Jiaqing “Jack” Lu
Applied Economics Consulting Group, Inc., Sr. Economist and Director of Economic Analysis, Austin, TX, USA
Recent Studies in the 25% Rule and the Relevant Data Issues
The 25% rule is based on observations that royalty negotiations tend to a royalty rate that equals approximately one-quarter of the licensee’s expected operating profits derived from the technology. Over the years, the rule has been generalized, and sometimes is referred as the 25% to 33% rule, depending mainly on technology, industry normal, and other relevant issues.
The 25% rule has been a useful rule of thumb for royalty determination. However, recent efforts to empirically prove its validity have been unsatisfying. For example, Goldscheider et al. (2002) demonstrated that the royalty rate as a percentage of operating margin appeared to be congruent with the 25% rule, but the work stopped short of exploring more fundamental relationships between royalty rates and profit margins. Kemmerer and Lu (2008) found that profitability and royalty rates were linearly associated, but the coefficients of various profit margins were much higher than the 25% rule would imply.
The lack of convincing evidence to empirically validate the 25% rule is mainly due to the very nature of the data used in the studies. First and foremost, the royalty rates calculated by the 25% rule serve only as a starting point for royalty determination, and are subject to up- or downward adjustments based on industry-, company-, and technology-specific factors. In other words, even if the 25% rule is widely used in practice, after a series of such adjustments, the actual royalty data is a variation of the rule.
