Intellectual Property License Agreement

This is not legal advise either. With respect, in my humble opinion and experience ventures which establish pricing solely or mainly as a function of return on investment or costs are missing the fundamental issue of pricing acceptance and elasticity in the market, i.e. what customers will pay. Studies show that over-pricing once corrected takes a long time to purge from customer reaction. Established conventional practice of course suggests a royalty in percentage of sales or per unit which must be market-driven. Accordingly pricing sensitivity analysis and customer testing are more useful than internal ROI.

** This information is not legal advice, you must consult a lawyer who has the proper opportunity to obtain instructions to give advice.

There are a few methods used to value intellectual property. One is the cost approach which is that the developer of intellectual property is entitled to be paid whatever it costs them to develop and maintain the property in question. The next is the market based approach which is used when there is a large, well-defined market with data about comparable products freely available. The price of the property concerned is then valued based on comparisons with other similar products in the market. The final common approach is the income approach which is based on the expected revenue which is to flow from the intellectual property created.

The most appropriate approach depends on the circumstances, but as a rule of thumb, the developer of intellectual property is usually entitled to about 25% of the price per unit sold by the distributor. It is important to be careful not to term the agreement as based on profits because this can easily be manipulated by a savvy accountant. A share of revenue per unit sold is usually preferable.

With a few exceptions, lawyers are not very good in answering business questions related to finance. They may give you a rule of thumb, or different calculation methods without telling you which one to use.
From the business perspective, whenever you do an investment, you have to compare it with other investments that have a similar risk level, even though the risk profile may be different, and look at the profit those other investments would give you. If this investment doesn't give you more profit, you shouldn't consider it. In the case your profit needs to come from a license agreement, you need to know what volume the licensee expects to sell, and how certain he/she is that this sales expectation is realistic and not a total pipe dream (here is part of your risk level, plus the risk that your development will cost you more than you thought). Based on this you can determine your per unit royalty. Maybe it should not be a percentage, but a dollar amount. Sales people can be incredibly good in enthusiastically describing a modest house as the finest imperial castle you can imagine, so you have to be careful with the predicted volume, and when this volume is achieved. And make the licensee commit to his/her promises. That is where you need the lawyer.