The ladder / Level 4 · New products and services/ Business math
Licence fees and royalties
Lump sum, percentage of sales or per unit; the volume at which options cost the same; minimum guarantees and contribution after royalty.
How numbers are rounded on these pages. Calculations are done at full precision and rounded only at the end, half up. Rupee amounts are rounded to the nearest rupee unless shown with paise, in which case to the nearest paisa. Percentages are shown to two decimal places, months to one decimal place, years and ratios (such as LTV : CAC) to two, and discount factors to four. Discounting assumes cash flows at the end of each year, compounded yearly. IRR has no exact formula: it is found by repeated trial and shown to two decimal places as a check value. Break-even quantities are rounded up to the next whole unit. All examples and quiz questions are Hypothetical: they show the method, not real prices or rates.
Royalty and licence fee math
A licence lets you use someone else's patent, design, technology or brand to make or sell a product. The owner (licensor) is paid in one of a few standard ways: a lump sum (one-time fee, usually upfront), a running royalty as a percentage of net sales, a per-unit royalty (a fixed rupee amount on each unit), or a mix, often with a minimum guarantee: a floor amount paid each year even if sales are low.
Which is cheaper depends on volume. A lump sum is a fixed cost: cheap per unit if you sell a lot, expensive if you do not. Royalties are variable costs: they lower your contribution on every unit but share the risk with the licensor. Find the volume at which two options cost the same, and compare it with your realistic sales.
Check what the agreement means by "net sales" (after returns and discounts; usually excluding GST). Tax deduction at source, GST on royalty and, for foreign licensors, foreign-exchange rules can apply; ask your chartered accountant.
The standard formulas
Terms used
- Licence
- Permission to use intellectual property (a patent, design, technology, trade mark) on agreed terms.
- Licensor / licensee
- The owner who grants the licence / the business that takes it.
- Royalty
- A payment to the licensor linked to use, usually a percentage of net sales or an amount per unit.
- Lump sum (licence fee)
- A one-time fixed payment for the licence.
- Minimum guarantee
- The least royalty the licensee must pay for a period, whatever the sales.
- Net sales
- Sales after returns, discounts and taxes as defined in the agreement.
Worked examples
HypotheticalBasicA percentage royalty
A start-up licenses a filter design and pays 5% of net sales. It sells 10,000 units at a net price of ₹2,000 (excluding GST).
- Net sales = 10,000 × ₹2,000 = ₹2,00,00,000
- Royalty = 5% × ₹2,00,00,000 = ₹10,00,000, or ₹100 a unit
HypotheticalIntermediateLump sum, percentage or per unit?
The licensor offers three options: (A) ₹15,00,000 once; (B) 5% of net sales; (C) ₹80 a unit. Expected sales: 12,000 units at ₹2,000.
- A = ₹15,00,000; B = 5% × ₹2,40,00,000 = ₹12,00,000; C = 12,000 × ₹80 = ₹9,60,000
- A equals B at ₹15,00,000 ÷ ₹100 = 15,000 units; A equals C at ₹15,00,000 ÷ ₹80 = 18,750 units
At the expected volume C is cheapest. The lump sum only wins if sales pass 18,750 units, and it must be paid even if the product fails.
HypotheticalAdvancedUpfront fee plus royalty with a minimum guarantee
Another deal: ₹5,00,000 upfront, then 3% of net sales, with a minimum guarantee of ₹6,00,000 a year.
- Year 1: 8,000 units → royalty earned ₹4,80,000, below the guarantee, so pay ₹6,00,000
- Licence cost per unit in year 1 = (₹5,00,000 + ₹6,00,000) ÷ 8,000 = ₹137.50
- Year 2: 15,000 units → royalty ₹9,00,000 (above the guarantee) = ₹60.00 a unit
Quiz: licence fees and royalties
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