INVENTION LICENSING AGREEMENTS EXPLAINED II

IV  Elements of Licensing Agreements

A.  Scope of License - The Granting Clause

First, a license agreement or assignment should define exactly what intellectual property is to be licensed, to whom, for what purpose, what type of license, and for how long.  This is the purpose of the “granting clause”.

In few cases is it intuitively clear what intellectual property is to be transferred.  Where a patent is licensed, reference to the patent itself may suffice.  But even transfer of rights to a granted patent may require some clarification as to what intellectual property is being granted.  For example, one licensing strategy is to convey both the patent and the technical “know how” to reproduce the invention.  This approach may be advantageous to the inventor because, if the patent is subsequently held invalid, the license is not necessarily void.  This strategy does require more complex language in the granting clause to provide some bare bones definition of what “know how” is intended.  Where a patent is pending, the language of the license agreement should specify whether the license includes follow-up patents, such as improvement or continuation patents.

The granting clause should also define to whom the invention is to be licensed.  Again, this may not be as easy as it seems.  Where the licensee is a corporation, the agreement should define whether subsidiaries or parent corporations are included. 

The uses authorized under the licence must also be defined.  Generally, the mere use of the term “make, use and sell” will be construed as a grant to exploit the licensed invention in any way the licensee can.  Where the inventor intends to convey less, the license agreement should clearly state this.  Another consideration that should be addressed is whether the license grants the licensee the right to have the invention made for him by a third-party manufacturer.

B.  Inventor’s Payoff - The Royalty Clause

1.  Royalty Calculations
The license agreement should define the inventor’s royalty precisely and unambiguously, including the amount of royalty as well as when the royalty payment is due.  One royalty option is to sell the license for a lump sum. This is generally the approach to compensation when an inventor assigns her invention.  Although rare in practice, a license can also be purchased through a lump sum payment.  More commonly, the royalty terms under a license pay a compensation that is tied to the degree to which the licensee uses or sells the licensed technology.  The licensee is unlikely to offer as much up front as a license based on the amount of use, because of the uncertainties involved in estimating future use or sales.

Where the licensee plans to sell the licensed invention, royalty payments under a license are most often calculated based on the number of units sold.  There are several ways to accomplish this.  First, the licensor may get a certain percentage of the licensee’s net selling price from the sale of the invention.  This approach may be appropriate where the selling price of the invention is hard to predict, because it ensures the licensor gets a fair share of the revenues generated by a product that becomes far more successful, and hence carries a bigger price tag than the licensor and licensee envisioned when they signed the license agreement.  However, it does leave the licensor and licensee with the difficult problem of defining what is the “net selling price” of the invention.  For example, the licensee should specify whether discounts and sales commissions are deducted from the retail price.  The percent-of-sales method also permit’s the unscrupulous licensee to manipulate sales in other imaginative ways to dramatically reduce the licensors royalty.  For example, the licensee may sell the invention at a very low price to a company owned by the licensor, resell the invention at the proper market price through the owned company and claim the price paid by the owned company as the net sales price.  This scheme would probably not stand up in court, if the licensor finds out what the licensee is up to.  But the licensee could disguise this scheme through a series of transfers, assignments, or other accounting steps, such that proving the licensee’s maneuvering would be very difficult.  Once again, the only sure winners would be the lawyers.

A second method for calculating royalties is as a fixed amount of money per unit sold.  The primary advantage of this approach is that it is easy to implement.  To calculate the royalties due, the licensor need only know the number of units sold.  This solves the problems discussed above that are inherent in the net selling price method.  However, it may not be appropriate where the selling price of the invention is very hard to predict.

A third possible approach is the profit-sharing royalty, in which the licensor shares the licensee’s profits on each unit sold.  This approach is rarely used - with good reason!  Profit-sharing puts the licensee at the whim of the licensors accounting system.  In order to verify the royalties, the licensor needs to be intimately familiar with the licensee’s business, from manufacturing costs and labor rates to the cost of supplies used in the front office.  The possibilities are boundless for the licensee to manipulate his books, within the guidelines of generally accepted accounting procedures, to minimize the licensors royalties.  The profit-sharing royalty is not appropriate for a licensing agreement.

Where the licensee is not selling the invention, but using it internally in her manufacturing operation, the royalty may be based on the amount of use.  For example, where the licensed invention is a machine, the royalty calculation may specify a certain monthly royalty for each machine in use during the month.  A second approach is to tie the royalty to the number of goods manufactured with the licensed technology.

The licensors royalty may also be calculated as a combination of these approaches.  For example, a license agreement may give the licensor a lump-sum payment, or bonus, as well as a periodic payment based on the number of units sold.  Where the licensor needs money up front, for example to cover his development costs, he may choose to insist on some front money in return for a lower royalty rate on subsequent sales.  The bonus payment also provides some assurance that the licensee will diligently work to develop the invention commercially, because prudent business persons would not spend money without anticipating a return on their investment.

Insisting on a bonus may not be the best strategy in all cases.  A licensee who is facing major expenses in tooling up to make the invention may be reluctant to pay an up-front bonus, and will charge dearly in the form of reduced future royalties.  Moreover, the licensor may have other assurances that the licensee will use diligence in developing the invention.  For example, a minimum royalty requirement and reversionary clause (discussed in the following sections) provide assurance that the licensee will develop commercial sales or risk losing the license.  In determining how aggressively to pursue an up-front bonus, the licensor should weigh her immediate financial need and her need for assurances that the licensee will diligently market the invention against the probable willingness of the licensor to pay a bonus.

2.  Amount of Royalty
The basic rule for determining the amount of royalty the licensor should ask for is, simply, that there is no rule.  The value of the license to the licensee depends on many factors unique to the invention to be marketed.  One such factor is the market potential of the invention.  A product with a broad-based strong market potential will likely command a higher royalty.  The inventor should determine how many potential buyers exist, what competitive products are already serving this market, and whether the market is expanding or mature.

Another factor that can influence the negotiated royalty is the riskiness of the venture:  how likely is the invention to sell.  In general, the greater the risk, the lower the royalty the licensee will be willing to pay.  While one-of-a-kind inventions present the opportunity to open a brand new market, they have the drawback of being riskier.  A lower risk invention is one that significantly improves on a pre-existing product that has already demonstrated strong sales.

Other factors that may influence the amount of royalty include the amount of money that the licensee will likely have to spend to find tune the invention for commercial sale or use.  The more such costs are anticipated, the lower the value to the licensee and the smaller the royalty expected.  Also, the terms of the license agreement affect the royalty;  an exclusive license will likely lead to a larger royalty than a non-exclusive license.  The portion of the value of the product sold that is covered by the license will also have an effect on the royalty.  A licensor of a single computer component is unlikely to garner as large a royalty on the sale of a computer that uses the component, measured as a percentage of the computer sales price, as would the licensor if he sold the components separately.  Finally, the relative negotiating skills of the licensor and licensee will have some impact on the amount of the royalties negotiated.

Although there are no set rules for what royalty is appropriate, there are guidelines.  Where royalty payments are calculated based on the number of products sold, a good starting point is a royalty of five percent of the licensee’s anticipated selling, price, or around 25 percent of the licensee’s anticipated profit (remember though, that the actual license agreement should not use a formula based on the licensee’s profit).  Adjust these figures up or down according to your assessment of the marketability, risks, additional investments required, licensing terms, and any other factors that may be relevant to your product.  A good way of validating your estimated value is to try it.  If you are unable to sell a license at the target royalty rate, this is a strong indicator that you have set your sights too high.

C.  Minimum Royalty

Many licensing agreements include a provision for a minimum royalty payment, which provides for payment of a specified minimum royalty regardless of sales volume the licensee actually generates.  This is beneficial to the licensor for several reasons.  First, it guarantees the licensor some minimum income from the invention.  Second, it provides incentive to the licensee to take reasonable steps to market the invention.  While exclusive licenses place some duty on the licensee to use its best efforts to sell the invention under license, the definition of “best efforts” is subject to various interpretations, and barring a negotiated settlement, the licensor usually has to go to court to fight for the right to terminate the license.  The minimum royalty is an attractive alternative because i in effect defines the minimum sales level that both parties have agreed is sufficient to maintain the license.  Furthermore the minimum royalty clause usually contains a reversionary clause, which specifies that the license automatically terminates, or may be terminated at the licensors option, when the licensee fails to pay the minimum royalty. 

Typically, minimum royalty clauses are used in exclusive licenses.  While some writers have suggested that they are not appropriate in non-exclusive licenses, this is not universally true.  Once granted, a non-exclusive license that lacks a minimum royalty clause can be hard to terminate, because there is no implied duty for the licensee to use its best efforts to market the invention.  The presence of a prior non-exclusive license, even one that the licensee has failed to actually use for years, will probably reduce the value of the invention to a future licensee, particularly one seeking an exclusive license.  In determining whether to require a minimum royalty, the non-exclusive licensor should consider what other assurances he may have that the licensee will actively market the invention, and what harm may result if the licensee merely shelves the license.

D.  Reporting Clause

With the exception of pure lump-sum royalties, all methods of calculating royalties depend on the licensee’s records of such information as units made or sold or sales revenues.  In order to verify the amount of royalty due, the licensor needs access to these records.  A licensing agreement should include provisions that make it possible for the licensor to readily access the licensee’s records.  These provisions comprise the reporting clause.  A thorough reporting clause should impose several requirements on the licensee.  First, the licensee should agree to keep records in sufficient detail to enable determination of the royalty payments.  Second, the licensor should be given access to the licensee’s books.  Third, the licensing agreement should specify that routine royalty reports be sent to the licensor on a regular basis, such as monthly or quarterly.

V.  Seeking a Licensee

A.  What to Look For in a Licensee

The ideal licensee is one that has the technical ability to make the invention, the marketing channels to reach the right consumer, and a business posture suggesting a vigorous interest in developing the invention.  Technical ability encompasses the manufacturing experience of the company:  does the company have the necessary tools and work force skills to efficiently design and build the invention?  In considering the potential licensee’s marketing channels, the licensor should determine what customers the invention will appeal to.  If the potential licensee has established marketing channels such as distribution, retail placement, advertising, and so forth, then the company has the proper marketing channels.

Also crucial to finding a good licensee candidate is a spectrum of considerations that define the company’s business posture.  One consideration is the company’s product line.  The ideal product is one that contains a number of related products, establishing the company as a known player in the market the invention will be entering.  On the other hand, the ideal product line does not contain a product that directly competes with the invention to be licensed.  A company is likely to be ambivalent about a new product, no matter how good, that cannibalizes sales revenue elsewhere in its product line.

Another consideration is the company’s current financial health.  It is probably not a good idea to sell an exclusive license to a near-bankrupt company.  If the company fails, protection under the federal bankruptcy law could tie up the invention for years, and at the least, the chances of receiving regular royalties would be greatly reduced.  Even a relatively healthy company may lack funding necessary to tool up and adequately market an invention that requires sizable start-up capital.

Finally, the would-be licensor should try to sound out the company’s track record for licensing outside technology.  A company that has had numerous successes licensing inventions in the past will likely be receptive to a new inventor.  On the other hand, avoid like the plague any company that has a history of being sued for patent or trade secret infringement.  Often one can get a sense of the receptiveness of a company to license outside technology by making a few well placed phone calls.  Many companies have standing policies of not signing confidential disclosure agreements before reviewing outside inventions for possible licensing.  Often this is the result of having observed or themselves been the object of unwarranted infringement litigation, after an invention viewed under such agreement turned out to be similar to development work under way in the company’s own laboratories.  If your invention does not have adequate protection other than as a trade secret, and you cannot convince a company to sign a confidential disclosure agreement without disclosing the invention, then you will have to cross off an otherwise excellent potential license from your list.

B.  Where to Find Licensees

To locate a potential licensee you might consider a company that has the reputation of selling their market.  It is important to select the proper complimentary channel of distribution.  In addition to the vast resources that are available on the Internet, use the following publications to locate a potential licensee as well:  Thomas Register of American Manufacturers (14 volumes), Dun & Bradstreet - Million Dollar Directory, Standard & Poor’s Register of Corporations - Directors and Executives, Standard Directory of Advertisers, Bacon’s Publicity Checker, Industrial Arts Index, Moody’s Industrial Manual, and Hendrick’s Commercial Register of the United States.  When approaching a licensee, it is important to do all preliminary homework, such as feasibility, manufacturing costs, market or focus group studies and other related information.  Contact the president first.  That way he will refer you to the correct person.  A person in middle management might not act as timely in licensing the invention.

Selling a license or assigning the invention requires the inventor to share the profitability of the invention with others.  But licensing (or assignment) is often the inventor’s best choice for several reasons.  First, a licensee usually is better equipped than the inventor to fully tap the market potential of the invention.  A licensee may provide manufacturing capability as well as the marketing and distribution channels needed to reach a broad customer base.  Second, a licensee usually has far greater experience in product development than the inventor does.  Third, a licensee can provide the capital needed to fully develop the invention.  Many inventors with a good idea lack the funds to develop the idea, and are unable to raise money by other means.  Banks often are unwilling to loan unless an established business exists, and then usually require the business to put up collateral in exchange for giving a loan.  Venture capitalists generally will not buy into the idea unless it has demonstrated sales potential.   This leaves the inventor with the task of finding a private investor willing to gamble on a high risk venture or, alternatively, licensing the invention to a deeper pocket.  Fourth, some types of inventions only have value when used in conjunction with the licensee’s business.  For example, an improved method of making injection moldings can not readily be sold as a product; the only practical way to develop the invention is to license it to a company that does injection molding.

Licensing agreements can cover virtually any type of intellectual property.  For example, licenses granting rights to use material covered by patents, copyrights, or trademarks are quite common.  Trademark licenses are usually called franchises.  Trade secrets, also referred to in licensing agreements as “submitted ideas”, “know-how”, or “proprietary information” are also commonly licensed.