When a patent-holder and a licensee come together to negotiate a licence agreement, where do they start? This article looks at important issues to consider when negotiating and drafting a licence agreement. It also gives advice on how to approach the negotiation.
Licence agreements usually (but not necessarily) involve payment of a royalty by the licensee. Deciding how the royalty will be structured is important.
- Will the royalty be a percentage of the sales price? If so, will it be gross or nett of associated costs? To ensure transparency, royalty payments can be made dependent on the Gross Invoiced Sales of the patented product, which is an objective and verifiable benchmark that is difficult to manipulate with accounting procedures.
- A per unit amount. This can be preferable to a percentage royalty because then you have a known data-point and all you have to police is the volume.
- Will the licence require an upfront payment? From the licensor’s point of view it is advisable to include an upfront payment as an essential component of the licence agreement because this payment may be all that the licensor will get. You can couch it as a pre-paid royalty.
- It can take several years for products based on an invention to come to market. In order to encourage a licensee, especially an exclusive licensee, to “get a move on” in their efforts to bring a product to market, a useful strategy is to require the licensee to make periodic lump-sum payments (e.g. every six months) until the product reaches the market.
With thanks to Roland Williams.
To assist in deciding on an appropriate royalty percentage you can search for comparable deals online. Various websites offer this information on a pay-as-you-go basis.
Many factors impact on the total value of the deal and affect the determination of an appropriate royalty percentage. For example, the following deal components cannot be divorced from the calculation of the royalty percentage:
- Is there a sign-on fee or are there milestone payments?
- Are there minimum royalty payments? There should be in an exclusive licence.
- Who is responsible for enforcement?
- Does the licence automatically include the use of future improvements?
- How many other patents apply to this product?
- How many other licences are required?
- Are there any restraints-of-trade in play?
- Does the patent validly stop the competition? This includes the question of whether the patent is valid.
- Consulting services. Will training or consulting form part of the package? It is advisable to keep training and consulting as a separate part of the deal. However, this aspect may affect the eventual value of the royalty settled upon.
- Duration of rights. A licence agreement can be drawn up to last the full term of the patent; thereafter, the licence can be renewed with reduced royalty rates. On the other hand, circumstances may exist where it is advisable to set the licence for renewable blocks of time, for example, 10-year blocks.
- Does the licence relate to a ground-breaking invention or an improvement? Products not seen before can worry licensees. A key challenge for the licensor of a ground-breaking invention is proving the commercial viability of the concept. No matter how much research and development has gone into an invention, complete novelty of the product tends to make the licensee apprehensive about risks. In this situation a combination of a lump-sum royalty and running royalty can be the answer.
- What is the estimated value of the improvement that the invention confers on the licensee? This usually applies where the invention is a part of another product. If it is a new, separate product, this may have to be a guess. Also, you will need to keep in mind the licensee’s contributions (including their future contributions) to the invention in the form of managing it, marketing it, etc.
- Royalty stacking (where multiple patents affect a single product). This is often a problem in biotechnology. A developer of a product has to take licences from all the owners of patents that affect the final product, and by the time all the royalty payments are combined the developer can be left with an unprofitable product. These are some solutions to the problem of royalty stacking:
Joint venture expense. Royalty payments owed to third parties are deducted from the net sales of the final product.
Royalty floors and royalty-free arrangements. The parties agree that the licensor’s royalty rate may be reduced, but only to a certain acceptable minimum royalty rate. In the royalty-free model, the technology is licensed outright with some combination of up-front and/or interim payment, and no royalties are owed downstream on the product sold.
Royalty must reflect commercial reality. Royalty rates must be adjusted to reflect the reality of the commercial situation.
With thanks to Dr Raju Adhikari, Sachin Dhakka, Dr Arun Kumar Kashyap, Donal O’Connell Simon Rowell, and Anthony van Zantwijk.
Clauses useful for avoiding underpayment of royalties
To discourage underpayment of royalties you can include the following in a licence agreement:
- A form of royalty report that includes detail on the period covered, the values of all the elements of a royalty calculation and the identification of the business records on which the calculation is based.
- A requirement to attach copies to the royalty report of all business documents used as the basis for calculating the royalties due.
- A right for the licensor’s representatives and outside auditors to inspect and audit the books and records of the licensee.
- A requirement for the licensee to pay a heavy, 20% unpaid royalty penalty to the licensor if the audit shows more than a minimal deviation between the royalty actually paid and the royalty due, as well as the reasonable audit fees for the audit.
- A requirement for the licensee to pay interest on the unpaid royalty, unpaid audit penalty and audit fees at the highest interest rate allowed by the law.
- A requirement for the licensee to pay reasonable attorneys’ fees.
- A requirement for the licensee to submit to exclusive jurisdiction and venue for suit for enforcement of the licence agreement in the home area of the licensor.
- A requirement for the licensee to put up some collateral or security to cover failure to pay royalties and other amounts suggested above, plus attorneys’ fees. This collateral may take the form of an agreed judgment or a security interest in the form of first priority lien on property of the licensee such as inventory, trademarks, real estate, stock or other property. The licensee should record and perfect the security interest in the correct recording office.
With thanks to Paul C. Van Slyke.
Miscellaneous other clauses in licences
For additional control over the licensed technology the following concepts may be introduced into a licence agreement:
Reach-through patents. This provision grants a patent holder future rights in new products that might result from the use of a licensed patent. This may include the right to own the patents and other IP of future products.
Field of Use clauses. This refers to the situation where the licensor licenses the patented technology only for a particular application (i.e. field of use), and is free to strike up other deals with other partners who will use the technology in other fields. This is common in US patent licences and is permissible in Europe.
With thanks to Dr Raju Adhikari and Clifford Tager.
Exclusive licences: Are they advisable?
Licensors should be wary of exclusivity as everything can end up in the hands of the licensee.
From the licensee’s point of view an exclusive licence is desirable as it gives them an advantage over the competition and is therefore more valuable to them.
The exclusive licensee should be made financially responsible for the prosecution, maintenance and enforcement of the patent, and possibly even for its filing costs, payable retrospectively. If this is not done and the licensor remains responsible for the financial aspects of the patent then the licensor may find himself or herself at the mercy of the licensee, who may not use his or her best endeavours to commercialise the invention. In such a scenario, the licensor’s financial obligations to the patent may soon overshadow any income received from the licensee under the licence agreement. Note: If the licensee is financially responsible for renewal and maintenance of the patent then attention should be paid to the question of how defaults in payment will be handled (since this could lead to lapse of the patent).
Also, the exclusive licensee should be made liable for any infringements of other intellectual property arising from use of the licensor’s technology (whether licensed under the current patent or any future patents).
The licensee should be required to grant back to the licensor any IP developed during the course of the licence agreement (but check first that local or foreign laws such as anti-competitiveness/anti-trust laws will not breached by doing this – see below).
The licensor will probably be required to allow the exclusive licensee to use any associated trademarks and registered designs, and to transfer all accompanying trade secrets and know-how to the licensee.
Commercialisation (and incentives to commercialise): An exclusive licence should set out a commercialisation plan and timeline to ensure that the exclusive licensee has obligations which will bring the licensed technology to market. Failure to implement the plan according to the timeline should be made an actionable breach of the licence agreement and escalating penalties should be made payable dependent on delays. An obligation on an exclusive licensee to make periodic lump-sum payments (e.g. every six months) until a licensed product reaches the market can serve as a useful incentive to the licensee.
With thanks to Dr Arun Kumar Kashyap and Roland Williams.
Impact of foreign laws
Many IP licences are international in scope or are negotiated between parties from different countries with very different legal systems. Unfortunately, choice-of-law and forum provisions cannot fully determine the laws that will impact on an international licence. Governments do not allow their rules of anti-trust, competition and patent misuse to be avoided by a choice of foreign law.
Some countries imply warranties into contracts even if the parties choose another governing law. When the time comes to enforce the licensed patents in a foreign country, the parties may find that a provision in their licence agreement that appears normal is, in fact, illegal and has rendered the licence void and the patents unenforceable.
General factors to consider when dealing with foreign jurisdictions
A foreign country’s laws may affect the terms of your licence in unexpected ways. You should ask questions like this about the country’s laws:
Does the licensor have an implied obligation to the licensee to take action against infringers of the patent? Is there an implied “best endeavours” obligation? Is there a risk that the licensor will be deemed to be a manufacturer for product liability purposes? If the licence explicitly states that the licensor does not warrant validity of the patent, will this be valid? Is there a non-excludible warranty that the licensed technology will achieve the result that the licensee desires?
Foreign laws may also impact royalty terms after patent expiration and may have implications in the case of bankruptcy of one of the parties. Government permissions may be required for licensing, remittance of royalties and/or enforcement of licences.
The tax and exchange-control framework of a country may come into play. For example, there may be differences in the treatment of income from royalties and income from business profits. This can impact on how best to structure a licence deal.
Anti-competitiveness (also known as anti-trust)
Some terms in licence agreements can fall foul of the law if they breach laws made to ensure fair competition.
In the United States, a patentee may license (or refuse to license) any right under his patent to the whole or any specified part of the United States. However, a territorial restriction in a patent licence could be illegal if it is a restriction on resale subsequent to the first authorized sale of the patented product (the “exhaustion doctrine”); or if the licence is simply a pretext for a horizontal market division scheme.
In Europe, the so-called Technology Transfer Block Exemption (“TTBE”) is a framework for assessing technology-licensing agreements under EU competition law. The TTBE sets out Europe’s rules on competition in the field of technology transfer. It applies to licensing agreements concerning patents, know-how, software copyright and combinations of these. Licensing agreements that do not comply with competition law could be void and the parties could also be exposed to the risk of a substantial fine from the competition authorities. Obtaining good legal advice is strongly recommended.
Be careful if your collaboration will reduce the players in a given technical field to fewer than four.
Licences in Europe are safe provided (a) they do not contain any so-called hardcore restrictions and (b) the combined market share of the parties is less than 30% (for non-competitors) or less than 20% (for competitors).
The hardcore restrictions mentioned above are considered to be so damaging to competition that they automatically exclude a licence from exemption, i.e. from protection afforded by the TTBE. The hardcore restrictions are different for licences between competitors and between non-competitors.
Hardcore clauses between competitors:
- Restriction of either party’s ability to set the price at which it sells products to third parties.
- Output limitations or “caps” in reciprocal arrangements (this covers cross-party licensing). However, agreements to use the technology only in certain fields of use or product markets (“field of use” restrictions) are permitted in reciprocal agreements.
- Allocation of markets or customers. There are exceptions to this hardcore rule. For example, licensor and licensee can agree territorial and customer restrictions in a non-reciprocal agreement. Also, a licensor can require a licensee not to use the technology outside of a given field of use. A requirement on the licensee to manufacture the products only for its own use (a “captive use” restriction) is also permissible.
- Restriction of the licensee’s ability to exploit its own technology or to carry out further R&D, except where this would inevitably lead to disclosure of licensed know-how.
Hardcore clauses between non-competitors:
- Restriction of a party’s ability to set the price at which it sells products.
- Restriction of the territory where, or customers to whom, the licensee can make passive sales of the product.
- Restriction of active or passive sales by retail members of a selective distribution system.
Safety Zones under the TTBE:
Under TTBE Guideline 155, the following obligations are permitted to be included in licence agreements:
- Confidentiality obligations;
- Obligations on licensees not to sub-license;
- Obligations not to use the licensed technology after the expiry of the agreement, provided that the licensed technology remains valid and in force;
- Obligations to assist the licensor in enforcing the licensed IP rights;
- Obligations to pay minimum royalties or to produce a minimum quantity of products incorporating the licensed technology;
- Obligations to use the licensor’s trade mark or indicate the name of the licensor on the product; and
- No-challenge clauses allowing termination of the licence by the licensor if the licensee challenges the validity of the licensor’s intellectual property.
With thanks to Ian Feinberg, Gillian Sproul and John Roberti.
How should parties approach the negotiation of a licence agreement?
Seeking professional legal assistance is highly recommended. Try to find someone (e.g. a patent attorney) to work with you on your licence because free advice is worth what you pay for it. Internet forum posts are unreliable because contributors have no idea of the underpinning detail, and it is very important to take that detail into account.
It is advisable to obtain a “freedom to operate” opinion when the technology in question is an improvement on existing technology. If the licensee is free to operate, the licensor will be able to command a higher royalty for the value he brings to the licensee. If the licensee is not free to operate, he or she will be required to take licences from other patent-holders whose IP rights are likely to be infringed by the usage of the licensor’s technology. The licensee will not want to become a third party infringer. Where there is no freedom to operate or where royalty stacking will cloud the picture (discussed above) the licensee may have second thoughts about seeking a licence.
As a patent-holder/licensor, be careful not to overvalue your invention as this may scare the licensee off or set negotiations off on the wrong foot. It can be useful to get an IP valuation done by a patent attorney or other suitably qualified professional.
Start by agreeing a framework of general principles. These basic terms of agreement can be put down on paper in the form of a simple, informal letter addressed from one party to the other and providing a space for signature by both parties. You may wish to call this summary a memorandum of understanding. The idea of the memorandum is to get agreement on the main issues of the licence structure, royalties, etc. before going into all the ancillary legalistic issues and boilerplate clauses.
The language used in these early stages of negotiation should not be prescriptive as this can give unnecessary offence to a licensee and cause the negotiation to break down unnecessarily. Thus, it is not advisable to use words like “shall”, “will”, etc. Instead, language like “the Licensee undertakes to …”, or “the Parties agree that…” should be used.
The licensee should be asked to go over the preliminary terms in the informal memorandum and to make any changes or clarifications necessary before signing. Once the memorandum has been signed a comprehensive licence agreement can be drawn up, working from the agreed principles.
As a final suggestion, keep in mind the basic rule for entering into any contract: while both parties are still amicable make sure you put in place the means to get out in case things turn sour!
With thanks to Dr Arun Kumar Kashyap and Roland Williams.