Calculation of Royalty – 25% Rule

The “Twenty-Five Percent Rule” (“25% Rule”) could be used to calculate the license royalty. It has been used over 40 years.

The 25% Rule suggested that the licensees pay a royalty rate equivalent to the 25% of expected profits for the product that incorporates the intellectual property at issue. The royalty amount stated in the license agreement at present is based on an estimate of profit in the future.

The rule of thumb is that the licensor and licensee should share the profit of products embodying the patented technology. The justification is that the licensee should retain a majority of the profits because it has undertaken substantial development, operational, and commercialization risks, contributed over its own and other technology.

Focus of the 25% Rule is placed on the licensee’s expected profits, because the license negotiation is meant to cover forthcoming, and ongoing, use of the intellectual property.

Focus is also placed on “fully-loaded” long-run profit, because access to intellectual property often will afford the user more that just immediate benefit.

Revenue:	No patent $100	With patent $110
Cost of sales:	No patent $40	With patent $40
Gross profit:	No patent $60	With patent $70
Operating expense:	No patent $20	With patent $20
Operating profit:	No patent $40	With patent $50

In this illustration, after deducting the royalty amount paid to licensor, the licensee’s net profit is $50 - $12.5 = $37.5 which is lower than the operating profit of $40 without implementing the patent.

Therefore, the licensee must carefully estimate whether the patent is really helpful to the increment of revenue.

The 25% Rule is used in actual commercial and litigation circumstances. In Standard Manufacturing and DBP v. United States (1999), the U.S. Court of Claims employed a two-step approach to determine a reasonable royalty.

The first step involved an estimation of an initial, or “baseline” rate,

The second step entail an adjustment upward or downward, depending on the relative bargaining strengths of the two parties, with respect to each of the 15 factors described in Georgia-Pacific v. U.S. Plywood Corp. (1970):

1. The royalties received by the patent owner for the licensing of the patent-in-suit, proving or tending to prove an established royalty;
2. The rates paid by the licensee for the use of other patents comparable to the patent-in-suit;
3. The nature and scope of the license, as exclusive or non-exclusive, or as restricted or non-restricted in terms of territory or with respect to whom the manufactured product may be sold;
4. The licensor's established policy and marketing program to maintain its patent monopoly by not licensing others to use the invention or by granting licenses under special conditions designed to preserve that monopoly;
5. The commercial relationship between the licensor and the licensee, such as whether they are competitors in the same territory in the same line of business, or whether they are inventor and promoter;
6. The effect of selling the patented specialty in promoting sales of other products of the licensee; the existing value of the invention to the licensor as a generator of sales of its non-patented items; and the extent of such derivative or convoyed sales;
7. The duration of the patent and the term of the license;
8. The established profitability of the product made under the patent; its commercial success; and its current popularity;
9. The utility and advantages of the patent property over the old modes or devices, if any, that had been used for working out similar results;
10. The nature of the patented invention; the character of the commercial embodiment of it as owned and produced by the licensor; and the benefits to those who have used the invention;
11. The extent to which the infringer has made use of the invention, and any evidence probative of the value of that use;
12. The portion of the profit or of the selling price that may be customary in the particular business or in comparable businesses to allow for the use of the invention or analogous inventions;
13. The portion of the realizable profit that should be credited to the invention as distinguished from non-patented elements, the manufacturing process, business risks, or significant features or improvements added by the infringer;
14. The opinion testimony of qualified experts; and
15. The amount that a licensor (such as the patent owner) and a licensee (such as the infringer) would have agreed upon (at the time the infringement began) if both had been reasonably and voluntarily trying to reach an agreement; that is, the amount that a prudent licensee – who desired, as a business proposition, to obtain a license to manufacture and sell a particular article embodying the patented invention – would have been willing to pay as a royalty and yet be able to make a reasonable profit, and which amount would have been acceptable by a prudent patent owner who was willing to grant a license.

The rationale for this appraisal methodology is that the plus or minus 25% apportionment is the price of a reasonable royalty, which appraising party would be willing to pay for a license for the property at that point in time, assuming that it did not own it.