Certainty/Uncertainty Trade Off

Refers to the licensing concept that a financial sum-certain is worth more and costs more than an uncertain sum. In many licensing situations there are two potential sums that the licensee may pay the licensor: A fixed up-front fee (that could be a paid-up license component) sometimes called a License Fee; and a running royalty based on the licensee’s sales of the licensed products, either as a percentage of value (ad valorum) basis or at a per-unit rate.

As a practical matter, usually the larger the fixed fee component, the lower the running royalty. However, for the licensor the fixed fee component is a sum certain, a running royalty a sum uncertain, but potentially much higher than the fixed fee; thus a licensor in effect trades certainty for uncertainty at some potential loss of “upside.”

For a licensee, a fixed up-front fee involves paying for something of uncertain value, while a running royalty means paying when the value of the license is established, and therefore a licensee will usually be less willing to pay a substantial amount as an up-front fee than a similar or even greater amount in the form of a running royalty. Similarly, for an author, a large advance may come at the cost of lower royalties on actual sales. The concept is also sometimes referred to as “risk premium.”

It should be noted that tax and accounting issues may have a substantial impact on the attractiveness of a pair up license as opposed to a royalty obligation – paid up fees can often be treated as capital, running royalties are costs.