Friday, September 11, 2009

Of Kings and Queens?

I am just back from visiting the old country, including seeing a real live Lord and a few dead kings and queens in churches, hence the delay in my blog schedule - and hence the blog title!

Well, this is not exactly about kings and queens. But, I did want to talk about Royalty - those large, pesky charges that can take months to negotiate, make accountants and operations cringe, yet oil the machine that drives strategic distribution deals including OEM, Strategic Reselling, and so forth.

I have had several questions recently about royalties. and what they should be for a particular situation. Rather than prescribe what a royalty should be, I want to highlight some areas that affect Royalty percentage - the knobs to turn, so to speak.

This chart provides a helpful framework. To explore this, first let's establish terminology: Royalty is what is paid by your distribution partner to you for the right to distribute that product to their customers. And, "Discount = 1 - Royalty"; the inverse. So, if you prefer to think in terms of the discount you give to a partner, you'll need to invert the following discussion. Note that I have carved out the royalty on maintenance or services from the product revenue stream. That is crucial, as the work share is entirely different for each revenue stream.

Margin is paid for effort from the selling partner: Including sales, marketing, G&A, inventory carrying, manufacturing, support - etc. All the things it takes to create and sell a product except, usually, the act of creating the Intellectual Property itself. The amount of royalty is typically inversely proportional to the amount of effort your partner does in helping you deliver the product to revenue-generating customers. The more work they do, the greater commitment they make, the lower the Royalty paid to you. Simple, right? Well, not really.

Here are just a few of the things that make negotiating Royalties so hard:
  1. Companies have financial goals. If you place a product in their sales channel, it is subject to the same internal "taxes", SG&A costs, etc, as for their own products. And, SG&A alone can be 50-60% of revenue, so that half of your product margin gone!
  2. Commitment. The greater the commitment from your selling partner, the lower the royalty you should expect from them. That works both ways, as you can sometimes negotiate higher commitments from your partner in exchange for a reduced royalty to you. Commitments can come many forms: taking on product manufacturing, making up front financial or volume commitments, assistance from you in selling the product, etc. A double-edged sword, so use it wisely.
  3. Channel differentiation. If your selling partner is going to be selling the same thing as you currently sell, how do you differentiate the products so that the result is incremental business to you? Do you even care if the volume is large enough? So, differentiation or "value-added" arrangements can drive down Royalties as they drive up channel differentiation. Again, a double-edged sword as they can be used to arrive at the selling partner's desire royalty by increasing differentiation in the market.
  4. Time. Royalties can vary over time. The best example for this is what I call the ramp-up period. For the first 6-12 months, a selling partner will often need lots of help from you to build market presence, expertise, close business and excite their sales team. That costs you something. At a minimum, you might pay sales people so they cooperate and not compete with your new partner. Use a discussion in this area to highlight the value of "effort" and negotiate an increase in your share of the deal.
  5. Joint value proposition. Lastly, and most importantly, remember that you are not just negotiating the share of YOUR revenue - you are sharing in the income from the joint value proposition you've created with your potential partner in the deal. So, make sure the partner takes stock of their own upside - that is most likely why they are doing the deal with you, to be sure, regardless of what they actually tell you! Use it in negotiating Royalty.

Another area of complexity is the meaning of "list price" in your own selling model. If you are selling enterprise software with a typical 50-70% discount to customers, you must base the royalty equation on a model reflecting those discounts, or on a Net to Customer rather than List Price basis, if feasible. Can be quite complex, but can kill a deal if not well understood.

So, have fun in the Royal court, and let me know if you have any scenarios or stories to share on the subject.

Until next time,