By Jeremy Cohen
It’s often said that the sign of a good negotiation is when both sides feel like they failed to get exactly what they wanted.
Royalty negotiations are some of the toughest business problems that can occur. These negotiations can be especially fraught given that one side of the table is generally much larger, and any inevitable compromises will likely benefit the Goliath rather than the David.
Yet by following a few well-trodden negotiation paths, it is possible to create a situation where you “let the other guy have your way,” to paraphrase the great Italian diplomat Daniele Vare, and come out ahead in royalty negotiations.
One example of a well-known company that negotiated an excellent royalty rate was Apple’s tussle with various music labels as the tech giant planned to launch its iTunes Store.
In the early 2000s, Apple spotted a growing demand for digital music and saw an opportunity to create a platform for purchasing and downloading music online. To make this happen, Apple needed to secure the rights to distribute music from major record labels, which was no small task.
Apple’s then-chief executive Steve Jobs personally negotiated with the music labels and managed to pull off one of his legendary business magic tricks, convincing them to license their music to his platform for a set royalty rate that Apple would pay to the labels for each song sold.
While the music labels initially demanded a high rate of up to $3 per song, Jobs was able to negotiate a much lower rate of just $0.99 per song. The labels weren’t happy with that counteroffer, but they also knew this rate was still enough to provide a decent revenue stream and encourage top artists to agree to their music being listed on the store.
For its side of the deal, Apple would have preferred an even lower royalty rate (in fact, Apple Music today offers a measly $0.01 royalty fee, so times have changed), but the successful negotiation by Jobs was a critical factor in the early success of the iTunes Store and the model of streaming music in general.
By keeping the final royalty rate sufficiently low, Apple could offer digital music at a price that consumers were willing to pay while creating a new revenue source for the music labels that faced an existential crisis.
This single royalties negotiation did more to make iTunes the most popular music download platform in the world and set the stage for the digital music revolution that continues to this day than almost anything else.
What are royalty rates?
A great way to understand royalty rates is to see them as an income-sharing tool that puts a dollar figure on intangible assets such as trademarks, patents, copyrights, goodwill, rights, securities and whatever might generate an alternative income for a company.
Royalty rates are usually considered when the owner of an intangible asset lacks the ability to scale a product with its own resources and instead must partner with better-positioned companies that do have this capability.
For example, let’s invent a fictional company called “Prince Energy Drinks” that has successfully locked up the market in North America but lacks any contacts in East Asia, which is its target region for expansion. To solve this gap, Prince approaches “Courtly Beverages Asia” to distribute its new soda across East Asia.
After a rambunctious negotiation, the two agree that Courtly Beverages will have a 15-year distribution exclusivity with a royalty rate of 6% from all revenue generated from sales of Prince’s drinks – a decent outcome for both parties.
The best part is that nothing stops Prince Energy Drinks from approaching a European distributor and doing it all again. That’s the amazing thing about the intangible asset of “brand” – often it can be used multiple times at almost zero extra labour and resources for the owner.
The 25% rule
Let’s now look at the most common themes and assumptions made when two parties sit down at the negotiation table.
Most royalty rate negotiations begin with the “25% rule.” It’s a fairly good rule, and it works in many situations. But the 25% rule is often criticised for being based on average profit margins which, according to 2022 data, no longer reflects reality (and hasn’t for a while). Licencing agreements have evolved greatly over the past few decades due to new and more accurate data while profit levels tend to vary across industries.
To illustrate the 25% rule, we can use the examples of our invented companies, Courtly Beverages and Prince Energy Drink.
These two firms kicked off their royalty rate negotiations using the 25% rule but the final percentage came out at 6% of gross revenue. How did they get to the final figure?
The first step required a high-level overview of the margins (net sales and estimated profits) along with the general strength of Prince’s worldwide reach outside the territories earmarked for Courtly Beverages. If Courtly could prove it had strong distribution channels and key buyer relationships across Asia, this would give Prince more certainty about a quick ramp-up of revenue once the license was granted.
The next step would consider the number of territories exclusively owned by Courtly. If Courtly only had access to two or three markets in East Asia, that could reduce its final royalty percentage.
The third step would look at the value of Prince’s other intangible assets such as brand, trademarks, logos bundled under the licensing agreement and the economics of top-line sales which can all be quantified, forecasted and audited. All of this could impact the final royalty rate as well.
Once these initial steps were debated, the final piece of the puzzle would be to compare the looming agreement with similar deals in similar markets (like with like).
At the end of this rigorous process (which will, of course, include a lot of back-and-forth), a reasonable estimate for royalty rates can be made.
Royalty rates in valuations
A less common, but still important, use for royalty rates is in organising transfer pricing, litigation or infringement damages, financial reporting and corporate strategy to better frame a business or brand valuations.
So, using the same two fictional examples as above, perhaps Prince Energy Drinks one day decides to break apart into one core entity with a group of satellite or sister companies. What should happen to the various licenses and brands?
Prince would need an accurate valuation of each of its royalty-generating intangible assets so external buyers can accurately judge the value of what they might be buying. It could use the income and market approach to uncover aspects such as relief from royalty and residual present-day value of possible cash flows attributable to any intangible assets. Such complex methods deserve a bit of explanation:
- Relief from royalty assumes that if a piece of intellectual property is not owned, it may need to be licensed from a third party which would incur a royalty;
- The present value of any royalty is the assumed value of the intellectual property based on the percentage of royalties generated should Prince choose to licence it;
- The market approach measures against similar transactions with similar intangible assets (not as easy as it sounds since intangible assets are embedded within a business).
Done right, royalty rates and intangible assets can be a highly efficient way to generate new and sometimes outweighed levels of income because there is often a non‐linear relationship between the cost of creating intangible assets and their true market value.
A good example is comic books. The cost of drawing a comic book hero is minuscule compared to the long-term franchising and royalty potential that such a fictional hero can generate. The history of Marvel Comics would be a great case study for a future article on royalty rates.
Overall, the negotiation for royalties is never easy. There are no universal standards underpinning a royalty strategy and the final percentage agreed between the IP owner and the licensee can vary wildly. It all comes down to the skill of the negotiators on either side of the table which requires that both understand the value of their intangible assets.
The art of negotiation is to create new opportunities while minimising the blood loss. As such, it pays to remember the famous quote by travel writer Caskie Stinnett who once said, “a diplomat is a person who can tell you to go to hell in such a way that you actually look forward to the trip.”