The Basics of Patent Licensing
Part I: Is there an IP licensing opportunity?
Are you an inventor or an entrepreneur?
From KickStarter and Shark Tank to Tesla and Facebook, people are excited about innovation. Sure, Elon Musk and Mark Zuckerberg achieved incredible success, but their stories are one in a million. The truth is almost all startups fail. This article presents intellectual property licensing as an alternative to the startup route.
If you enjoy discovering customers, creating markets, and developing teams, then you may be an entrepreneur. A successful path may be to create a company and work on an exit strategy. On the other hand, if you enjoy discovering problems, creating inventions, and developing products then you may be an inventor. A successful path may be to create an intellectual property portfolio and work on a licensing strategy.
What can you do with intellectual property?
Intellectual property (IP) generally refers to creations of human intellect and creativity that governments reward by granting property-like rights to their creators. The basic types of IP are patents, copyrights, trademarks, and trade secrets. Patents protect new and useful inventions; copyrights protect original works of authorship; trademarks protect the goodwill of a business or brand; and trade secrets protect confidential valuable business information. For simplicity, this article focuses on licensing of product patents.
Assign a patent
An assignment is the transfer of IP rights from one owner to another, for example from an inventor to a company. This must be done in writing, and is often accomplished by language like “For good and valuable consideration I hereby assign all right, title, and interest in my Invention X to Company Y.” Assignments commonly occur when the assignor (e.g., inventor) prefers an immediate payment over a potentially larger but less certain payment in the future. Assignments are also common when the assignee (e.g., company) prefers to have control or ownership of the IP for strategic, accounting, finance, or tax purposes.
License a patent
Instead of “outright selling” IP rights as an assignment, an inventor may “lease” them as a license. IP Licenses are usually in writing due to their complexity, but they can be oral. The prototypical license establishes a running royalty to be paid by the licensor (e.g., company) to the licensee (e.g., inventor). Both parties may benefit from a license: the licensor can expect robust royalties if the invention achieves market success, and the licensee can expect not to pay royalties if the invention fails in the market.
Dedicate a patent to the public
An inventor can simply give away his IP or abandon it altogether. This is not generally a viable monetization strategy, but it may be a way to earn credibility as a prolific inventor or to absorb goodwill of a company who will put an invention on store shelves.
How are the relevant industries and markets configured?
Some inventions have a very specific market and an obvious distribution channel, for a non-stick frying pan. But some inventions span multiple markets, for example a low-friction coating. Understanding the markets are how they are configured can be a good starting point for licensing.
A non-exclusive license gives a licensee the right to exploit the IP, but the licensor may grant additional licenses to others concurrently. This can be advantageous for a licensor when his IP improves a product made by several companies having roughly equal market share, for example computers or shoes. Several lower royalty-rate licenses to several companies can earn substantially more total royalty revenue than a single higher royalty-rate license to just one company.
An exclusive license gives the licensee the right to exploit the IP, and the licensor may not grant additional licenses to any other party, nor may the licensor exploit the IP himself. Consequently, the royalty rate is usually higher than for a non-exclusive license. The scope of exclusivity can be based many parameters, such as field of use, geographic territory, or market channel. Exclusive licenses can be advantageous for both parties when the licensee is a large company with national or international channels to market. But they can be disastrous for a licensor when the licensee has insufficient market power to create or satisfy market demand.
A sole license gives the licensee the right to exploit the IP while permitting only the licensor to continue to exploit the IP. This is an uncommon arrangement that sometimes arises in cross-licensing agreements (where two parties each have intellectual property that the other wants to exploit).
Hedge your bets against an uncertain future.
An inventor may believe in the long-term market potential for his invention, but he may be uncomfortable relying solely on speculative future earnings from IP licensing. In this case the inventor may wish to trade-off some running royalties (future) for an up-front payment (present).
Up-front payment (lump-sum royalty)
An up-front payment, also called a lump-sum royalty, is a dollar amount the licensee pays to the licensor usually at or near the start of the license term. If the licensor suspects the IP is so weak that it may be easily designed around or that the technology is changing so rapidly that what is valuable today may be obsolete tomorrow, he may wish to trade-off running royalties for an up-front payment. On the other hand, if the licensee believes the market is unstable or consolidating or that the market is so competitive that a design-around is inevitable, it may wish to omit an up-front payment altogether. However, maximizing an up-front payment can be detrimental to both parties. It can limit how much cash the licensee has available to commercialize the invention, resulting in either poor execution and a product failure or slow time-to-market and a missed market window.
Running royalties are amounts paid to the licensor over time based on the revenue earned by the licensee from sales of products that embody the licensed IP. A licensor may wish to forego an up-front payment for higher running royalties if he believes the IP is so strong that it may never be designed around or that the technology is either unchanging or so fundamental that its value will endure. Similarly, a licensee may wish to offer an up-front payment if it believes the market is stable or growing or that it has so much market power that design-arounds are not a concern. However, maximizing the running royalty can be problematic for both parties. If the licensee erroneously assumes a rapidly growing market and continued market power, it may fail to achieve the economies of scale necessary to support the high running royalty.
Combination of up-front payment and running royalties
Up-front payments and running royalties are not mutually exclusive. It can be beneficial for both parties to balance these appropriately.
Part II: How to optimize an IP license?
What types of products will embody your IP?
Running royalties, commonly just “royalties,” are generally proportional to how well the licensee exploits the IP. The two most common methods to compute royalties are based on sales revenues (dollars) and based on units sold.
Royalties as a percent of sales
Royalties as a percent of sales—typically net sales and rarely gross sales—can be beneficial for licensors whose IP is embodied by expensive and low-volume products, or for products whose price is expected to increase over time. The percentage is normally fixed but can vary proportionally with sales volume.
Royalties per unit sold
Royalties based on the number of units sold can be beneficial for licensors whose IP is embodied by inexpensive and high-volume products, or for products whose price is expected to decrease over time. Like percent-of-sales, the per-unit rate is normally fixed but can proportionally with sales volumes.
Royalties per use
Technology that tracks user’s usage has given rise to royalty rates based on the number of times a product is used. Example uses may be when a user opens a smartphone app or when he queries a cloud-based server. The former is similar to royalties per unit whereas the latter is similar to royalties as a percentage of revenue.
Royalties per unit time (lump sum)
Sometimes it can be easier to compute royalties based on time, for example how long a computer program is active. Time-based royalties can use computed per month, minute, or any duration make sense.
What should you base running royalties on?
Licensors often focus on the royalty rate—believing higher is always better. But this is only half the story:
Licensor: “I’m so happy. I negotiated a 10% royalty rate!”
Friend: “Great! But 10% of what? Gross sales? Net Sales? Profits?”
Royalties based on gross sales
In most cases gross sales is simply the total of all invoiced amounts, in other words what the licensee charged its customers. It is rare to base royalties on gross sales, especially in industries like retail where it is customary for vendors (licensees) to pay for shipping, markdowns, and volume discounts.
Royalties based on net sales
Net sales is gross sales minus expenses related to the sale of products, for example shipping, returns, and trade allowances. This is the most common basis for royalty rates; however, it can be easily overlooked or misunderstood. A seemingly high royalty rate can be eviscerated by excessive deductions.
In many industries it is common to deduct the following expenses:
- Volume discounts. These usually increase total sales and therefore both parties benefit.
- Product returns. It can be unfair to pay a royalty on such an unprofitable transaction.
- Product freight and insurance. Customary.
- Local taxes. Customary.
A licensor should generally resist permitting the licensee to deduct of the following expenses:
- Sales commissions. This can encourage a licensee to pay excessive commissions.
- Marketing and/or advertising. These are normally the licensee’s costs of doing business.
- Unpaid debts. The licensor should not be accountable for the licensee’s customer management.
- Vaguely specified fees. Such catch-all categories can become sources of contention.
It is beneficial for a licensor to cap the total amount of deductions to some percentage of gross sales.
Royalties based on profits
Because there is so much variability in companies’ financial management and accounting, it is best to simply avoid using profits as the basis for royalties.
When should running royalties accrue?
A licensee almost always computes royalties when it ships goods, invoices for those goods, or receives payment from its customers.
Accrue royalties on shipment
Computing royalties when products ship can be an attractive option for licensors who rely on royalty payments for cash flow. However, if net revenue is the basis for royalties and there are extensive or delayed deductions, then accrual on shipment can complicate bookkeeping. For example, if the licensee pays the licensor quarterly royalties but it credits buyers for volume discounts annually, then the licensor may need to pay back the licensee for royalties paid in excess.
Accrue royalties on invoice
Computing royalties when products are invoiced is very common because it provides a clear basis for computation—the invoice quantity or amount. In practice, sellers often invoice buyers shortly after they ship products, so there may not be much practical difference in timing between accrual on shipment and accrual on invoice.
Accrue royalties on payment
Computing royalties on payment uncovers a subtle issue—not only does accrual determine when the royalty payments become payable, but it determines what the royalty payments are based on. Royalties that accrue on payment are based on products the licensee sold and received payment for. In other words, if the licensee never receives payment from a customer, then the licensee will pay no royalties on those products. A good way for licensors to negotiate against accrual on payment is to remind the licensee it is the licensee’s responsibility to choose its customer wisely.
How to ensure your IP is adequately commercialized?
An IP license can be worthless if the IP is never commercialized. Licensees sometimes exclusively license IP to prevent that IP from being commercialized (called shelving), usually if the licensee wants to protect its own competing product. A licensor should negotiate for some sort of assurance that the licensee will work diligently to adequately commercialize the IP.
If the license agreement is for an invention that requires significant time to commercialize, then it is customary for the parties to determine a schedule of milestones for the licensee to achieve. The licensee almost always pays the licensor a lump-sum amount for each milestone it achieves. The license agreement should clearly express what happens when the schedule slips for various reasons. Example milestones are “building a functional prototype” or “starting clinical trials.”
A minimum royalty is a quarterly or annual amount that the licensee must pay the licensor whether or not the licensee sells enough products to generate adequate royalties. This may be the most important provision of an IP license because it provides the licensor with some certainty for future income.
Minimum royalties align the parties’ expectations of the commercial value of the licensed IP. For example, assume the parties want an exclusive license for a simple invention having a market size around $10 million and agree to a 5% royalty on gross revenue. This should generate expected annual royalties of roughly $500,000. So if the licensee refuses to agree to a minimum annual royalties above $100,000, then it means the licensee may expect to capture just 20% ($2 million) of this market ($2 million * 5% = $100,000). In this case the licensor may want to propose a non-exclusive license with this licensee or to explore exclusive licenses with other companies who are more confident that they will fully serve this market.
Importantly, minimum royalties provide a straightforward way for to modify or terminate an agreement with an underperforming licensee. For example, if the licensee falls short of one minimum royalty payment then the license could convert from exclusive to non-exclusive; if the licensee misses two payment then the license could terminate. Minimum royalties are no guarantee of commercialization, though, because the licensee can usually just pay these minimums out of pocket—as long as it can afford to do so.
Who should get rights to improvements to the IP?
It is important to consider whether the IP may be further developed and by whom. Which party will own and/or have rights to such improved IP depends on many factors, including: (1) the size, sophistication, and business models of the parties; (2) the strength and maturity of the IP; and (3) the amount of research and development required to commercialize the IP. A reasonable rule of thumb is that the party who creates some improved IP owns that improved IP.
Retain ownership to improvements
A licensor whose business is creating and licensing IP may want to negotiate to retain rights to all improved IP created by either party. This prevents the licensee from inventing around the licensed IP and thereby undercutting the licensor’s business. A licensor may retain ownership of improved IP but agree to license it to the licensee at some fair market value.
Grant ownership to improvements
Most licensees want to own improved IP that its employees create or which it paid to have created. This is a reasonable expectation, especially when the licensee is in a better position than the licensor to file, prosecute, and maintain the improved IP. Further, a licensee may ask for an automatic license to all improved IP created by the licensor. While seemingly unfair, the licensee is simply protecting its investment in the licensed IP. This prevents the licensor from creating improved IP and then demanding additional royalties and/or up-front payments while threatening to take the improved IP to a competitor.
Agree that each party owns improvements it develops
Licensors and licensees generally operate at arm’s length and may therefore further develop the IP without regard for the other party. In this common situation each party pays to develop and protect the improved IP it creates, and consequently owns such improved IP. Whether the other party gets rights to the IP up for negotiation.