Determining the right royalty rate: key to pharmaceutical and biotechnology success
It’s a jungle out there. Deriving the right royalty rate for new pharmaceuticals and biotechnologies is a real tangle. This is a critical business function, and it has never been more important for companies to get it right. Propose a royalty that’s too small and you lose out on great deals. Pay too much in royalties and you eat up potential profits. So how do you determine the right royalty rate?
A recent study outlines key background, approaches and considerations for setting royalty rates and will help you navigate the royalty rate jungle and emerge with your best outcome possible.
This article discusses a summary of the report’s findings.
Over the last two decades, there has been much upward pressure on royalty rates. The reasons are simple. It’s becoming harder and harder to discover effective and marketable new drugs and biotechnologies. With more than 10 years and several hundred million dollars tied up in the development process for any one product, the total investment is huge. There’s endless pressure to discover promising new products to fill a company’s R&,D pipeline. And external competition for intellectual property resources is fierce indeed.
In this environment, three factors still serve as the primary forces driving royalty rates:
– Amount of Profits. What is the economic benefit generated by the intellectual property or new technology, after accounting for development and production investments?
– Duration of Profits. How long will the profits continue? Consider patent life, technological obsolescence and consumer reaction.
– Associated Risk. What are the risks related to regulatory, market, economic or inflationary considerations?
Old royalty assumptions
Several simple rules of thumb are often used to set royalty rates. The danger here is clear: Every deal is different. A cookie-cutter approach to setting royalties could spell disaster for the venture, and perhaps your business.
This straightforward method sets the royalty at 25% to 33–1/3% of before-tax profits from operations in which the licensed intellectual property is used. But which profit line do you use? Gross profits only consider and deduct the direct costs of production, but not operating expenses (sales, marketing and administrative). Operating profit, the profit remaining after these non-manufacturing expenses, is a somewhat better measure (identified as a profit-margin percentage or rate) on which to base royalties.
5% of Sales Method
This age-old method of setting royalties is popular in a wide variety of industries. The calculation is simple:
Sale x .05 = Royalty Payment
It sounds nice and simple, and seems fair enough, but this method ignores a key component of the business process: The huge cost of developing a product and bringing it to market. This method also ignores the profit you may or may not be making, nor does it consider the development investments that you, the licensee, make in the product.
It can be attractive to just do what the rest of the industry is doing. For instance, one study of 458 pharmaceutical and biotechnology license agreements found a 7% average royalty. That is attractive as a simple option, but it also ignores the investments and risks you take bringing the product to market, and it doesn’t consider your profitability as a measure of success.
New royalty approaches
Pharmaceutical and biotechnology companies today use varying techniques to negotiate and set royalty rates. Here’s a rundown of the major approaches. Perhaps you can adopt some of these methods, or incorporate aspects of them, into your own royalty rate decision models.
While no one wants to end up in court for infringement or have to deal with other kinds of legal action regarding royalty rates, it was a court case that spawned this approach. The idea is to complete an analysis that identifies industry profit margin rates (operating profit margin is an example), and compare that rate to the company’s operating profit margin with the license or technology. The difference provides a guideline for negotiating the royalty rate:
Expected Profit Margin (with patent) – Normal Profit Margin (industry norm) =
Royalty Rate Basis for Negotiation
Generic Pricing Analysis
Here is another comparative way to begin discussing potential royalty rates, but there is less analysis to consider. The idea is to compare the price differential between proprietary drugs (brand names under patent protection) and generics (patents expired), and use the difference as a basis for setting the royalty rate.
Comparable License Transactions Analysis
A simple comparison of the royalty rates for similar licensed intellectual property can be a sound way to identify a reasonable royalty rate for new pharmaceuticals or biotechnologies. There are, however, a few points to keep in mind:
• Do not use internal licenses between corporations and subsidiaries as examples (they can be lower).
• The examples should be recent.
• The negotiations for the rates should have been between independent parties.
• The intellectual properties should be similar.
• Exclusivity terms should be similar.
“From this, the cash value of the intellectual property can be identified, and a basis for royalty negotiations identified.”
Investment Rate of Return Analysis
Another way to value a pharmaceutical or biotechnology license is to analyze what the new intellectual property will do to the company’s rate of return on investment. This method is simply attributing the proper proportion of profits (that can be traced to the patent or technology) and expressing it as a percent of revenue. This figure provides a basis for setting the royalty rate. Here’s the summary equation:
Investment Rate of Return Including Patented Drug or Technology –
Investment Rate of Returns Excluding the Patented Drug or Technology =
Royalty Rate Associated with the Patented Drug or Technology
Discounted Cashflow Analysis
This approach for setting royalty rates is similar to the Investment Rate of Return Analysis, with this difference: Instead of rate of return, a discounted cash-flow analysis is used. The goal is to come to the present value of the expected cash flow, and make sure that present value is related directly to the licensed intellectual property.
From this, the cash value of the intellectual property can be identified, and a basis for royalty negotiations identified. You must consider investment risk (what return could be gotten elsewhere on your money) and time value as part of the discount, these are important measures for ratcheting down to the true cash value of the intellectual property.
Risk Adjusted Net Present Value Method
Developing drugs and biotech products are expensive, time-consuming and risky propositions. With multiple stages of testing, clinical trials and regular reviews by the FDA, there are multiple hazards along the roadway to a marketable product that will actually generate revenue for your company. And all the associated costs are huge.
The Risk Adjusted Net Present Value Method considers the “success rate” for drugs going through the development process, and uses that success rate to adjust the Discounted Cashflow Analysis mentioned above. This is a very valuable step in finding a drug’s fair market value. It is important to know the drug’s chances for success before setting a royalty rate.
“The analysis calculates the present value of the money saved by owning a patent and not having to pay royalties to a third party to license that patent.”
Relief from Royalty Method
This is a simple, reliable and respected way to value a patented invention, but the method’s success relies on the accuracy of the inputs. The analysis calculates the present value of the money saved by owning a patent and not having to pay royalties to a third party to license that patent. Key inputs include:
• Remaining life of patent protection
• Forecast revenues
• Royalty rate
• Tax rate
• Discount rate
Armed with this data, a complete analysis can identify how much the patent protection is worth, and from that you can begin to work on setting a royalty rate.
No matter which approach you take for deriving royalty rates, one of the key considerations is how to handle the number of documents and amount of data your company will generate in the process. All this information is key to setting the rates, and it’s essential to keep it on hand and accessible during the process and in the future.
“…to attract the best deals, you need to know how to set a royalty rate that is attractive to the licensor but makes sense for your company as licensee, too.”
One solution that more and more pharmaceutical and biotechnology companies are using today is using a VDR solution. A VDR serves a key role by providing a robust, secure and reliable electronic solution that is designed to gather, organize, store and manage the massive quantities of documents companies need for a successful outcome.
How are you navigating the royalty rate jungle these days? Keeping your company’s R&,D pipeline full is essential. But to attract the best deals, you need to know how to set a royalty rate that is attractive to the licensor but makes sense for your company as licensee, too.
An old-fashioned, cookie-cutter approach to this pursuit is likely not the best option. Good luck on your journey into the royalty rate jungle. Now you have some tools for creating a clear path through it.
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For further information on effective, real-world options for setting royalty rates in the modern environment, click here for the full report, Royalty Rate Derivation for Pharmaceuticals &, Biotechnology, sponsored by Merrill DataSite.
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How do you determine the right royalty rate?