Although not a big amount in itself, the royalty rate a brand attracts can lead to significant income for its owner. It therefore pays to make sure that you get the figure right. Thayne Forbes of Intangible Business reports

 

Changing a royalty rate by just a fraction of a percent can mean the difference between just covering costs and generating huge profits. It is therefore of fundamental importance to both licensee and licensor that the royalty rate reasonably reflects the strength of the brand in a defined sector and territory in relation to its competitors and is set by recognising the correct point on the supply chain. There are a number of factors that can be applied to determine an appropriate royalty rate which deserve attention. Firstly, the commercial context within which royalty rates exist needs examination to engender a full understanding of their application. Next it is necessary to have a good understanding of the sales on which they would be based, and in particular the price point in the supply chain on which royalties are to be based. Then a range of comparable royalty rates can be researched and market research can be used to position within that range. Profitability analysis will then give a view on the reasonableness of the royalty rate to the licensee to assess affordability. There are also a number of other considerations from a licensing agreement, such as marketing investment, which might impact on royalty rates. Given the significance of intangible assets to many businesses, and that royalty rates are often key in assessing their value, royalty rates will often be key to business and brand value.

 

Use in Practice
Royalty rates are seen in practice in license agreements for intangible assets and valuations of intangible assets. There are many such assets used in business today which are highly valuable, for example patents, copyrights, trademarks or brands, or a combination:

 

Patents
Patents are like official licenses from governments enabling (and excluding others from) manufacturing, using or marketing an invention for a limited period. They should, in the majority of instances, have brands built around them, which has three major benefits. Firstly, after the patent term expires - usually after about fifteen or twenty years, or sooner if a registration lapses - all and sundry are entitled to copy the invention. Attaching a brand to the patent will therefore help induce immortality to the invention. Secondly, it makes the patent more marketable as it becomes more relevant and identifiable with consumers. And thirdly, the brand will increase the value of the patent which would increase its purchase price and merit a higher royalty rate. Dyson's fundamental patents, for example, relate to the basic principles of putting two cyclones of increasing efficiency into a vacuum cleaner to increase the overall separation efficiency of the cleaner. It doesn't matter what the machine looks look like or what trademark is used to sell it.

 

Copyrights
Significant value resides in copyrights - legal protection to authors of ‘original works of authorship' such as software, books, films, plays, compositions and other intellectual works for a certain number of years. For companies such as EMI, which is totally reliant on its artists and back catalogue, appreciating the full value of these assets and reflecting this in the royalty rate for licensing agreements to publishers and merchandising partners, as well as for payment to its artists, is increasingly important.

 

Trademarks
Trademarks are the words, symbols or devices that are registered and protected by law - frequently a name, logo, or strap line. These distinguishing characteristics are often the physical manifestation of a brand and it is the consumer brand, where there is a wealth of developed research and theory, that is the focus of this article. The same principles of royalty rate analysis applies to other intangible assets, such as business-to-business brands, copyrights, trademarks and patents, although there is often a need for a different focus.

 

In this article we concentrate on consumer brands where there is a wealth of developed research and theory. The same principles of royalty rate analysis also apply to other intangible assets such as business-to-business brands and copyrights, contracts or patents, although there is often a need for a different focus.

 

Context
Before any analysis aimed at quantifying a royalty rate it is worth standing back and assessing the background on why it is needed. License agreements are drawn up for many reasons and support different strategies. Licensing might be the core activity of a business, it might be a deliberate exploitation of dormant Intellectual Property, it might be a strategy for markets which cannot be as well developed otherwise or it might be a strategy for non core products (to name but a few strategies). So as an example the royalty rate for Smirnoff within a distribution arrangement for the Japanese vodka market might be say 40%, very different from a royalty rate for the same brand in the US confectionary market (say 5%).

 

Within a license agreement the royalty rate may be interlinked with other factors, most notably minimum royalty commitments and decreased royalty rates once certain volumes are reached. Minimum royalties are often a commitment for some form of exclusivity or access to the brand in a market. Decreasing royalty rates could be used to incentivise the licensee to achieve higher volumes as the unit cost of branded products then becomes less.

 

It is important, however, that the agreement benefits both parties because as the following example illustrates, it can go horribly wrong. Arthur Andersen, the accountancy firm, effectively licensed the use of its name to Andersen Consulting, the management consulting firm. Andersen Consulting wanted to extricate itself from paying for the use of its name largely because it believed it was paying too much. Arthur Andersen asked as the price of extrication approximately billion - which Andersen Consulting naturally baulked at. The case went to arbitration which ruled that Andersen Consulting did not have to pay this but had to change its name, which it subsequently did, to Accenture. Arthur Andersen got are poor deal - it lost "royalty" payments, lost the goodwill Andersen Consulting used to contribute to the Andersen name, lost the billion, lost as the settlement offers Andersen Consulting proposed and gained a raft of negative publicity. A little while later Arthur Andersen itself closed in one of highest profile corporate disasters to date.

 

Licensing agreements
Licensing agreements should therefore be designed to benefit and protect both the licensee and the licensor to ensure its longevity and success. There are six key component sections:

 

1. Definition of brand
The brand must be defined, trademarks copyrights and other relevant intellectual property identified.

 

2. Definition of sales
The price point to which the royalty rate is attached is one of the most important considerations. Two important price points are wholesale and retail. Retail prices are usually twice that of wholesale so royalty income or payments can, say, halve or double, depending on where it is set.

 

3. Control over brand
License agreements do not give licensees carte blanche to use a brand wherever it likes but it allocates specific market sectors or products, channels and territories to which the brand can be applied. For example, it if the Savoy Group wanted to leverage some of the value that resides in its portfolio of brands such as the Savoy Hotel, The Connaught, and Claridges, it would need to maintain control of its brand's prestige so would be unlikely to allow distribution of products through supermarkets. Likewise if the Savoy Group agreed to license a brand to a rain coat manufacturer, it would need to be stipulated that disposable bin-bag like raincoats were not allowed whereas a premium variety was. This may seem like common sense but unless it is actually in writing problems easily arise.

 

Even within the restrictions that are set out, approval still needs to be granted for activity from the licensor. This is to ensure that the use of the brand by the licensee is consistent with that of the brand owner: it must add value not dilute the brand. A well known example of brand dilution through licensing is Pierre Cardin. The Pierre Cardin name was licensed to appear on over 900 marginal products such as push chairs, olive oil, frying pans, floor tiles, sardines, orthopaedic mattresses, socks, ‘Memory' pillows, phone holders, pens, coffee pots and thermoses (See picture). Also, distribution was not controlled. Pierre Cardin products were retailing at knock down prices in discount shops and the brand was seen on paraphernalia that detracted from the brand's core values. Pierre Cardin himself, though, defends his licensing position by stating, the €30m profits it generates for him a year aside, that why shouldn't his brand be accessible to everyone? He even adds: "If someone asked me to do toilet paper, I'd do it. Why not?"

 

This example highlights the requirement to impose limitations on licensing contracts. One way to achieve this is to include authorisation procedures in the contract.

 

4. Time periods:
A specific time period needs to be set. Contracts can then be renewed, cancelled or revised at the end of the period, say 5 years.

 

5. Marketing commitment
As well as guaranteeing a royalty rate, minimum income and usually an initial amount, the licensor often insists on a guaranteed marketing commitment - either a percentage or a fixed amount. The licensor may contribute to marketing as well but investment from the licensee is often usual. This can often effect the royalty rate; if there is no marketing commitment the royalty rate increases, if there is one, the royalty rate reduces.

 

6. Other requirements
There are a whole host of other requirements that are also included in a licensing agreement. One important one is the right for the licensor to have access to audit the licensees company.

 

These factors will also influence, to a greater or lesser extent, the royalty rate. If a licensee agrees, for example, to contribute to brand marketing then the royalty rate might be reduced to compensate for this. Invariably there is an initial amount paid to the licensor as well as a guarantee of minimum payments and expected forecast of royalty income.

 

Brand valuation
Brand valuation has been around for about ten years or so. The primary method used today is the relief from royalty method which calculates the amount they company would be prepared to pay for a brand if it did not already own it - as if it was operating through a license. An applicable royalty rate is therefore extremely important as a single percentage difference can significantly alter the value of a brand. The relief from royalty approach is the most commercial realistic approach and is used in a number of circumstances.

 

There are three main requirements for brand valuation: legal, financial and marketing.

 

1. Legal
Licensing agreements do not always go according to plan. In licensing disputes, brand valuations are often used to determine the value lost to a brand as a result of a contract being terminated. If a soft drinks manufacturer suddenly reneges on the licensing agreement it has with a brand owner then there may be an entitlement for compensation based on a number of factors including the minimum royalties in the contract. Additionally there may be room for lost profits and brand value.

 

2. Financial
Brand valuations are required under specific circumstances under International Financial Reporting Standards (IFRS) and US Generally Accepted Accounting Principles (US GAAP). Here, a royalty rate can have a tangible effect on a company's balance sheet as a significant portion of the brand value - which has to be reported on the balance sheet.

 

3. Marketing
Brand valuation is used for a variety of marketing reasons including market and opportunity analysis and calculating and monitoring return on brand investment. One of the most effective ways to use a brand valuation is in portfolio management. Identifying the value all the different brands, licenses, contracts, copyrights and patents contribute to the enterprise enables effective decisions on resource allocation to be made on an informed basis.

 

Once the context for a brand valuation is established, and if the relief from royalty method is the primary brand valuation method, royalty rates will be extremely important. They are also likely to have some influence over other valuation parameters such as forecast sales growth and the discount rate. A thorough understanding of the mechanics that go into creating a royalty rate therefore becomes starkly apparent.

 

Sales on which royalties are calculated
Royalties are based on sales and so it is helpful to have an understanding of the market, its projected growth, competitor activity and the brand's market share. This will give projected sales of branded products to which the royalty rate can be referenced. We set out below an analysis for a hypothetical menswear brand in Italy, and it can be seen the analysis helps in assessing the branded sales which will ultimately drive the royalties.

 

Such an analysis brings greater understanding of the sales carrying the brand. Key figures can also be charted for an easier comprehension of trends, and anomalies. The chart below indicates that Brand B has gained market share rapidly and its share of voice now exceeds that for our Brand. Given that share of voice and share of market are generally thought to converge in the long term this highlights an issue of how realistic the forecast growth in market share is, on which a royalty rate can be calculated.

 

Price points and supply chain
Even if a brand drives value at retail level, market dynamics may not allow for royalties to be charged on retail prices. They may, for example, be paid by the manufacturer to the brand owner, and the royalty rate will then be based on the manufacturer's price point rather than the retail price point. So a higher royalty rate will be needed to give the same royalties. This could mean that a royalty rate of 17% on the manufacture price point is equivalent to a royalty of 5% on the retail price point, as illustrated on the diagram below.

 

This diagram illustrates the significance of positioning the royalty rate to an appropriate price point. Royalty rates at retail level, as the diagram illustrates, are usually about 5%. If however, this royalty rate was applied not at the point of retail but at the point of distribution, then the royalty income would only be .50; a loss of .50 per item sold. It is therefore of considerable importance that the point at which the royalty rate is applied is correct and stipulated.

 

Certain caveats are often included in licensing agreements to make it more affordable for licensees and more beneficial to the brand owner. Once a certain royalty level has been paid the royalty rate can often decrease. This can serve as an incentive to.

 

Benchmarks
For any royalty rate analysis it is useful to find out comparable royalty rates - any analysis is easier when relevant benchmarks in the market can be referred to. Comparable royalty rates can be obtained from a variety of sources, including:

 

Analysis of existing available agreements. This can sometimes be, for example, a supply agreement for a range of goods including the use of the brand. Such agreements can be analysed to give brand royalties.
Searching on the SEC database, which contains a number of disclosed license agreements.
Research or enquiry in the industry or comparable industries.
Buying information from licensing database holders.
Analysis of business acquisitions or share prices.
An analysis of comparable royalty rates can also reveal products and sectors not previously exploited. Such analysis exposes opportunities not previously considered. For example, if the a charity such as Save the Children was to evaluate the use of its brand through licensing it might discover that other comparable charities, such Oxfam, Bernados, Red Cross and Greenpeace, have considerably more successful licensing arrangements in operation. And that these arrangements contribute significant amounts to the charities bottom line enabling them to do more to help their causes.

 

Brand strength analysis
The next stage is to assess how a brand can be positioned in such a range. There are many ways in which this can be done but a simple and practical approach can be to use a Brand Strength Analysis. This takes a number of key value drivers for a brand, based on market research, and scores the brand against those drivers relative to the competitive set. This then gives a score against a minimum and a maximum possible and is used to position the brand in the royalty rate range. An example of this is shown below:

 

Profitability
Royalties are a way of showing value brought to a business by a brand, and determining compensation to the brand owner. Such value will often be based on the profitability of the business, together with other factors such as the strength of the brand. An analysis of this profitability can be done on a see through basis through some or all of the supply chain. The resulting see through profit can be attributed to various business functions, but one will be the brand. In the long term royalties relating to this part of the supply chain will be a proportion only of the see through profit. For commercial arrangements to be successful on a long term basis the value brought by the brand will need to be shared by all concerned in bringing it to market.

 

Significance
Royalty rates are typically small percentages, but they are applied to sales figures, meaning that royalty values are often significant. They drive brand values which are in themselves often highly significant (the Malibu spirit brand was bought by Allied Domecq in May 2002 for £560 million - this transaction was mostly attributed to brand value). Given this significance they warrant in-depth analysis - so that significant decisions are made on an informed basis.

 

The royalty rate analysis illustrated in this article has been 5%. When applied to the forecast sales (in the illustration of brand sales in menswear in Italy) this gives significant annual forecast income of £80 million in 2007, and when capitalised as a brand value using a relief from royalty methodology it can amount to £674 million, as shown below. Significant by any standards.

 

What this article demonstrates is that there are significant repercussions for the application of a royalty rate. It may be a tiny number but that tiny number can generate untold millions for a brand in direct revenue, stimulate access to new markets, territories, products and sectors, increase the relevancy of the core product and ultimately increase the overall value of the brand. Because so much is at stake, investment in setting an appropriate royalty rate - for both parties - is critical to ensure the success of the licensed products and brand.