The rule of thumb

Use Of The 25 Per Cent Rule In Valuing IP
BY ROBERT GOLDSCHEIDER, JOHN JAROSZ AND CARLA MULHERN*

Introduction
s the importance of intellectual property (“IP”) protection has grown, so has the sophistication of tools used to value it. Discounted cash flow,1 capitalization of earnings,2 return on investment,3 Monte Carlo simulation4 and modified Black-Scholes option valuation methods 5 havebeen of great value. Nonetheless, the fairly simple “25 Per Cent Rule” (“Rule”) is over 40 years old and its use continues. Richard Razgaitis has called it the “most famous heuristic, or rule of thumb, for licensing valuation.”6 The Rule suggests that the licensee pay a royalty rate equivalent to 25 per cent of its expected profits for the product that incorporates the IP at issue. The Rule has beenprimarily used in valuing patents, but has been useful (and applied)

A

1. D.J. Neil, Realistic Valuation of Your IP, 32 les Nouvelles 182 (December 1997); Stephen A. Degnan, Using Financial Models to Get Royalty Rates, 33 les Nouvelles 59 (June 1998); Daniel Burns, DCF Analyses in Determining Royalty, 30 les Nouvelles 165 (September 1995); Russell L. Parr & Patrick H. Sullivan, TechnologyLicensing: Corporate Strategies For Maximizing Value 233-46 (1996); Richard Razgaitis, Early-Stage Technologies: Valuation and Pricing 12158 (1999). 2. Robert Reilly & Robert Schweihs, Valuing Intangible Assets 159-66 (1999). 3. Parr and Sullivan, pp. 223-33. 4. V. Walt Bratic et al., Monte Carlo Analyses Aid Negotiation, 33 les Nouvelles 47 (June 1998); Razgaitis, pp. 160-77. 5. Dr. Nir Kossovsky& Dr. Alex Arrow, TRRU™ Metrics: Measuring The Value and Risk of Intangible Assets, 35 les Nouvelles 139 (September 2000); F. Peter Boer, The Valuation of Technology: Business and Financial Issues In R&D, 302-06 (1999). 6. Razgaitis, p. 96.

in copyright, trademark, trade secret and know-how contexts as well. Since the Rule came into fairly common usage decades ago, times, of course, havechanged. Questions have been raised on whether the factual underpinnings for the Rule still exist (i.e., whether the Rule has much positive strength) such that it can and should continue to be used as a valid pricing tool (i.e., whether the Rule has much normative strength). In this paper, we describe the Rule, address some of the misconceptions about it and test its factual underpinnings. To undertakethe latter, we have examined the relationship between real-world royalty rates and real-world industry and company profit data. In general, we have found that the Rule is a valuable tool (rough as it is), particularly when more complete data on incremental IP benefits are unavailable. The Rule continues to have a fair degree of both “positive” and “normative” strength.

History of the Rule
Oneof the authors — Robert Goldscheider7 — did, in fact, undertake an empirical study of a series of commercial licenses in the late 1950s.8 This involved one of his cli-

ents, the Swiss subsidiary of a large American company, with 18 licensees around the world, each having an exclusive territory. The term of each of these licenses was for three years, with the expectation of renewals if thingscontinued to go well. Thus, if any licensee “turned sour,” it could promptly be replaced. In fact, however, even though all of them faced strong competition, they were either first or second in sales volume, and probably profitability, in their respective markets. These licenses therefore constituted the proverbial “win-win” situation. In those licenses, the intellectual property rights transferredincluded: a portfolio of valuable patents; a continual flow of know-how; trademarks developed by the licensor; and copyrighted marketing and product description materials. For those licenses, the licensees tended to generate profits of approximately 20 per cent of sales on which they paid royalties of 5 per cent of sales. Thus, the royalty rates were found to be 25 per cent of the licensee’s...