Inventing for Money: To Venture or to License?
One of the first major decisions that inventors must resolve as they develop their ideas into products is whether to venture or to license their inventions. The answer depends largely on the inventor himself; where his passions lie, what his strengths are, what his resources are, and, frankly, his willingness to take risks. Here, we'll go over the pro's and con's of these two selling strategies, so you can determine for yourself which course you should pursue to sell your idea.
Let’s say that you have an invention that you’re excited about. Perhaps you’ve tested it with friends and family, and the response is positive. You think it has real market potential.
But you’re not sure that you are interested in manufacturing and selling it yourself. Perhaps inventing is a hobby and you just don’t have the time, or you’re daunted by the idea of managing such a venture. So you consider licensing the rights to an established company.
This means that you agree to give control over your invention to a company that can monetize it -- they will manufacture it, market it, and make a profit. In return, the company agrees to pay you money at designated intervals of time.
The choice can sometimes be obvious; other times it will take some thoughtful consideration.
Consider a typical inventor, Sandra. With her backpack full of handmade knee brace prototypes, she visits the office of a patent lawyer. Sandra was a graduating senior in the Engineering Design program at Stanford University. As part of her senior project, she researched and designed a special knee brace for use by athletes (and those who mistake themselves for athletes) suffering from knee pain, especially knee pain resulting from twisting or rotation of the leg as might be experienced by basketball and volleyball players. Sandra’s knee brace invention was constructed primarily of an elastic, synthetic material that she identified initially as being used in a certain brand of bicycle seats. The material has the interesting property of being very flexible along the warp, but very resistant to stretching in the weft¾the direction perpendicular to the weave. When a square of the material is formed into a cylinder, with the warp parallel to the axis, the cylinder bends very easily. Attempting to twist or deform the cylinder about the axis, however, is difficult.
Sandra had cut and sewed the material into tubes and shaped the tubes so that the tube slipped snugly over the kneecap. Walking and running in this knee support was comfortable. The prototype tube, however, made twisting at the knee almost impossible.
Sandra’s question was what to do with her new invention. She had tested her knee supports on several sports teams at Stanford and received rave reviews. The trainers provided several suggestions for venting and ease of use, but were extremely enthusiastic about using the product with their players. Several orthopedic surgeons evaluated the design and gave the product high marks, especially for athletes with knees weakened from ACL surgery. Sandra was very excited about the product and wanted to understand her options with respect to commercializing the idea.
Sandra basically had two options for making money from her idea. Although there might be various combinations of these two paths, commercializing this product from Sandra’s viewpoint could happen either by venturing the product or licensing the invention. Let’s review our discussion and see if we can determine the best solution for Sandra.
In Sandra’s case, venturing the product is a shorthand way of describing the process of building a business of manufacturing and selling knee braces. This can be by far the most lucrative path for exploiting her idea. Venturing requires that she will either build the knee braces herself or contract with a manufacturing company to build products for her. Once she has products she then needs to find stores and other sales outlets that will carry her product and sell them to end users. Eventually she will want to work with or hire professional product distributors that will help her penetrate into geographical areas and end-user markets that she might not otherwise have access to -- for instance, orthopedic surgeons working in Paris, France.
Here is how she does the math.
- Based on market research, Sandra believes that the market would easily support a retail price to the end consumer of $20.00 each.
- In quantities of one thousand pairs of knee braces, Sandra estimates her manufacturing cost to have the knee braces made by a third-party manufacturer, including the cost of materials, was $2.50 each.
- She adds up the costs associated with handling her own distribution by delivering primarily to local retail outlets and selling over the Internet and mail order. The costs are $4.00 each unit sold.
- She calculates her profit could easily exceed $12 for every knee brace sold. She could add a distribution channel to her business, thus potentially greatly increasing sales, while still retaining as much as $7.50 (remember the 4X distribution model of Chapter 1) on every knee brace sold.
Venturing, however, is not without its major risks. One significant problem is that Sandra has never before owned or even worked in a real business. She worked some in high school as a babysitter, and held a few odds and ends jobs during college, mostly tutoring at the local high school. Consequently, she felt very unsure of how businesses operate and was nervous about the prospect of starting her own business.
A second major drawback for Sandra was that she did not have the working capital necessary to purchase the initial goods needed to get the business going. At the price that made sense to her, the minimum initial order for the knee braces was 1,000 units, requiring her to scrape together $2,500. She could save money by initially working out of her apartment, but this was still a lot of money for someone who has practically never worked and had no outside source of income.
Assuming she could borrow $2,500 from credit cards, parents, her trust fund, etc., since the profit margins are so high on this product, it might be possible for her to bootstrap the venture. She could order and sell the first thousand pairs by visiting local drug stores and sports shops offering to consign the first units (leave product for a short while and collect payment when the products sell). If the product is a success and all the thousand units sell for $20, her $2,500 investment will have profited her $12,500. She can pay herself a small income ($2,500) and still have enough to reinvest in perhaps 4,000 pairs of supports instead of the original 1,000 pairs. With this increased order, she may even be able to negotiate a discount from the manufacturer, thus increasing her profit margin. Once this second order is sold, she can purchase 16,000 pairs (profit of $200,000), then 64,000 (profit of $800,000) pairs and so on until she has reached a point where she will need to consider other distribution methods.
But venturing, despite being the most lucrative, is not always the best option for many inventors. Venturing is inherently risky. Since the successful venture often requires a great deal of attention, inventors with full time jobs, family commitments, and busy lives may not have the ability to jump into a new business, uncertain whether their product will be commercially successful
The second option for an inventor to commercialize his or her invention is to license the rights to another company to manufacture and sell products based on the idea in exchange for payment, often in the form of an ongoing royalty proportional to the value of the goods sold.
A license is a legal permission. The owner of a certain legal right such as a patent or a copyright (called the licensor) can grant permission to another party (called the licensee) to use the legal right for a specific purpose.
For Sandra’s knee braces, there are several companies that would be good potential licensees. These companies already sell bandages, athletic wraps and supports, athletic gear, and orthopedic products. Sandra could approach them and then enter into an agreement with one company to build and sell the knee braces for a percentage of the revenues generated on the sale of products.
For example, one licensing target might be ACE Bandage Company. Sandra could approach ACE and offer them a license to sell her knee braces under their own ACE Bandage Company label. In exchange, Sandra can expect to receive a small royalty payment, generally in the range of 2% to 8% of ACE’s sale price on the products. Since ACE is manufacturing the product and probably selling to a third-party distributor, who then sells to an end retailer, ACE may only receive $10 per each pair sold. If Sandra cuts a deal with ACE that gives her 5% of ABC’s gross sales, then she effectively earns $0.50 per pair on ACE’s sales.
As a general rule, there is a lot more money to be made from starting a business to build and sell the products yourself. If Sandra starts a venture, she is keeping the profits for herself that would, in a license agreement, be taken by ABC. However, this assumes that Sandra can manufacture and distribute the product for the same cost as ABC.
The advantages of licensing the invention are many. Sandra had just graduated from college and was about to start a new job as an industrial designer working for a major automotive company designing car dashboards. She was very excited about this first new job and had significant reservations about foregoing this opportunity for the unknown prospects associated with selling knee braces from her efficiency apartment. Since she had no prior business experience, the risks associated with venturing this product would be greatly increased.
Also -- and this is very important -- her passion was the creativity associated with the design process. Although passionate about design and about her invention, she was not particularly enthusiastic about the prospects of manufacturing and selling knee braces. What she really wanted to do was to spend her time designing products, not running a business.
Money was also a problem. She owed a five-figure sum on her student loan account, and was not sure where she could come up with the $2,500 seed money to get her started. Her father would probably lend her some money, or she could borrow against her credit card, but she already was heavily in debt and wanted to get her head above water before borrowing further.
She also was frustrated at the time line required to bootstrap products into the marketplace. Even if sales were outstanding, it would take several years without borrowing significant capital to make her knee braces available worldwide to anyone who needed them. She was very interested in having as many people as possible use her product to relieve the type of knee pain that she had suffered as a student athlete.
The right licensee would handle all of the headaches associated with manufacturing and selling the product. Also, since the licensee is generally already in a business closely associated with Sandra’s knee brace, it is very likely that they will be able to quickly and efficiently move large quantities of product into the marketplace.
The Economics Of Licensing
As mentioned above, licensors (inventors) of product ideas generally receive a royalty on the order of 2% to 8% of the sales price of products sold by the licensee (manufacturer/distributor). Many factors go into determining a fair and reasonable product royalty. Principal among the factors of what the right price to charge for a license is the “going rate” for like products or services in the marketplace. For instance, some drug-related inventions carry royalty rates of up to 15% or more. Justifying these sky-high royalties, however, are the significant R&D efforts that go into creating and testing pharmaceuticals. At the other extreme, many chemical compounds are often licensed for 1% or 2% of the sale price, since many chemical formulas have reasonably equivalent substitutes.
Factors that can affect the royalty rate include:
- The uniqueness of the invention
- The ability to design around any monopoly protection that might prevent copying
- The popularity of the invention
- Profit margins of the manufacturer
- The size of the market
- The ability of the market to pay
- The availability of suitable alternatives
If your idea relates to a service or process for performing a service, the percentage might be a few points higher. For example, an improvement to a mousetrap might yield a royalty of 4% to the inventor; however, if the license is to a patented process for sterilizing pet mice, for example, a more typical royalty might be 8% of the fee charged by the local veterinarian for performing this service.
A company that desires to be the exclusive licensee (the only company allowed to manufacture and sell the licensed product) would be expected to pay a higher royalty than a company that is only one of several manufacturers of a product. The obvious reason for this is that a company that is the exclusive licensee is able to earn a higher profit margin from the sale of the product since there is no direct competition for the goods.
Another key factor to remember about licensing: when you license your invention to another company, you put yourself in the position of depending upon the company to provide you with honest and transparent financial reports. They may decide to downplay your invention’s potential or even underreport sales figures. Then you have to get lawyer and force the company to open its books.
So what does this all mean for the inventor? If you chose to license your products as opposed to venture, and if you can earn a royalty rate of 5% (healthy, but not unreasonable), then it takes $50 million in product sales to earn a $1 million from product licensees.
Compare this to the $3.5 million estimated earnings of the King of Pet Rocks, Gary Dahl, on $15 million in venture sales. Of course, Gary Dahl had a tremendous profit margin. From the $3.95 retail price, he made a profit of one dollar, which is a 25% profit margin.
The bottom line is that if you can consider a venture, then write up a business plan. Try to figure out your costs and your real-life revenue expectations. Factor in the cost of your own time, especially if you already have another regular job that you may have to give up. Balance that against the convenience and ease of licensing, and make an informed decision.