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Tiered royalty rates are designed to generate maximum revenue (and, eventually, profit) from a license agreement. In a standard patent, copyright, or trademark license, the inventor charges its partner either a flat fee or a simple percentage of total sales. Tiered royalties go one step further by adjusting those simple royalty rates in various ways. The result: Both the inventor and the manufacturing/distribution partner can maximize their sales, and thus serve their shareholders better.

Let me illustrate the concept through a couple of example scenarios.

Promoting lots of volume

In its simplest form, a tiered royalty deal acts like a volume discount. The first 100,000 units sold while using the intellectual property asset in question might send 5% of the distributor's net sales to the original inventor or designer. Units 100,001 to 1 million could fetch an 8% royalty rate, and anything beyond that would be tagged for a 5% royalty fee.

That's an incentive to drive higher sales volumes. With this type of royalty structure in place, manufacturers and distributors have a solid reason to put their backs into marketing blitzes. Meanwhile, the original inventor of the patent -- or designer of the trademarks and copyrighted information -- is assured of decent payouts when sales volumes turn out to be small.

In a slightly more complicated real-world scenario, display technology researcher Universal Display signed a six-year OLED technology deal with electronics giant Samsung in 2011. Here, the companies replaced a simple royalty percentage agreement with a two-part structure:

  1. Samsung pays Universal Display a flat fee in installments, once every other quarter. This sum started at $10 million in 2011 and has escalated to a total of $60 million in 2016. This sliding scale was put in place in the original contract, and the increases are predictable.
  2. On top of that license arrangement, Universal Display also resells the required OLED chemicals and pockets a fee for that service. Samsung has agreed to certain purchase volumes and is always free to order more than expected. That revenue stream is nearly twice the size of the base license payment, with the caveat that Universal Display doesn't break out Samsung's materials contribution from other clients. Gross margins from this process currently stand at 71%, deducting the cost of ordering the actual materials from chemicals manufacturer PPG Industries.

Like the "volume discount" example, this structure promotes high production volumes and gives Samsung every reason to step up manufacturing and sales of OLED products. Slowing down would make the basic license fee more costly on a per-unit basis, and it could trigger other penalties for not buying enough materials.

The nitty-gritty details are not public knowledge, and the companies are likely to hammer out a new deal when this contract expires in 2017. The details we do have still make for an enlightening example of an alternative tiered royalty agreement.

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Global reach

Tiered royalties are very popular in the pharmaceutical industry. In this case, it's a matter of targeting each market according to what patients and insurance systems are able to pay.

The World Health Organization recommends a tiered royalty method when setting prices in the developing world. Crucial medications for life-threatening diseases like malaria or HIV/AIDS should start by determining their royalty rate in high-income markets. The rates from places like the U.S. and Germany are then adjusted for relative income per capita when setting prices in less prosperous countries. Furthermore, nations with particularly high disease burdens get an additional discount beyond what's normally a heavy per-capita income rebate.

This structure lets drug developers and medical device inventors recoup their development costs with large royalties in richer markets. At the same time, the benefits of their inventions are extended to places that cannot afford the first-world payments. The arrangement benefits the drug developers too: Places like Somalia and Suriname can generate a modest level of low-margin sales. Under the standard royalty rate, sales would be indistinguishable from zero in these markets.

These are just a couple of examples of tiered royalty rates and how they can boost business. Tiered structures allow the parties to tailor agreements to their specific market conditions. When this is done right, tiered royalties can boost overall sales while maximizing the resulting revenues and bottom-line profits.

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