At this stage, let's consider a pure royalty-based calculation (there is no upfront payment, no milestone payments, and royalties are a percentage of the sales of the product protected by the patent). Let's also consider that the license is an exclusive license, and let's exclude sublicense issues. The typical case is that of the license of a patent (considered as granted), that protects a product which is still in the development stage (i.e. several years are still needed prior to marketing, and significant investment is still needed to be made, at a certain level of risk).
In fact, royalty is nothing else than a share of the "benefit" made by the licensee, which is paid to the licensor. Therefore, three questions arise at this stage: (i) how to define the "benefit"? (ii) how to take into account the investments to be made prior to marketing stage, the required time to develop the product, and the associated risk? and (iii) how to share the "benefit"?
There is no universal definition of "benefit." Depending on the country (many deals are concluded between parties coming from different countries where accounting principles and/or habits are different), depending on the perspective (i.e. operating, accounting, financing, …), "benefit" covers different notions. For example, "accounting benefit" which is the easiest to access since it is included in the profit andloss statementofeverycompany,neither reflects the level of investment of a company for developing a product, nor the financial risk taken by the licensee. Its format in many countries is set-up for tax reasons, and is therefore not easy to handle for the purpose of royalty rate determination. Let's, therefore, introduce a "for the purpose of royalty rate calculation benefit" called "B."
B is calculated after establishment of a "simplified provisional profit and loss statement" (SPPLS) related to the product protected by the patent (see Table 1 and Table 2). In order to establish SPPLS, one has to consider two phases: (i) pre-marketing phase during which there are only expenses and no revenues (R&D costs, registration costs, pre-production costs, pre-marketing costs, …)—see Table 1, and (ii) marketing phase during which there are still costs (residual R&D costs, production costs, marketing costs, …), which are hopefully balanced by revenues—see Table 2. Between these two phases, there is what we call "moment zero" (M0), which may correspond for drugs to the day the marketing authorization is granted. In fact, this is just a virtual moment, taking place between December 31st of year-1 and January 1st of year+1, allowing calculation of the present value of investments.
Costs of the first phase are added year by year, after application of a discount rate in order to take into account the financial risk taken by the licensee. This rate is generally between 8 and 20%. It reflects the risk taken by the licensee at investing financial resources in the project (i.e. the return on investment the licensee would have had if it would have invested these resources in its current business). Thus, 100 Euros invested one year prior to M0 account for 115 Euros if the discount rate is 15% (discounting factor DF = 1.15). On the same basis, 100 Euros invested three years prior to M0 account for 100 x 1.153, thus 152 Euros. The invested amounts during this pre-marketing phase take into account all the expenses that the licensee has to make in order to market the considered product. All these costs are summed up, the sum being called "Σ."
Σ = Z x (DF)n + … + C x (DF)3 + B x (DF)2 + A x (DF)1
This Σ will have to be "amortized" during the second period (i.e. deducted from revenues for the calculation of B). Arbitrarily, it is proposed that Σ be amortized over a 10-year period if the patent expires later than ten years after M0 , and therefore, Σ/10 is added each year to provisional costs of the second phase during the first ten years. For the second period, costs are deducted from revenues. These costs include not only Σ as explained earlier, but also production costs (all costs incurred by licensee to produce units of product sold), marketing costs (all costs paid by licensee to market units of product sold), and sometimes residual R&D costs (all potential direct R&D expenses that licensee has to make in order to optimize the production of the units of the considered product). Noticeably, if an important investment is required after M0 for the production of the product (e.g. a new plant), this investment also has to be amortized. In addition, residual R&D costs cannot include expenses linked to new products (that must be treated separately). Thus, for a given year x, Bx is calculated as follows (and does not take taxes into account):
Bx = Sx -Σ/10 - Px - Mx - Rx (with Σ/10 not taken into account after year 10)
At the beginning of this second period, costs may be higher than revenues. Therefore, an "average provisional benefit" called "APB" is calculated over a long period (for example the first ten years) in order to smooth low and high values. On the same way, "average provisional revenues/sales" called "APS" can be calculated.
APB = (B1 + B2 + … + Bn) / n and APS = (S1 + S2 + … + Sn) / n
Now arises the difficult issue of sharing APB between licensor and licensee. A rule of thumb is to consider the "25% rule" [5], according to which "licensor is legitimate at receiving 25% of the benefit." In general, an agreement is found between 25% and 50%, generally around 33% (i.e. 1/3 for licensor, and 2/3 for licensee).
The next step is to express APB as a percentage of APS since revenues are the easiest figure to take into account (and to control). For example, if APS is 100 and APB is 30, APB is 30% of APS. If it is agreed that the licensor has to receive 1/2 of APB, the royalty rate is 15% of revenues/sales (10% if agreement is made on 1/3, and 7.5% if made on 1/4). This royalty is (generally) due to the licensor until patent expiry.
As can be seen, key parameters to be taken in consideration are (i) the share of APB due to licensee, (ii) discount factor, (iii) invested amounts prior to M0 , (iv) revenues/sales, and (v) production, marketing and residual R&D costs.