By Ulrik Darling Larsen (M.Sc./Ph.d./Inventor)
Disclaimer: Please note that this article represents the authors view and Licentix does not in any way endorse or warrant practicing the advice given herein.
A proposal may consist of several different payment schemes and can be quite complex, so for simplicity’s sake, I will just consider down payment and royalty-fee based licensing here. You should not ask for one or the other, but for both. Royalties are your way to get a share of the potential of your invention, whereas, on the other hand, a sizable down payment makes sure that the buyer has the right intentions (some companies might buy IP to get it off their hands, never intending to launch the product).
Once you’ve presented your IP, you may have exposed what you think your invention is worth, and it is almost certain that you will be asked to come up with a number. My advice is that you try to avoid exposing your expectations first. If you are uncertain about the value of your IP, you will set the value too low, and the buyer is in for a bargain. On the other hand, if you set the value too high, the buyer may think that it’s not worth the effort to negotiate a lower price for your IP. The point here is that you don’t know what value the buyer has in mind, so you risk ending up in a position that you can’t get out of again. So, let’s be clear about this, you should never give the buyer a fixed valuation unless you are cool with finding out later that you were framed.
Instead, you should try to get the buyer to expose their interest in your IP. If you’ve provided the buyer with exclusivity for negotiating with you, you are not able to say that you have other interested buyers in the process. Instead, tell him that since he has been given exclusivity, you are now prevented from testing the valuation, and hence, he should come up with a proposal so you can consider if the negotiation should move forward. Make sure that the buyer understands that you are ready to end his exclusive deal if the valuation is too low. If you didn’t provide the buyer with exclusivity for negotiation, you may simply use the old “I have another buyer in the process” routine to wait for the buyer to give his proposal. He may not believe you at first, but doubt may kick in as time passes, and regardless, it’s your excuse for not exposing your expectations. Now, you can just wait and see what happens.
It is understandable that waiting can be the most difficult part of the negotiation process. You may have expended a lot of energy and money on just getting one buyer to consider your IP, and now you are almost willing to give it all away for a small sum. But remember this – if you learn later on that the buyer is making a fortune out of your invention, wouldn’t you regret that you didn’t try harder to achieve the right valuation? If the buyer is truly interested, it will just make him even more eager if he believes that you are about to walk away from the table.
Now, if the buyer is not willing to give you a valuation for your IP, he is either not truly interested or he may be trying to play you to see if you are bluffing. In both cases, you are better off by ending the negotiations and waiting to see if the buyer comes back later on.
Once you get a valuation, it is most probably way lower than what the buyer is actually willing to spend, and it will most probably be in the form of a single payment for the full exclusivity. The proposal could also be based on milestones, so that the buyer will incur a reduced risk in the development phase. Anyway, what the buyer is trying to achieve is to pay a fixed price for your IP, so that he will be able to take the full profit for himself, once the development expenses are factored in and written off.
Now the ball is in your court. Don’t give an answer right away – take your time. If the proposal is far below your expectations, don’t get discouraged yet. In some situations, this is just another test to see if you actually have any idea what you are dealing with. If the proposal were above your expectations, remember that hit was most likely set way below what the actual value was estimated to be.
The buyer may be pushing you to provide an answer as soon as possible. He may also say that it’s the only proposal you’ll get, and set a tight time limit for you to respond to. Just remember that, unless he is being childish, breaking such stated ultimatums normally come without any consequences. As a businessman, he may be using all the tricks in the book, but, at the end of the day, he also wants to close that deal. Stay calm and consider your answer and its consequences. It’s better to say “I’ll give you my reply later” than rush into decisions that can’t be undone.
Now, the proposal you’ve been given is your point of reference. Behind that number is a calculation of revenues, costs and risks combined with some business cunning. In order to expose some of these factors, try to suggest that by including royalties into the deal, you will be sharing the risk with the buyer. It is generally accepted that whoever shares the risk also shares the reward. The buyer’s willingness to discuss royalties will tell you something about his assessment of the risk. In general, you should expect that the higher the risks are, the more willing the buyer will be to negotiate royalties. So, if he refuses or maybe suggests increasing your down payment instead, you should know that he is probably considering the risks to be low. In this situation, you must insist on royalties!
Remember that royalties should always be based on total sales and not on profits – there are many ways a company can reduce the profits by shifting expenses around from other development and sales activities. If the buyer insists on royalties that are based on profits, you should claim that you have no way of controlling sales expenditures and effectiveness, so if the profit is low, it may simply be due to bad corporate practices, which you have no part in. You can use the estimated profit on sales to make a conversion between royalties based on profit and royalties based on turnover, e.g. for a 30% profit on sales, a 10% royalty on profit will convert to a 3% royalty on sales.
Now the ball has been sent back into the buyer’s court.
Getting paid with royalties is the only way of making sure that you are not getting trapped. However, whether to aim at royalty percentages of 0.01% or 10% of total sales is impossible to determine without knowing the sales projections and sales-impact provided by your IP. You will need to make your own projections to develop a top-down estimate of sales and profits, in order to understand the consequences of the royalties and how they scale with sales. What is the outcome based on different royalty percentages in a best or worst case model? How does this match your expectations?
Secondly, use a bottom-up model to estimate what value your invention will constitute of the full product value-chain. Include all costs from production to retailers in order to estimate the profit margin. You need to be fair in making the estimates, so don’t forget to include the development cost, which is going to be written off over the first half of the product’s life-cycle. Also, try to estimate the importance of your technology. Is it completely necessary for realizing the product or is it more of a ‘nice to have’ bonus feature? Given the cost structure and necessity of your invention, you should be able to find the range where your royalty should be.
From the top-down and bottom up models, you now have found the goal for the negotiations. If your negotiations are based on mutually sharing the risk and profit, you could try to disclose your calculations in order to convince the buyer about the facts. If you both agree that in the most likely situation you are both becoming wealthy, it’s a win-win situation.
All this said, no two negotiations are alike, so you’ll need to be very strategic and understand that you are indeed playing a game of poker where bluffing is part of the process. Your opponent may have done this many times before and he may even try to convince you to accept their corporate rules governing how they do business with inventors. You should never accept any process or rules the buyer presents – they are only designed for his benefit. Be assured that there are no “this is how we always do it” rules in business - it’s how the buyers want to do it. But don’t be afraid to bend the rules, and when you are being praised for your negotiating skills, you are only about half done. Don’t feel bad about being unfair – your opponent would never feel bad for making a fool of you. Once you are done, you’ll be able to sleep better at night.