The Licensing Model

In an earlier edition of The Wiglaf Journal Bob Brill and Carmen Patti, of Patti and Brill LLC, discussed the key role of the patent attorney in defining effective patent claims and prosecuting the patent application for a new and innovative development. They also introduced the concept of commercializing patented inventions by licensing. In this note I would like to discuss a little further the factors affecting the options of manufacturing products based on patents and know-how, or of licensing these intellectual property rights (IPR). Then I will offer a basis for assessing the factors that control the design of a licensing agreement to fulfil your objectives and those of your licensees.

In order to reach an informed view of the alternatives open to your company you will, I am sure, have gathered and reviewed information on the industrial sector where the invention will have application, and will have assessed whether it is best considered to be a component, a process, a subsystem or a product sold to an end-user by the Original Equipment Manufacturer (OEM). In addition you will need, if you are going to adopt the manufacturing option, to have the financial resources and the management team to build manufacturing and marketing capabilities, and to establish the credibility of the technology. At this point I am going to assume that, based on the availability of resources or the challenges of the marketplace, you have chosen the licensing option as the best route to gain real benefit from your proprietary innovation. The ideas offered are focussed on the needs of a company addressing licensing for the first time.

The market data that you have gathered provides a starting point for deciding the type of companies that should be prospective licensees. It may be, for example, that the best solution is to license component manufacturers to produce the part covered by the patent and sell it to the OEMs. Alternatively, it may be beneficial to license OEMs, who would acquire the patented part from qualified subcontractors, but would themselves be responsible for paying the fees and royalties required by the license agreement. Keep in mind that in the world of internationalized business the manufacture of components, or the processing of materials may occur in more than one country, affecting both license terms and the patent filing strategy.

Establishing Credible Value

If you have decided to license the IPR you have to think about who needs to know what you are planning, and how you should tell them. The probability is that you are going to have to dislodge some strongly held opinions in the minds of people working for companies that will be important to your future. To overcome such reactions there are two key tasks. First, it is essential that the technology on which the invention is based has credibility, and is recognized positively by the target industrial sector. Secondly, your company must itself win credibility. Technical credibility can be gained from publication in professional journals, from editorial comment in the trade press, by attending, and preferably by exhibiting and giving papers, at conferences. These activities should help to build personal and corporate credibility, but it is also important to be aware that any licensee will want reassurance that your company, the licensor, has the resources to provide technical support for its licensees and to protect the IPR.

The “make aware” programme should include reference to the adoption of a licensing strategy, with the objective that, as a result, you will be contacted by companies interested to know about the availability and cost of your technology. The response should include as many as are available of:

• A short-form description of the technology;
• A description of the company, including reference to key team members, and of investors, if this would reinforce commercial credibility;
• Technical papers, together with such supporting data as can be presented without the need for a non-disclosure agreement (NDA);
• Copies of positive press comment;
• Copies of issued patents.

The cover letter will welcome the approach you have received and propose further contacts, so it will be desirable that should have already prepared the license agreement and defined the licensing strategy in detail, since these will probably be discussed.

Managing the Relationship

The license agreement serves two purposes:

1. It defines a working relationship between the owner of IPR and the company(ies) licensed to commercialise those rights;
2. It provides the framework for resolving disputes between the parties to the agreement.

This agreement may last for decades. It is vital that it should been seen as defining a partnership for the mutual benefit of both parties and not as an unfriendly preparation for litigation. Of course, if one party infringes the agreement it will then be the agreement that provides the basis for resolving the dispute, and its terms should define the rights of both parties precisely. But resolution of disputes in court is a slow and expensive process. A practical means of minimizing any apparent inclination towards resolving disputes by litigation is to specify that disputes should be resolved by use of one of the methods of alternative dispute resolution that are available. This sounds friendlier and it saves money.

A license agreement is, in legal terms, an undertaking by the owner of IPR (the licensor) not to sue another company for use (strictly: “manufacture, sale or use”) of the IPR provided that other company (the licensee) fulfils the obligations defined by the terms of the agreement, and also subject to the obligation of the licensor to fulfil its obligations. But more importantly, for both companies, it is the vehicle by which the commercial value of the IPR can be realised for mutual benefit. These are complex objectives, but fortunately the license agreement provides a good check list for defining the terms by which they can be achieved.

Generally, a license agreement starts with the “Recital” which describes the parties and why they want to enter into the agreement. The next section is “Definitions”. The agreement is going to depend on many terms, some quite normal but with specific meanings in this particular agreement. The section must include a definition of every term for which the specific meaning may differ from general usage, or where a precise statement is needed, for example, to calculate costs or royalties. As a practical matter, definitions tend to “emerge” as the agreement is written. They become an important part of providing the required legal clarity. But they are also important, for example, in defining product specifications and fields of use, and thus for ensuring that the agreement meets the business objectives of the parties.

The agreement describes how the parties will reach their objectives and, following the Recital and Definition paragraphs, it continues by saying what rights are being licensed. In most cases these are the patent rights (as defined) and are licensed subject to specified payments. At this stage it is necessary to say whether the rights are licensed “exclusively”, or through a “sole license” or “non-exclusively”, and this is an important decision. The difference in meaning is clear, but there are also differences in how they work:

1. Exclusive: Only the licensee can sell the licensed product. Your prospect will claim, correctly, that investment is needed for manufacture and marketing (and possibly development) and, for these reasons, needs an exclusive agreement. But remember that if you go this way you will have given up licensing your IPR to the sectors of the market that the exclusive licensee does not reach, probably more than 50% of the whole market. And what if the licensee fails to achieve success, or even to attempt to make a serious effort? You will have been advised, as a protection, to include a requirement for a minimum royalty in the agreement, but it will be low (believe me!). A better alternative would be a requirement to achieve minimum product sales. This will give you some recognition in the market. Enforcement of failure to meet a minimum target usually results in conversion to a non-exclusive agreement, but you might wish the opportunity to offer an exclusive agreement to another party by termination if the licensee fails to achieve the minimum – not easy to negotiate. Instead, it may be better to think about other restrictions on exclusivity. Time, and/or territorial limitations are a way of preserving flexibility while allowing some exclusivity. With any exclusive agreement be sure to check with your legal advisor about the possible impact of changes in the European Union “Block Exemption” rules, as they are changing and do affect exclusive license agreements in a large market area.
2. Sole License: Both your company and the licensee can “make, use and sell” products based on the IPR. It can be attractive for two relatively similar companies that often license rights that are, in effect, exchanged to minimize conflict. But for early stage companies with new technology it is an uncommon form of agreement.
3. Non-exclusive: You can have lots of licensees and you can compete against your licensees, but it better not to. There is usually no differentiation offered to licensees, so the commitment they make is most likely to be motivated by demand-pull. Have you the resources to stimulate the market? How else can you motivate them? Perhaps a brief period of exclusivity for a key licensee, or an initial restriction on the number of licenses granted will stimulate the market.

The choice among these alternatives is usually determined by the relative bargaining strength of licensor and licensee. Effective preparatory work by the licensor can provide the foundation for gaining negotiating strength.

The agreement should also define whether the licensee may sub-license, or may have the licensed product made by a sub-contractor. It may also be important to you to define the end-products with which the licensed product can be used, and the market sectors in which it can be sold.

The next issue is how to deal with improvements. The licensee will prefer to retain ownership, and in some countries this is a mandatory right. However, if the agreement is non-exclusive there is an advantage in requiring that improvements that come within the scope of the licensed patents shall be licensed by the licensee to the licensor, with rights to sub-license, and to include them in an “Improvements Pool” open to all licensees. Everyone gains and there is a route towards technical progress.

Payments

An early question from all prospective licensees concerns payments. Your preparatory work should include a search for any information that may be available about the norms in your industrial sector. There are some rules of thumb, the commonest being a royalty of 20% of gross margin on the licensed product. It is also worth attempting to calculate the contribution that the IPR makes, and if possible, to assess the saving in R&D effort. Normally a license will have an initial payment and also royalties on products sold. Some licensees prefer a “fully paid” licensee, but it is difficult to agree the amount. All licensees dislike royalties but recognise that a royalty is a convenient way to relate returns to success. Remember that costs decline with increasing output, and so should the royalty rate. As a general rule, licensors make more from relatively low initial payments and royalties.

The rights are usually licensed for the life of the patents in each of the countries in which patents have been, or may be obtained, but the IPR may include know-how and/or trade secrets that are important in exploiting the technology. There may also be a trade mark that the public associates with the product. These parts of the IPR are usually licensed under a separate paragraph, as they are not time-limited and provide an opportunity to extend the life of the agreement if you have protected the rights properly. The payment section can then provide that in a territory where there are no issued or pending patents royalty rates for the right to use know-how, trade secrets and trademarks are reduced, say by 50%, but continue in effect, winning an attractive continuation of the royalty flow.

We have now dealt with most of the elements of the agreement where there may be heavy negotiations. There remains a good deal of “boiler plate” covering books, recording and reporting sales, quality control (essential if a trademark is licensed), patent and trade mark enforcement, including requirements for mutual assistance, the term of the agreement and the basis for termination because of breach of obligations. It is at this point that the chosen route to “Alternative Dispute Resolution” should be included, if it is wanted.