Royalties represent the main profit-sharing mechanism that operates when the product is on the market. Royalties are usually paid on the net sales value and reflect the risk/ reward ratio between the licensor and licensee.

Royalty rates can be fixed or variable. If the royalty rate is fixed for the duration of an agreement, this tempers the incentive for the licensee to expand its market share as well as limiting the ability to react to changing market circumstances. Variable royalty rates can be employed in a contract to act as an incentive. A low initial royalty eases cash flow during the launch phase. Similarly, a lower rate for higher tiers of sales encourages the licensee to hit these sales targets.

Royalties do tend towards an industry norm. Industries such as telecommunications have fairly fixed royalty rates in the range of 10—15%; other industries have lower average rates, for example electronics and food industries have rates mostly in the range of 2—5%.

Royalties can also vary according to therapeutic area; for example, diagnostic products generally cannot sustain the same level of royalties as pharmaceuticals because the profit margins are lower.

Overall, the royalty rate agreed for product or technology will depend on:

• the strength of the intellectual property;

• the exclusivity of the rights granted;

• the territorial extent of the rights granted;

• the uniqueness of the technology transferred;

• the duration of the licence;

• the stage of development of the technology;

• the risk associated with the product.

Strength of the intellectual property

The degree of protection has a major influence on the royalty that a product or technology can command. If there is only process cover as opposed to compound per se then this is less effective in deterring competitors. Similarly, the validity and enforceability will also influence the royalty rate.

Exclusivity and territorial extent

If the licence granted is a global, exclusive licence then royalty will be at a higher level than for a regional non-exclusive licence. An important clause in a non-exclusive licence is a 'most favoured licensee clause' whereby the licensor will not grant another non-exclusive licence on more favourable terms. This would ensure parity in the market-place in terms of the royalty burden of the product or technology.

Uniqueness of technology

If the technology is intended as a basic platform technology, it is often licensed very broadly to many companies on a low royalty rate which encourages companies to take a licence. For a very novel and unique NCE it is possible to command a far higher royalty.

Duration of the licence

If there are only a few years remaining of patent life, the licensor may intend seeking a higher royalty rate to maximise the return on the product. A potential licensee would be inclined to resist a high level, however, because the promotional investment required in establishing the product may not be recouped before generic competition is evident.

Stage of development and risk associated with the product

The royalty rate will also reflect the risk inherent at the stage of development when access to the technology is secured. The risk in establishing the product is reflected in the royalty. For fully developed products on a simple distributionship the transfer price may be 40% of the market price. For an unidentified product lead from an assay or chemical library, the royalty may be between 1 and 5%.

Market factors

It is not unusual to see different royalties operating for different sales thresholds, for example sharing the benefit of good market performance. Alternatively, in difficult market circumstances the royalties can decline to encourage improved sales performance.

Sales targets

The royalty return is often used as a performance measure as well as a guarantee of income to the licensor. Failure to meet the minimum return may invoke penalties, such as loss of exclusivity. Occasionally, to allow for difficult market circumstances, the licensee may be able to make up any shortfall by a lump sum payment; however, the performance criteria will remain in place for subsequent years.

Hardship provisions

Royalties can be reduced in the case that the licensee is facing particular hardship in the market-place. There will be a very precise definition of what constitutes hardship; examples are:

• where generic or unlicensed competition reaches a level in excess of 20% of the market sector; or

• where price cuts have caused more than a 15% reduction in price.

In such cases, the licensor may accept a reduction of up to 50% in the royalty rate to allow the licensee to protect its competitive position. The acceptance of such a provision will be tempered by the viability and willingness of other parties to be appointed as alternative licensees.

© Sharon Finch

This text is an extract from the Financial Times Pharmaceuticals report 'Successful Licensing — negotiating and drafting optimal pharmaceutical deals', by P. Ranson & B. Driscoll of Simmons & Simmons and S. Finch of Medius Associates. For information on how to order call FT Business on +44 (0) 171 896 2031 or www.pharma.ft.com

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