What Is the 25% Rule?

There are two common usages of the term "25% rule":

  1. The 25% rule is the concept 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 poses a potential risk, as the municipality may have trouble servicing the debt.
  2. The 25% rule also refers to a technique for determining royalties which stipulates that a party selling a product or service 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 also commonly applies to trademarks, copyrights, patents, and other forms of intellectual property.

Key Takeaways

  • The 25% rule is a heuristic that can refer to either public finance or intellectual property law. 
  • In public finance, the 25% rule prescribes that a public entity’s total debt should not exceed one-quarter of its annual budget.
  • In intellectual property, the 25% rule suggests the reasonable royalty that a license should pay an intellectual property holder on profits.

Understanding the 25% Rule

In both uses of the term, the 25% rule is more a matter of customary practice or heuristic (i.e. a rule of thumb), rather than an absolute or optimal threshold, or a strict legal requirement.

In the public finance setting, the 25% rule is a rough guideline for fiscal planning based on the confidence of bondholders and credit rating agencies. In the intellectual property arena, the 25% rule evolved from the customary rates negotiated between intellectual property holders and licensees. 

25% Rule for Municipal Debt

Local or state governments looking to fund projects through municipal bond issues have to make assumptions about the revenues they expect to bring in, often through taxation or projects like toll roads, 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 cause them to default on their obligations and hurt their credit rating.

Municipal bondholders want to make sure that the issuing authority has the capacity to pay, which can be jeopardized by getting too deep in debt. Bondholders are, therefore, cautious against purchasing bonds from local or state governments that are in violation of the 25% rule.

Tax-exempt private activity bonds - bonds issued by municipalities on behalf of private or non-profit organizations - also have a 25% rule applied to the proceeds from the bonds. This rule states that no more than 25% of bond proceeds may be used for land acquisition.

25% Rule for Intellectual Property

Patent or trademark owners use the 25% rule as a yardstick for defining a reasonable amount of royalty payments. The rule assumes that a licensee should retain at most 75% of the profits of a patented product given that s/he took on the bulk of the risks of developing the product and bringing the intellectual property to the market. The patent owner takes the remainder as a license royalty.

Setting the value of intellectual property is a complex matter. Although royalties are typically assessed against revenues, the 25% rule applies to profits. Furthermore, the 25% rule does not closely define what "gross profit" includes, which creates ambiguity in the valuation calculation. Because it's a simple 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 attracting demand in the market through advertising.

In the 2011 court case of Uniloc USA, Inc. v. Microsoft Corp, the court of appeals for the Federal Circuit ruled that the 25 percent rule may not be used as a starting point for a patent damage analysis bound for the courtroom. The appeals court concluded that the rule does not rise to an admissible level of evidence and may not be relied upon in a patent lawsuit in federal court. While the 25% rule may still be used by other parties in estimating a proposed patent royalty, it should not be considered a legal mandate.