Royalty is a critical component in any IP deal. SoC companies want IP companies to share the risk of success (or failure) of their SoC and to enable that they want IP vendors to accept a substantial part of their payment to be paid as royalty. But the customers are also not very interested to shell out huge money to IP companies if the SoC is successful and hence they would like to have the royalty percentage as much as low which IP companies find non-acceptable in several situations.
One way, the IP companies can overcome the challenge is to provide a buyout option to its customers. The buyout option allows buyer to pay a certain amount of money to the seller and stop all future royalty payment. SoC companies will go to buyout option if they see the cash outflow of all the future royalty is more than the buyout price. IP vendor can demand of higher royalty percentage with the buyout option.
But the issue becomes here is that here only the IP seller is carrying the risk, not IP buyer. In case of downside i.e. product failure the IP buyer will not exercise the option and IP seller will be a looser. In case of upside i.e. product success the IP buyer will exercise the option and limits the IP seller to get the full benefit. Hence the seller should be able to charge some money for that risk. The question becomes how much the seller should charge. This can be calculated by option pricing method. The buyout option is equivalent to a call option and the money the IP vendor should charge is equal to the price of the call option.
Here the present value of future royalty payment is equivalent to the current price of stock which is owned by IP seller. Exercise of the option is equivalent to buying that stock by IP buyer from the IP seller.
Let us assume that the on average expected revenue from the SoC is USD 1 million every year and the IP royalty is 3% of that revenue. The SoC lifetime is 5 years and volatility of SoC revenue is 50%.
Hence the average expected revenue from IP royalty is USD 30K and it is spread over 5 years. The volatility of royalty payment is 50%
So the current stock price S[SUB]0[/SUB] = PV of the future royalty payment = 30 (e[SUP]-0.1[/SUP] + e[SUP]-0.2[/SUP] + e[SUP]-0.3[/SUP] + e[SUP]-0.4[/SUP] + e[SUP]-0.5[/SUP]) = USD 112.3K and volatility σ = 0.5
The duration of royalty payment is equal to the period of option as IP buyer can exercise the option at any time during this period hence duration of option T = 5
The dividend generated by the stock is 20% (1/T) as every year by not exercising the option the IP buyer is losing 20% of the stock value (basically he is paying the royalty money to the IP seller and hence not able to save the money)
Let us assume that the buyout price is USD 125K i.e. the IP buyer needs to pay USD 125K to the IP seller to avoid future royalty payment (equivalent to owning the stock). So the exercise price K = USD 125K
Let us assume that cost of capital is 10%. Hence r = 0.1
Now the price of call option = S[SUB]0[/SUB]e[SUP]-qT[/SUP]N(d[SUB]1[/SUB]) – Ke[SUP]-rT[/SUP]N(d[SUB]2[/SUB])
d[SUB]1[/SUB] = [ln (S[SUB]0[/SUB]/K) + (r – q + σ[SUP]2[/SUP]/2)T] / σ√T
d[SUB]2[/SUB] = d[SUB]1[/SUB] – σ√T = = [ln (S[SUB]0[/SUB]/K) + (r – q – σ[SUP]2[/SUP]/2)T] / σ√T
d[SUB]1[/SUB] = 0.016, d[SUB]2[/SUB] = -1.1
So price for call option = 112.3 x e[SUP]-0.2 x 5[/SUP] x N (0.016) – 125 x e[SUP]-0.1 x 5[/SUP] x N (-1.1) = USD 13K
Hence the IP buyer should pay USD 13K as price for option to IP seller
So the summary is
- IP buyer will pay 3% of SoC price as royalty to the IP seller
- The SoC where the IP gets integrated is expected to generate USD 1 million revenue for the next 5 years
- The volatility (standard deviation) of SoC revenue is 50%
- IP buyer has a right of stopping payment of all the future royalty by paying IP seller USD 125K and for the above right the IP buyer will pay USD 13K at current time