Licenses and Royalties

A license agreement is a complex contract because intellectual property rights involving patents, trademarks, copyrights, trade secrets and know-how have unique property rights.  Special actions are required for creation of these property rights and continuing maintenance actions are necessary.

An inventor of a complicated patented product may make commitments to the licensee during negotiations.  The inventor may promise that the product may be manufactured with minor modifications and that he will produce design documents and locate and supervise component manufacturers.  However, if the inventor fails to adhere to his promises, a long period of time will pass and substantial expenses will be incurred without successful production. 

The inventor may receive substantial royalties under the license. 
If the inventor’s promises are not documented in the agreement, the licensee may have no recourse against the inventor and, moreover, may not withhold payment of royalties.

Exclusive v. non-exclusive licenses
Many licensees prefer an exclusive license because they are unwilling to deal with competitors.  However, licensors usually offer a non-exclusive license in order to spread royalty income over a number of different licensees, thereby increasing the prospect of higher return.  If the property is freely available to various businesses, then all licensees have an opportunity to compete.  There is a reduced potential of a lawsuit from a rejected prospective licensee.

Exclusive patent licenses are more valuable, however, typically require minimum royalties and initial payments.  If a licensee does not want to pay for an exclusive license, a head start arrangement may be permitted.  A head-start arrangement involves the licensee receiving an exclusive license for a limited period.  Alternatively, the licensee may obtain an exclusive license that may be converted to a non-exclusive license with a lower royalty in the event that the licensee later decides an exclusive license is not required.

Types of royalties
Patent royalties may consist of the following:
(i) a one-time, up-front payment;
(ii) a periodic specified amount (e.g., quarterly or yearly);  or
(iii) a periodic payment based on a percentage of sales or services rendered in connection with the product.

Royalties may include an up-front royalty and a periodic payment based on sales.  Under combined royalties, the licensee receives the benefit of a low initial payment and also may obtain credit for such payment against royalties on future sales.  Sliding-scale royalties (i.e., reduced percentage for increased sales) or yearly or lifetime caps on royalties may be negotiated.  A licensee may require items to be exempt from royalties, such as demonstration or promotional units or products used in-house by the licensee.

Royalty Rates
The strategic issue in negotiating a license involves assigning a dollar value to the property. 

The following factors affect the value of a license:
Costs in acquiring and setting up the property

Tangible costs include:  research and development costs;  design costs of devising a trademark or copyrighted work;  costs of making the invention commercially viable;  costs of advertising and promoting the trademark or copyrighted work;  and costs such as the legal costs, engineering costs and accounting costs.

Contribution of the property to the profitability of the product or the business
Important factors include: the name recognition of the property;  new features that add value to the product; and cost reduction features.

Dollar values can be allocated for these features.  If the property generates increased revenues by opening new markets or increasing market share, values may be estimated.  Projections of increased sales, revenues and employees based upon the new technology should be taken into account, although projections are subjective.  Each party to the negotiation will make its own projections.

A crude rule of thumb for royalty rates in non-exclusive licenses involving patents, trade secrets or know-how is 5%.  Non-exclusive license royalty rates vary from 10% to 25% or higher.  Exclusive license royalty rates are higher because of the exclusivity.  The licensor is at risk if the licensee fails to perform.  Courts have reviewed reasonable royalty rates in terms of damage awards in infringement suits. Courts have considered the following factors: the remaining life of the patent;  the advantages and unique characteristics of the patented device over prior devices;  evidence of customer preference for products made under the patent;  lack of acceptable substitutes;  the extent of the infringer's use of the patent; and the alleged profit the infringer made attributable to the patent.

In court cases, awards have ranged from 8% to 25%.  Because royalty valuation involves a number of factors, each case must be analyzed on its own merits based on the factors described in this section.

Trademark royalties vary based upon the scope of rights conferred ranging from a mere license to a complete business franchise.  Copyright royalties are in the 15% range for authors of books and games, including video games, however, these vary according to the type of the rights conferred, e.g. movie rights to a best selling book by a widely acclaimed author, merchandising rights to cartoon character for children's clothing.

The term of the license is critical in setting royalties.  If the term is lengthy, the licensor is dependent upon the licensee's efforts.  Lump-sum, initial payments and royalty schedules are higher for longer-term licenses.  The licensor will require higher royalties for a large exclusive territory.

Royalty rates will be reduced due to a variety of factors.  For example, an untested product creates market uncertainty.  Environmental concerns or FDA approval requirements reduce royalty rates.

Reduction in manufacturing or sales costs or a famous trademark, or a well-known new property will increase royalties.  New product features which make a product more appealing without significant increase in cost increase the royalty rate or up-front payment.

The basis of the royalty must be set carefully.  It is undesirable to base royalties upon the savings derived or a percentage of net profit because these are uncertain and changeable quantities which may create misunderstanding and possible manipulation.  It is advisable to translate those values into the equivalent percentage of the selling price which is an ascertainable amount.  It is important to determine a fair and reasonable royalty base.  If a small component is the key ingredient which makes a complicated system functional, appealing and saleable, the royalty should recognize the inherent value of the component.

If royalties are based upon a percentage of profits or receipts or upon the number of goods sold, there is an implied promise of diligent performance and good faith.  Licensors want to ensure that the licensee will use his best efforts to capitalize upon the property and maximize the licensor's income.  One method is to add a clause in which the licensee promises to use his best efforts. 
It may be possible to require the licensee to meet certain targets.  The license may require the licensee to invest a minimum amount in promotion and development of the property.  The investment may be quantified in dollars, man-hours or specific performance or sales goals.  A simple approach is to fix a minimum royalty.  The licensee must pay a minimum dollar amount in annual royalties, whether or not the licensee's sales actually sustain those royalties.  The most common approach may involve agreeing upon minimum performance levels.

Usually, a most favored licensee clause is included which provides that if a subsequent licensee is given a license on better terms than an earlier licensee, then the earlier licensee has the right to obtain the more favorable terms.

Relatively simple royalty formulae are favored.  Calculations may be based on a percentage of the entire product containing the patented invention, rather than on the value of the patented component, which may be difficult to determine.  Royalties are often based on the invoiced amount of sales, less taxes, freight charges, trade discounts and bad debt.  The licensee should be given sufficient time to calculate and pay the royalty at the end of each royalty accounting period.

Some common issues of patent licensing are described below.

Consulting services
The creator ordinarily has the most knowledge about the invention which was no doubt developed after countless hours of trial and error.  In order to draw upon this know-how, the inventor should be obligated to provide specified consulting services with reference to the design and manufacturing of the invention as a condition of receiving royalties.

Improvements, related inventions and foreign patents
A patent license should include any patentable improvements to the basic patent.  It should also include patent rights on present and future inventions of the inventor related to the licensed process or product.  If the licensee may distribute the patented product in other countries, provisions should cover the duty to obtain foreign patents. 

A license must clearly define the licensed property.  A license may involve one or more patents, or a portion of a patent.  A license may confer only a trademark or an entire corporate image, including names and advertising and promotion system.  A copyright may cover a variety of rights, including the right to copy a book or other printed material in the print media, to translate it into another language, to adapt it for other media, such as video, to create derivative works, to merchandise its characters and scenes on clothing and toys.    The license may be limited by territory.  The licensee may be restricted to making and selling a patented device in one county, state or region.  Antitrust law compliance must be reviewed in these cases.  Geographical limits may be applied only to the initial sale.  The licensee may be restricted to making and selling the patented device in the designated territory.  After the licensee transfers the product, the license may not control where the product is used or resold.  Territorial limitations appear in trademark licenses, particularly when franchises are involved.

All licenses include time limitations.  A patent license should not extend beyond the life of the patent.  Such an arrangement would constitute an attempt to extend the patent right beyond the statutory period and would invalidate the license and make the patent unenforceable.  Payments after patent expiration should be avoided.    Patent licenses may restrict the licensee from using the patent in specific markets (e.g., OEM markets).  These markets may be reserved for other licensees or the patent holder.  These restrictions may not be appropriate in all geographic areas or distribution channels.  In the U.S., a licensee may be restricted to selling a patented product to discount stores, but such a limitation would be inappropriate in Europe and Japan because chain stores do not exist.

In licenses of know-how or trade secrets, the licensee must obtain sufficient rights to make use of its license.  A licensor must specify any desired limitations.  For example, a software license may allow only the use of software, not the right to modify it or combine it with other software or hardware.

If a trademark or copyright is licensed, the license may be limited to only wholesale or only retail, or certain types of stores such as discount stores, chain stores, supermarkets or department stores.  The limitation may apply to the type of goods:  toys, children's clothing, children's furniture, posters or specified media.

The prospect of success is increased by contracting with a competent, motivated licensee.  The licensor should research the net worth, credit rating, experience, reputation, manufacturing and sales capability and the prior licensing track record of prospective licensees.  In this fashion, the licensor will be able to eliminate unqualified licensees.  A licensor may negotiate a reversion clause which removes the licensee and returns control to the licensor in the event that specified targets are not achieved.

Grant-back clauses require the licensee to assign or license back to the licensor new properties developed by the licensee.  Licensors want to avoid losing the benefits of their own technology from new inventions.  However, licensees do not want to perpetuate the licensor’s control nor to share innovations that they have created at their own expense.  Antitrust issues may arise if the grant-back involves an assignment or exclusive license, particularly if the licensor has a right to sublicense.  The licensor could take advantage of this perpetual technology conduit to dominate an industry.  A non-exclusive license to permit the licensor to avoid regressing is generally accepted.

Transferability and Termination
Generally, licenses include a provision that the license is not transferable by the licensee to prevent the licensee from assigning the license.  The licensor does not want to work with a licensee who he did not choose or approve.

The constraint on transferability of the license has limitations.  The licensee cannot be prevented from transferring the license in the sale of the business which holds the license.  Solutions include providing a right of first refusal in favor of the licensor or providing short-term licenses.

Patent licenses often prohibit sublicensing or transfers of the patent license.  Exceptions should be made for contract manufacturers of the patented product and purchasers of all or substantially all of the licensee's corporate stock or assets.  Patent licenses usually permit the licensor to terminate the patent license if the licensee fails to make a required royalty payment.  Patent licenses may allow a licensee to cancel the patent license and any minimum royalties if the patented product proves to be impossible to manufacture or is supplanted by other technology in the marketplace.  The licensee should negotiate provisions for cancellation by the licensee in the event that manufacturing or marketing difficulties are experienced.

A technology license should cover the essential elements underlying the transfer in order to provide the intended benefits and protections to the licensor and licensee.  There are innumerable cases of licensees incurring substantial losses and damages because their license agreements were signed without adequate legal review and negotiation.   Precise drafting and negotiation of license agreements may permit higher returns, avoid misunderstandings in manufacturing and distribution and prevent unexpected losses.  There are many other important issues such as confidentiality, non-competition, warranties, infringement and audits which are not covered in this summary.

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