Income approaches appraise the intellectual asset based on the value of the excess revenues or reduced costs that arise from use of the subject technology. Such approaches assign a price based on the level of extra or incremental benefit generated by the anticipated higher volumes, higher prices, or lower costs. Income approaches take various forms.
- The profit split approach, i.e. the 25% rule where one assigns 25% of the licensee’s expected pretax profits to the licensor. This rule has come under fire over the years but still provides a good starting point especially for manufactured product technologies. As shown in the “Reported Royalty Rates vs. Rates from the 25% Rule” figure, the 25% rule provides guidance between the gross profit margin and EBITDA margin for almost all industries.
- The incremental income approach compares a profit for the intellectual asset at issue with the next best alternative. The alternative is often times used for commercial products already in the market.
- The discounted cash flow approach calculates the excess cash generated by the intellectual asset at issue, discounting future flows to the present at the projected cost of capital.
All of these three approaches must take into consideration the reliability of the projections, the owner/user benefit sharing between the parties, selection of the next best alternative to be used in the comparison, income versus cash flow modeling, and the appropriate discount rate.