DEFINITION of '25% Rule'
1. The idea that a local government's long-term debt should not exceed 25% of its annual budget. Any debt beyond this threshold is considered excessive and a potential risk, since the municipality may have trouble paying the cost of debt.
2. A technique for determining royalties which stipulates that a party selling a product based on another party's intellectual property must pay that party a royalty of 25% of the gross profit made from the sale, before taxes. The 25% rule applies to trademarks, copyrights, patents and other forms of intellectual property.
BREAKING DOWN '25% Rule'
1. Municipal governments looking to fund projects through bond issues have to make assumptions about the revenue they expect to bring in, which in turn will allow them to support bond payments. If revenue falls short of expectations those municipalities may not be able to make bond payments, which can hurt their credit rating. Municipal bond holders want to make sure that the issuing authority has the capacity to pay without getting in too deep.
2. Setting the value of intellectual property is a complex matter. The 25% rule does not closely define what "gross profit" includes, which creates ambiguity in the valuation calculation. Because it's a hard-and-fast rule, it does not take into account the costs associated with marketing the product. For example, the holder of a copyright will receive a 25% royalty, though the party doing the selling usually incurs the cost of creating demand in the market through advertising.