to $800M allows a
reasonable royalty rate of 6%.
Another interesting result of this analysis is that the increase in the royalty rate due to increase in sales volume is marginally diminishing. Using our previous example of $100M investment and 20% required rate of return, a rise in sales volume from $400M to $500M increases the adequate royalty rate from 1% to 5%, while a rise in sales volume from $700M to $800M increases the adequate royalty rate from 9% to 10%.
The figures presented in Tables 3 and 4 show that the range of
reasonable royalty rates is wider than the 4%-12% range proposed
by Mr. Corey and Mr. Kahn and such rates can vary from 1%-12%
(assuming that 20% rate of return is the minimal rate required
by the company). These results are consistent with my experience
with licensing technologies at early stages; for such technologies
royalty rates in the range of 1%-4% is usually acceptable.
The most important insight provided by such analysis is the strong
positive relation of royalty rates to sales volume. This point
is totally overlooked by the industry-standard approach and according
to my experience is usually not taken into consideration. The
university usually determines its desired royalty rate by the
appeal of the technology (cutting edge technologies deserve higher
royalty rate), its proximity to human trials and the extent of
the patent coverage. The company usually determines its affordable
royalty rate by considering the amount of investment required
for the development and the extent of patent coverage. The analysis
shown here demonstrates that the expected sales volume is a key
determinant of the economically reasonable royalty rates, and
thus the factors that determine the expected sales volume such
as the potential market, possible competition, the expected product
price and the geographically coverage of the patents should be
seriously considered while determining such rates.