Licensing

LICENSING FOR PROFIT

 

From driver’s licenses to hunting licenses and business licenses, we are all familiar with what a license is. A license is a right to do something that would otherwise be prohibited, given by someone in authority to authorize the activity. In the realm of entrepreneurship and intellectual property, licensing is a key concept to understand because it opens up tremendous business opportunities. Intellectual property (“IP”) has long been recognized as adding value to a business, in the form of patents to protect products, trademarks to create brand recognition, and copyright to protect creative works and works of authorship. However, licensing is a way to extend and elevate the value of intellectual property from protection to direct revenue generation.

Licensing also offers flexibility and alternatives to the fundamental question of whether to build or buy what you need in your business, whether it is technology, sales force, branding, etc. Licensing makes business less about who owns an asset and more about who controls an asset and in whose hands the intellectual property can be best put to use. Licensing is about leverage – getting better results with what you already have or can obtain access to. It is a key ingredient to effective collaborative business models, and some not so collaborative models.

Using licensing in your business model, you can change your thinking from viewing intellectual property and its enforcement as a necessary business expense, to thinking of intellectual property as an important aspect of your business development and revenue generating plans. Further, licensing is not limited to patents. It can be applied to nearly any intellectual property.2

Owners of intellectual property – whether patent, trademark, trade dress, copyright, trade secret3, possess rights incident to ownership. In the case of patent, for example, ownership entails the right to exclude others from making, selling or using the patented invention. Some individuals misinterpret the patent owner’s right to exclude others from doing something as an absolute right of the owner to do or make the patented thing themselves. In some instances, however, those rights are not absolute, but are subject to the rights of other owners of patented technology as well.

Many law students are introduced to this concept with the following classic example of the three-legged chair.

 

The Patented Three-Legged Chair
Consider Inventor A has invented and patented a three-legged chair. The patented scope of the invention is a seating platform supported by three legs. Thus, Inventor A has a right to exclude others from making, using and selling a chair having three legs4. As a practical matter, Inventor A can use his right to exclude others to give himself a market advantage as the only person able to commercialize the three-legged chair for the life of the patent.

Now consider that Inventor B finds the three-legged chair to be too unstable, but when the platform is supported by a fourth leg, the chair is much more stable. Imagine that Inventor B applies for a patent and is successful in patenting the invention of the four-legged chair as a seating platform supported by four legs. When it comes to commercializing the four-legged chair, is Inventor B unfettered in his right to commercialize the four-legged chair even while Inventor A’s patent for a three-legged chair is in effect? What about a third inventor, Inventor C, whose patented invention is the student desk which is a four-legged chair with integrated writing surface?

The short answer to both questions is “No” – both the four- legged chair and the student writing desk infringe the three-legged chair patent, because the four-legged chair in both instances has three legs. The fact that it also has a fourth leg, which is in and of itself a patentable improvement, does not diminish the fact that it has three legs and infringes the patent for a three-legged chair. Further, Inventor C infringes both Inventor B and Inventor A if he proceeds to manufacture student desks, even though his chair with integrated writing platform is itself a patented improvement. For the life of the three-legged chair patent, Inventor A has a right to preclude others from making, selling or using any chair having three or more legs, because all inherently have three legs. Inventor B, and others interested in dealing in chairs having three or more legs have a duty to respect the rights of Inventor A for as long as the patent for the three-legged chair is in effect. Inventor C must respect the rights of multiple prior patent owners in pursuit of his own business surrounding student desks.

 

Setting the Scene for The License
In the example above, Inventor A has created a situation with licensing potential as the owner of three-legged chair technology. Inventor B may go merrily on his way making and selling four-legged chairs without regard to Inventor A’s patent.5 However, such action would infringe the rights of Inventor A. Inventor B’s manufacture and selling of four-legged chairs is subject to the risk that Inventor A may enforce his patent by suing Inventor B for infringement damages. Worse yet, all of Inventor B’s distributors may be subject to similar risk for selling, and his end customers may be subject to risk for using, the infringing chairs.

Everyone in the chain of commerce of the infringing product has become a potential target for an infringement suit by Inventor A. Inventor A has been given the authority, by statute, to enforce its patent. It follows then that Inventor A has the authority to grant licenses to those whom he permits to deal in three-legged chairs, and others whose products, like the four-legged chair or student desk, would otherwise infringe on his rights. Thus the license could be freely negotiated between the inventors or their assignees, for the benefit of both patent owners.

Patent rights are typically assigned to a company; usually the employer of the inventor or the sponsor of the research. For the ensuing discussion, Inventors A, B and C, will be substituted with Company A, B and C. Under this construct, Company A is effectively the gatekeeper to the market for three-legged chairs and all chairs dependent on this patented technology. Company A can use the patented technology and make three-legged chairs and exclude all other infringing product manufacture and sale. But, interestingly, Company A can’t make, use or sell four-legged chairs or student desks without infringing others, because those patented technologies are owned by Company B and Company C, respectively.

 

Voluntary Licensing
In the chair example, Company B would be wise to have researched the market and been aware of the patent rights of Company A.6 Once those pre-existing rights were identified, Company B could approach Company A for a license to use its patent. This function is often the domain of a licensing executive in the technology office or business development arm of the business or organization. For entrepreneurs, it is just another of your many hats.

Often the patent owner/licensor is interested in licensing the patent to the licensee because the licensee has an interest in, and ability to expand the licensor’s reach to new markets. In a licensing transaction, the licensor grants the license for the licensee to use the licensor’s technology in exchange for a royalty paid by the licensee. The net result is that the gross revenue from the licensee will be less that would have been realized from the sale of the actual goods, but without the licensor incurring the costs and allocating the resources typically required to produce such sales.

For example, the licensor doesn’t need to build new sales force, engage in new marketing, buy tooling, carry inventory or incur other typical costs of sales to enjoy the benefits of the increased market and revenue. The royalty itself becomes the revenue source, one without a direct cost of goods sold and without most indirect costs. Consequently, a licensing transaction can be very profitable. It is sometimes considered easy money with the effort of receiving the royalty often jokingly considered to be that of picking up the check from the mail. But there is a great deal more to it, not the least of which is the creation of the underlying subject matter of the license.

Compulsory Licensing
Assume that Company B did not approach Company A for a license to the three-legged chair technology it would have been infringing Company A’s patent by making or selling the four-legged chair. In the case where a patent or other intellectual property has been infringed, the owner of the infringed property can demand the infringer take a license to avoid further infringement. These interactions often start with the patent owner sending a demand letter advising the infringer of the infringement and demanding that the infringement stop or that the infringer take a license to continue operating in the protected space. In response, the infringer may agree to a lump sum settlement for past infringement together with an ongoing royalty to be paid by the infringer/licensee under the terms of a new license agreement.

In the event no settlement can be reached, the patent owner can file suit to obtain a judicial remedy. In some cases, patent owners skip the demand letter and jump right to suit, using the suit as additional leverage to force the license either through settlement of the suit, or ultimately by obtaining a favorable judgment through the courts. Patent litigation is often high-stakes, bet-the-company litigation where a negative result can put a company out of business. Sometimes, it is only a licensing deal that can save the infringing company from closing its doors entirely.

 

Anatomy of a License
In practical terms, licenses are just special purpose contracts, so standard contract principles apply. Common provisions include identification of the parties, the purposes and term of the contract. Definitions of key terms or terms of art in the industry that are critical to understanding the deal should also be included.

Special subject matter for licenses includes key provisions defining what the scope of the license is, often referred to as the license grant. It may also address what is expressly not granted, whether by reservation of rights by the licensor or license restrictions. It may identify what is included to be delivered to the licensee as part of the license, or items that may be required to be purchased by the licensee. Whether or not the license is exclusive or includes the right by the licensee to sublicense are also included here. Licensees may also be granted “most favored” status meaning they will always get the most favorable licensing deal available to any of the licensor’s licensees.

Because technology is improved over time, and frequently in response to market demand which may be in closer communication with the licensee than the licensor, it is important to address what is to become of improvements made by either the licensee or the licensor. This includes such issues as whether improvements will be included in the license, which party will secure patents, which party will pay related costs, and which party will be the assignee of the patented improvement. The status of the licensed subject matter is also very important.

The parties will generally make representations and give one another warranties related to the deal. In the case of the licensor, representations and warranties may include that the licensed patent is valid and that the deal being executed is not in violation of any other deal the licensor has. A licensee, on the other hand, may represent and warrant that it is authorized to enter the transaction. Both parties may want to define what the consequence should be in the event a representation fails, such as by a licensed patent being subsequently challenged or invalidated, or in the event the license is breached or terminates while any litigation or other issue is pending.

Because many patent licenses are compulsory licenses arising from infringement situations, many licenses will address issues related to the resolved infringement, such as forgiveness for payment. They will also frequently address what each party’s duties are with respect to infringement by others, considering such infringement may affect the market and the value of the license. These provisions may assign which party is responsible to file suit against infringers or, conversely, to defend suits brought by others alleging infringement by the subject patent or licensed products.

Equally important is the consideration to be paid for the license. Licenses may be royalty free or royalty bearing. Royalty bearing licenses may be paid with royalties stated as a percent of sales or profits, fixed amounts, per unit amounts or other combinations. Royalties may also be triggered by the completion of milestones reached by either party. Further, the licensee may be subject to minimum royalties, even if milestones aren’t met, and and such minimum royalties may be credited against earned royalties.

In connection with payment, currency must be designated. In the event of international transactions there may be issues of currency exchange. In addition, royalties may be paid in equity as opposed to currency. Equity deals open up a whole range of issues such as what company’s equity is to be used, licensee or a new company, valuation of the stock and class of stock to be used as consideration.

A number of training, reporting and auditing matters are also important to be addressed.7 These may include the type and frequency of licensee inspections, if any; and technical support that may be provided to train and enable the licensee. The nature and frequency of licensee reporting is also important to address.

Lastly, the license will also include typical boilerplate provisions concerning interpretation, integration of any preceding oral arrangements, choice of law, dispute resolution, notice, assignment, and signatures. Consistent with other business contracts, the parties to the license agreement have latitude to make the best agreement they can mutually agree upon. Of course, as with other agreements, there could be a significant disparity in the bargaining power of one of the parties over the other, especially in the case of the compulsory license.

 

The License Grant
In an effort to give some additional substance to the lists above, some additional detail is provided here. The grant both identifies and defines the scope of what is being licensed. For instance, licenses can be so complete as to be almost an entire conveyance of the intellectual property being licensed. Licenses can be granted that are perpetual in duration, cover the entire world, and every market channel, without an obligation to pay royalty, and include all liability and obligations of maintaining and enforcing the licensed intellectual property falling on the licensee. On the other hand, the license can grant less than all of the rights on any one or more of a multitude of aspects. An example would be narrow license for a specific use, in a small market, for a limited period of time and requiring reasonable royalties.

 

Territory
A license can be granted to a defined territory. Territories can be actual geographic territories, or they can be defined as markets, or combinations of the two. A licensee could be granted rights to market only in a certain territory defined as a certain continent, in certain countries, or states within a country. Alternatively, a license could be granted only for the licensee to sell in a certain marketing channel, such as through specific named big-box retailers, or through an online storefront. Obviously care must be taken to ensure that the rights granted to multiple licensees are consistent and avoid conflict. For instance, you wouldn’t want to grant rights to one licensee in a geographic territory, and to another according to market channel, where the territory granted to the first and the channel granted to the second may overlap.

Some technologies may have application in different industries. If so, it may make sense to grant a license to one licensee limited to the industry where it has a strong market presence, but grant another license to a second licensee strong in another industry. Basically, the goal should be to put the license in the hands of the party best capable of being successful in commercializing your intellectual property, and defining the scope of the license to coincide with the licensee’s strength.

 

Term or Duration
As a company grows and evolves, so does its licensing needs. Licensors and licensees may grow along with one another, and be a substantial reason for one another’s mutual success, but that is not always the case. The licensee you have at sales of $1 million, may not be the licensee you want when your target is sales of $100 million. Consequently, you may want to have a way out of the license in three to five years. At the same time, licensees may be reluctant to deal with you if your time horizon is so short that they may not recoup their investment over the term of a short license. These things should be taken into account when negotiating the duration, and possible renewal, of the license agreement.

 

Performance
Typically, you enter a license agreement to obtain a commercial advantage you couldn’t achieve yourself, or don’t want to allocate resources to. Even so, a nonperforming licensee is no better than having no licensee at all, and it can be worse. Therefore, it is common to require the licensee to meet certain performance standards as a condition to maintaining or renewing a license. These are generally measured with the same criteria the royalties are calculated on, namely sales volume or pieces sold, etc. In a startup without sales history, it may not be unusual to have the licensee commit to a certain level of investment in the development or marketing of the technology, in the form of dollars budgeted and spent on the project in lieu of sales benchmarks, at least until sales becomes, or should have become a reliable measure.

Performance may also relate to the quality of the product or service delivered by the licensee. Especially in the case of trademark licensing, which denotes that the goods or services provided originate from the licensor, you want to include the performance criteria or product specification subject to the license, and include a right to inspect or audit the goods and services for compliance with the specification, as well as auditing the correct use of the mark.

 

The Royalty
The royalty component of the license is often stated as a royalty rate, usually a percentage of sales. It may be based on gross sales or net sales, or some other meaningful measure. Gross sales is often a preferred sales measure because net sales or profits are often subject to differences in accounting methods and may be manipulated to reduce reported amounts. Alternatively, royalties could be stated as a piece rate. Royalties may include fixed, lump-sum payments as well as variable payments.

With regard to establishing an appropriate royalty rate, valuation of the intellectual property is important. There are a variety of valuation methods, including cost, market value and income approaches. While these are useful in establishing boundaries, in practice you will get whatever you can negotiate. Further, different industries, or different levels in the chain of commerce, tend to have different typical royalty rates. If you research your industry, you will become familiar with royalty rates commonly paid for certain types of licenses in your space, but always keep in mind, no two deals are exactly alike. Be willing to be flexible to get the licensee or the deal you want. At the same time, if you intend to grant many similar licenses, standardization will help you keep track of them better from a compliance perspective.

As your business grows, there may be times you need strong data to back up your royalty rates. For this purpose, there are data aggregators whose businesses revolve around the collection and sale of royalty data. In large commercial transactions, it is not uncommon for parties to pay tens of thousands of dollars to such companies to obtain reliable and well documented royalty information to support their decision making and negotiations in such transactions.8

In some cases, you may not want to charge a royalty at all. This is particularly true where the license is one concerning a trademark and the purpose is to promote the broad recognition of the mark. Allowing the mark to be freely used encourages its use by the licensee, under your supervision, and allows the licensee’s efforts to augment your own efforts at building brand strength and good will. In this regard it is important to document that trademarks obtained will be obtained in the licensor’s name and that the good will associated with them belongs to the licensor on termination of the license. Otherwise you may encounter disputes when switching trademark licensees at some time in the future.9

Licensing Examples
Following are examples of both low piece-rate, and high piece-rate royalties. The first is a royalty for a license on a proprietary yet common electrical connector used ubiquitously in computing devices. The royalty may be an initial lump sum amount to have access to the technology, of perhaps $10,000, followed by a small amount per connector used in a device, on the order of cents per connector. In a market where millions of devices are sold, and assuming 10 such connectors per device, even a

$0.05 royalty per connector could result in millions of dollars in revenue during the life of the license.

The second example is that of a an airfoil design that when incorporated into a commercial aircraft results in fuel efficiency saving the airline millions of dollars in annual fuel economy. Such an item may command a royalty of tens of thousands of dollars per installation, not necessarily because the item is inherently that expensive to produce, but due to its economic benefit, it is that valuable to the licensee or its customer.

Compliance
Obtaining and measuring compliance with a license is always important. This is especially true in the case of compulsory licenses where the licensee was not interested in licensing in the first place, having previously decided it was better to go around you than through you to employ your technology or intellectual property. Therefore, including provisions to assist in obtaining compliance is important. The administrative burden of ensuring compliance is also one of the costs of licensing.

Obtaining compliance with a license is best when you have done a good job of selecting a readily available revenue or profit metric as

the license base. The license agreement should require that the metric be reported on a periodic basis. This could be monthly, quarterly or annually. This typically corresponds to the period for which royalties are paid, however it doesn’t always need to be so. It is possible to have the license be an agreed flat, or rolling average monthly rate which is an estimate, with a periodic reconciliation to actual on a less frequent basis.

Regardless of the royalty structure, the periodic reporting is intended as a way for the licensor to review the number and determine whether the payment of royalties is consistent with the numbers being reported. There can be discrepancies even between what is reported and paid, and what should have been reported and paid. While these discrepancies may result from unscrupulous licensees, they may also result from human error in data entry, poorly selected metrics, or poor implementation of the selected measurement in the management information system or reporting tool. For this reason, it is important to have a provision that enables the licensor to audit the licensee periodically, either directly, or more commonly through its agents – a CPA or consulting firm retained by the licensor specifically for that purpose. To avoid the overuse of the audit right and the intrusion and interruption it imposes on the licensee, such audit rights should be limited in frequency, commonly no more than once annually. It is often common to limit how far back such an audit can go, to avoid reauditing the same period multiple times, but to ensure you can audit all time periods once unless waived.

 

Licensing as a Business Development Tool
In the chair example, there were several licensing opportunities. Without licensing, and without infringing, the only active business would be that for three-legged chairs. By engaging in licensing, the licensor of the three-legged chair could increase its revenue by licensing both Company B and Company C to market their own four-legged products under the license. Company A could go a step further by licensing Companies B and C, or other third parties, to produce three- legged chairs as well, increasing the number of sources for its own patented invention in the process. Company A could go further still by obtaining licenses from Companies B and C , so-called cross-licenses, so that Company A could enter the markets for four-legged chairs and student desks to augment its own product line.

If Company A prefers to deal with fewer people, Company A could license Company B to not only use the three-legged chair technology but to license it to others in a sublicense, in exchange for a higher royalty. That way, Company B could license to Company C a package with both the three-legged chair and four-legged chair technology. The royalty to Company A need not be at a higher stated rate, it could be higher in the sense that it is charged on a larger base of both the Company B sales and Company C sales, channeled and reported through Company B. Thus the possible business combinations and relationships between licensors and licensee can be endless depending on the structures and technology combinations desired.

 

Intellectual Property as the Business
The value of intellectual property has become widely demonstrated, not just as a component of a viable business, but as the basis of the business. Entire companies have been established for the sole purpose of acquiring, maintaining and enforcing intellectual property rights. It is the business model of so-called “Patent Trolls” to acquire patents, monitor the market for potential infringers, and pursue such infringers to obtain infringement damages and compulsory licenses.

More commonly, however, intellectual property development, acquisition and monetization occurs in the course of ordinary business, springing up around things the entrepreneur or business is already doing or intending to do. Consequently, most intellectual property is developed internally for use in the business, but that doesn’t have to be the case.

 

Identifying Licensing Opportunities
Many entrepreneurial minded individuals or existing businesses may find that a diligent search of existing intellectual property could help them find a match in something they would like to pursue commercially. This is true of venture capital groups as well. It is growing increasingly common for venture capital to be channeled into special purpose funds the sole purpose of which is to search out and identify suitable candidates for acquisition, and further development.10 In similar fashion, inbound licensing candidates can often be found using similar methods.

In the licensing space, licensing target candidates are often found among the surplus in portfolios of companies that have existing IP but ultimately opted not to pursue the related project for one reason or another. This is particularly true of large organizations that have high required returns on investment or pursue only projects having a certain minimum potential market size. Smaller organizations with lower ROI requirements or smaller target market requirements may be willing and able to profitably take on such projects. In these scenarios, both the large organizations as licensor and the smaller organization or individual licensee win. The large organization can outbound license its small projects and recoup costs and gain revenue from what would otherwise be an abandoned project, and the small organization licensee can inbound license a project that may already have substantial research and development and proof of concept behind it, and supply the needed manpower and marketing resources to see it through.

Bankruptcy estates may also be good sources of existing intellectual property that could be revived and used successfully by new management or repurposed in new markets.11 University technology transfer offices are also good sources of existing intellectual property that may be suitable for commercialization outside the university setting. These scenarios may be more suited to outright acquisition, but licensing opportunities are also possible.

Franchising is an example of elaborate application of licensing principles. In a franchise agreement, the franchisee licenses from the franchisor the entire business model, generally including all the patents, trademarks, and other intellectual property, and further including related infrastructure resources and support, but usually limited to a finite geographical territory.12

Academic Resources
The research university setting provides another interesting licensing option. Not only do university technology transfer offices maintain portfolios of university developed intellectual property for outbound licensing, they are frequently in a position to assist inventors and companies in developing outside intellectual property. A university may be able to take on a project either on a contract basis for hire, under a collaboration agreement as a university project when aligned with existing university sponsored research, or in conjunction with federally funded research grants. However, the potential downside of these collaborations can be that the resulting improvements in the intellectual property are encumbered by obligations to the government or the university. Nevertheless, they can be good options under the right circumstances with both parties benefitting, and having opportunities to commercially exploit the results, typically through cross-licensing arrangements.

 

Conclusion
Licensing can be a powerful addition to a business plan. Licensing from others, granting licenses to others, or both, can add to your market reach and market penetration and increase your product offering. Licensing offers a way to increase revenue with low direct costs, leveraging the resources of others. Opportunities to license are highly available, if you know where to find them, and readily implemented through typical contracting principals. Taking time to identify your own intellectual property, and that of others operating in your markets, will surely reveal licensing options. Don’t let them go to waste. Turn unused or underutilized intellectual property assets into profits through licensing.

 

Additional Resources
Additional information on licensing can be found through the following organizations, to name just a few:

The Licensing Executive Society (“LES”), at www.lesusacanada.org;
The Intellectual Property Owners Association (“IPO”), at www.ipo.org;
Association of University Technology Managers (“AUTM”), at www.autm.net;

 

The World Intellectual Property Organization (“WIPO”), at www.wipo.int;
The International Trademark Association (“INTA”), at www.inta.org; and
The Copyright Clearance Center (“CCC”), at www.copyright.com.