Ratcheting Royalties

Participants in pay-for-performance+ need to feel that performance has been measured fairly (or at least, biased in their favor). This is the basis of the financial incentive. Along the way, they need directional measures to allow them to adjust actions should their payment seem to be in jeopardy. At the end they seek a just measurement.

The firm pays for performance, and so we need a way to shows the firm understands it’s in their best interest that commercialization+ partners feel they’ve been fairly treated. So the firm voluntarily imposes a penalty regime on itself, at the start of commercialization, for any shortfalls in the measurement of performance at the end. Partner-vendors are assured they will either receive just compensation at the end, or they will receive an even higher compensation once the marketplace demonstrates performance should have been measured higher.

The marketing department at Warner-Lambert (now part of Pfizer) estimated first year sales of Lipitor™ at 200-300 million U.S. dollars. The first year came in it at over $800 million, and Lipitor™ reached over $2 billion in sales by the end of the 2nd year. DIA Pharmaceutical Industry Survey+ Participant

The Commercial Operations+ team (e.g., sales and marketing) is typically internal to the firm, and controls key variables in the measurement of performance (e.g., price, market share, marketing costs, competitor positions). The firm can unilaterally reduce product value by being overly cautious in its estimates of these key commercial variables. We use the measurement penalties to offset this caution.

We use a very simple measure of performance: projected revenue. The blockbuster+ will not be launched into the marketplace if it doesn’t have the customary industry margins (or it will be launched as a sub blockbuster+ with customary margins). In either case, the blockbuster measurement is revenue. We do this simply to make comparison of the pay-for-performance measurement comparable with publicly reported financial results (i.e., revenue by product).

One approach to the penalty regime is for the firm to promise ratcheting royalties+. If the product turns out to be wildly more successful than calculated during its commercialization, then the firm pays royalties to make up for the earlier shortfall (lower revenues do not retract earlier payouts, hence the ratchet). Royalties are structured so it would have been much less costly for the firm to over-value the product at the end of commercialization. These royalties are shared across all commercialization partners, according to their participation in the pay-for-performance reward scheme.

By using ratcheting royalties, the firm is incented to get the performance measurement right (or overstated) at the end of commercialization. Everyone eventually gets paid according to the fair market value of the product. If the measurement is too high, the firm pays out too much at the end of commercialization. If the measurement is too low, the firm risks paying out even more in the form of future royalties. In general, with blockbuster pursuits, even if the firm significantly overpays at the end of commercialization, the benefits from having a blockbuster product far outweigh the additional cost. We’re doing this for the incentives, and the firm must act as though it wouldn’t have had the blockbuster product without the payments.