This article will review the main methods for pricing licenses to use intellectual property. It will focus on the granting of licenses to use technology in consideration for payment, as distinguished from licenses to use other information, such as customer lists. In many cases, a technology is leased or sold, in which case the difficult problem of pricing arises due to the complexity of the parameters involved. In practice, the legal and economic significance of the sale of software is the granting of a license to use the technology.

There are several methods for pricing the lease or sale of technology. One customary method is based on the payment that is common in the field. According to this method, which is undoubtedly the simplest to implement, the pricing is based on the accepted rate of royalties in the specific market and is adjusted to the expected return on the technology and to the current stage of its development. The contracts themselves will often be written based on the revenues or different profit measures, while taking into consideration the projected profit margins in the sale of the ultimate product or service. In the drug market, for instance, royalties in the amount of 15–20% of the sales are not uncommon, since drugs often carry high gross profit margins exceeding 80%.

Other than the projected volume of sales, the amount of the royalties depends on the degree of innovation of the patent. Royalties may be up to three times higher for innovative inventions than for similar inventions that are not equally innovative.

Sellers tend to perform the pricing based on the profit they deem reasonable in view of their total investment until such time and therefore often extremely misvalue their asset. In general, it is important to understand that pricing should not be based on the development costs incurred until a certain stage, but rather on the future return which the invention is expected to generate. A developer must always remember that any investment made until a certain point in time constitutes a premium on an option for success. If the development fails, then the investment is meaningless, and if the development is successful, then the return on it does not depend on the investment made until that time (except, of course, its significance as a barrier to rapid duplication by third parties).

In many cases, a lump sum or upfront license is paid in cash for the right to use intellectual property for a fixed period of time. In addition to this payment, there are usually other components, which essentially include payments for the period of use of the technology (time-based payment) and payments based on the success of the technology (success-based payments). Calculating the correct combination of the payment components, which may be made in cash or in shares, is an art that takes into consideration various elements relating to the identity of the owner of the intellectual property and of the licensee, the technological innovation, and the relevant field of activity.

Pricing a License to Utilize a Patent

The total payment for a right to use a patent may include a lump sum, commitments for future payments (certain minimum payments), an equity component, debt, and so forth. The components which have a material effect on the pricing of rights may be classified into several principal categories, each presenting many questions which need to be addressed. The following list does not purport to be comprehensive, and its sole purpose is to indicate the main considerations which need to be taken into account when negotiating a license to use a patent:

• The quality of the technology— What stage has the development reached? Is it a finished product or are there still uncertainties as to the applicability of the technology?

• The market potential— Has the existence of the market already been proven? What possibilities are available for shifting various production risks to the end buyers (i.e., what is their price sensitivity)? What is the size of the target market? Is the license being awarded for a certain geographic territory? If so, to what extent is this restriction enforceable? Is the license being awarded for a certain field of activity? If so, to what extent is this restriction enforceable?

• The ability to protect the technology and the competitive situation— To what extent can patent and trade secret laws be employed to protect the technology? What stage has the protection of the technology reached (are the patents pending or have they already been awarded)? What is the probability that potential competitors will circumvent the patent? Can clauses be included in the contract to reduce the buyer's risk (for instance, a downward adjustment of the price if principal claims in the patent application are rejected by the Patent Office)? To what extent is it possible to sue potential violators of the patent, and what is the projected cost of such actions? Who is the licensee—is he or she someone who breached the patent, with whom settlement negotiations are now being conducted, or is he or she an ordinary customer? How different is the technology from other technologies that meet the same needs, even if they do so by a different method?

• Negotiation considerations— How many competitors are seeking a license to use the technology? What is the likelihood that such competitors will resort to other technologies?

• The added value of the licensee— How strong is the licensee in the geographic territory and field of activity covered by the license? To what extent is he or she able to raise capital? How good is his or her technological ability to manufacture and market the product? Is the specific licensee the one who will make the optimal use of the technology in the said geographic territory or field of activity? Are there any restrictions on granting other licenses in the same area? Is there any commitment to remain bound by the contract even if either party's expectations are not fulfilled?

• The profitability of the end product— What are the expected gross and operating profit margins for the product? Does the contract divide the risk between the licensee and the owner of the rights (for instance, by deriving profit-based, and not revenue-based, fees)? What other economic costs are involved in launching the product on the market? Will the licensor be involved in such process? What cost structure will the product have, and will it be possible to affect such structure by using outside manufacture forces (outsourcing)? Will the choice between self-production and outsourcing affect the relevant profit rates with respect to the payment of royalties? Does the profitability of the product depend on the number of users or on increasing the revenues extracted from each user, and can a creative method of pricing be conceived, based on the number of users or on a change in the amount of revenues generated from each user?

• Risks attendant to the technology— Which party to the agreement bears the risk of third-party claims (such as product liability claims)? Are damages offset against the profit that serves as a basis for the calculation of the royalties? Could there be any legal restrictions, either at present or in the future, on the rate of the royalties (for instance, a restriction on the rate of royalties payable on drugs due to a medical reform in the country)?