Royalty rates, sub licensing considerations
and joint ventures.
In a previous article ("The Economic Sense of
Royalty Rates", Economic Working Paper Archive, ewp-fin/970903,
Sept. 1997) I have discussed the economic aspects of determining
a fair royalty rate for a licensed therapeutic technology. The
analysis shown there, using a simple financial model which takes
into consideration the unique characteristics of the drug development
process, demonstrated the main determinants of economically based
royalty rates.
This article tackles two additional features of technology
transfer compensations: sub licensing considerations and equity
holding. Sub licensing considerations are received when the licensee
grants a sub license to another company to produce and sell the
licensed product. A portion of such considerations is due to the
university that initially licensed the technology. Equity holding
is sometimes offered when the licensee is a start-up company,
usually backed by a Venture Capital fund. In such deals the university
usually receives a share in the new company's equity and in return
agrees to reduce its royalties. The determination of fair values
to the university's portion in the sub licensing considerations
or to its share of the company's equity is not straightforward.
Obviously both compensations are substitutes for royalties and
thus should be linked to the royalty rate due from sales, however
the exact relation between royalty rate, sub licensing consideration
and equity holding is usually controversial.
Splitting sub licensing considerations and sharing
equity are similar in the sense that both compensations represent
forms of profit sharing. By sub licensing its rights in the technology
the company foregoes its opportunity to profit from manufacturing
and selling the licensed products, and shifts this opportunity
to another company in return to royalties, lump sum and milestones
payments etc. Such considerations are in principle net income
to the sub licensor, since they do not involve manufacturing and
marketing costs (however these considerations are subject to income
tax). Thus the percentage allocated to the university from such
consideration should reflect its claim on part of the company's
profit.
By definition a share in the company's equity is
also a claim on part of the company's profit.
In the former article I have shown that a fair royalty
rate, based on economic grounds, is that percentage of sales,
payable to the university, that will ensure the company its required
rate of return. By sub licensing the technology or by giving the
university a share in its equity, the company saves the royalties
payable to the university, but in return it is required to pay
a portion of its net income. Thus, a fair portion of the company's
net income, which completely substitutes the royalty obligation,
is such portion that ensure the company the same rate of return.
By utilizing the financial model presented in my
previous article (see full details in EconWPA, ewp-fin/970903),
and assuming that the total cost of the therapeutic technology
development is $100M during 10 years, and the required rate of
return is 25%, I have calculated the portion of net income, payable
to the university, that will ensure the company 25% return on
its investment. These calculations are presented in tables 1:
Table 1:
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(*) Royalty rate are taken from my previous article (ewp-fin/970903).
With expected sales volume of $600M, the fair royalty rate will
be 2%, and the fair division of net income will be 10% to the
university and 90% to the company. If, however, the expected sales
volume rises to $800M the university's entitlement will rise to
30% of net income.
Obviously the company will be indifferent between the two alternatives:
royalties or profit sharing since its required return on investment
is not altered. However, the university too will not be affected
by which alternative is chosen if its appropriate discount rate
is the same as the company's rate of return. In order to demonstrate
this point I have calculated the net present value (NPV) of royalties
versus profit sharing using 25% discount rate (The NPVs of both
royalties and profit sharing are calculated on after tax basis)
These calculations are presented in Table 2:
Table 2:
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In the case of splitting sub licensing considerations it is straightforward to use the profit sharing percentages, presented in Table 1, as the appropriate ratio for such splitting. The connection between royalties and a fair ratio for splitting sub licensing considerations can be summarized by a simple rule:
This "5 factor rule" is quite robust and is not
dependent either on expected sales volume or on the rate of return/discount
rate.
The case of equity sharing, however, is not straightforward. The
main difference is that when the university receives a share in
the company's equity its compensation is not necessarily related
to the success of its licensed technology. It is not uncommon
for biotechnology companies to shift their focus from their initial
technology to a different technology, if the initial one proves
disappointing. Thus, its possible for the university to hold shares
in a company without contributing to its technology and products.
In addition royalties and sub licensing considerations are payable
only during the term of the license, usually while the patents
are still in force. Equity holding, on the contrary, is not limited
by the term of the license. For these reasons equity holding
represents a premium to the university compared with simple profit
sharing. Such premium should be taken into account when calculating
a fair equity sharing.
In order to tackle this problem I will refer again to the basic
feature of the joint venture: the university is giving away its
entitlement to royalties and receives instead a share in the company's
equity. Thus, the university should evaluate its share in the
company's equity according the present value of its foregone royalties
. These present values, using discount rate of 25%, are already
presented in Table 2. Comparing the royalties present value with
the initial investment in the new company gives a basis to a fair
equity sharing.
The magnitude of the present value figures in Table 2 should be
given a moment of consideration. A therapeutic technology, with
a potential to generate $800M sales volume during 10 years with
6% royalty rate payable to the university, has a present value
of merely $10M after tax. This alleged discrepancy is unique to
biotechnology and pharmaceutical technologies due to the long
time horizon and the high risk which characterize their development.
Assuming that a joint venture is established, based on the licensed
technology, and such JV raises an initial investment of $5M (which
is sufficient to fund the pre clinical stage during the first
two years), I have calculated the university's share in the JV.
These calculations are presented in Table 3:
Table 3:
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The dominant role of expected sales volume is apparent in the
case of JV too. If the expected sales volume is $600M the university
should be satisfied with 33% of the JV's shares, however if the
expected sales volume rises to $800M the university should have
66% of such shares.
The more deals, which involve equity holding, consist of a combination
of royalties and share holding in the new company. I have analyzed
an example of such deal, using the figures in Table 3, and assuming
that the expected sales volume is $700M. This analysis is presented
in Table 4:
Table 4:
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If the university receives royalty rate of 1%, its share in the
JV should be reduced from 55% to 43%. However, increasing the
royalty rate to 3% should reduce the university share holding
to 12%.
These simple calculations demonstrate the complexity of technology transfer deals. I have discussed only the main features of such deals, but in reality we find a plethora of variations including among others: non dilution clauses, warrants, milestone and lump sum payments etc. However, I believe that such complexity should not deter technology transfer practitioners from sound evaluation of their technology in order to achieve a fair deal for their institution.