technology license agreement

Part I of this two-part series on technology licensing dealt with the non-financial terms of a typical microsoft samsungtechnology license agreement: subject matter, scope, territory, exclusivity, sublicensing and improvements.  This Part II of the series will deal with the most contentious aspect of any license agreement, the financial terms, which are usually negotiated last.  The reason that the terms that the parties probably care most about are negotiated last is that it is only after issues like subject matter, scope and exclusivity are defined that the parties know exactly what they’re pricing.

In terms of perspective, the licensor should know at the outset of negotiations how much it will need in order to achieve a positive return on its investment in research and development for the technology.  The licensee, on the other hand, will need to figure out how much it could afford to pay the licensor after taking into consideration the production and other costs it will incur and in the context of what the market will bear (i.e., what it could charge for the finished product).

Technology license payments fall generally into one of two categories, lump sums and royalties, with licensing deals often consisting of a combination of both.

Lump Sums

lump sumLump sum payments can be made at one time (e.g., at closing) or on a periodic basis (e.g., on designated anniversaries), and can also be made contingent upon achievement of certain milestones. For example, in a biotech licensing deal, typical milestones might be designation of a lead compound, filing a new drug application, completing a clinical trial or consummating a first commercial sale. A lump sum payment is often thought of as the licensee’s cost of admission, and a way for the licensor to recoup some of its investment.  These payments could also be made creditable against future royalties, which could in turn justify higher royalty rates.

Royalties

Royalties are a function of the use of the technology and for that reason are more prevalent than lump sums in licensing deals. Royalties have two components: base and rate.

Royalties could be based on things like manufacturing cost, units produced or net profit, but these are seldom used.  Manufacturing cost and profit are deemed to be sensitive proprietary information that the licensee would rather not reveal.  Basing royalties on units produced is simple from an accounting standpoint: count the units made and multiply by the fixed royalty amount per unit.  The problem with units produced from the licensee’s perspective, however, is that the licensee may produce lots of product but not sell much.

For the foregoing reasons, royalties are more often based on sales, either units sold or the dollar amount of such sales.  Units sold has the appeal of simplicity: just count the number of units sold and apply the applicable rate per unit.  In this case, the licensor may consider negotiating for a periodic adjustment of the rate based on some index such as the producer price index.  Royalties could also be based on the dollar amount of sales.  The most prevalent measure of sales in license agreements is gross sales minus those costs that are unrelated to the technology such as packaging and shipping .

royaltiesThe second component of every royalty arrangement is the rate.  The key to success of most licensing deals is choosing a royalty rate that is high enough to enable the licensor to earn a return on its investment, but low enough to make it profitable for the licensee.  Too low a rate could lead the licensor to reduce or eliminate further investment in research and development.  Too high a rate will leave the licensee with little or no incentive to produce and sell licensed product.

The royalty rate need not remain constant.  The rate could start out relatively low and increase either over time or as sales grow.  This would help enable the licensee to develop a market or achieve profitability as it builds market share.  Alternatively, the rate could also decrease as volume increases; this would incentivize a licensee to sell lots of product and get out from under the burden of the higher royalty rates.

Licensors very often negotiate for minimum royalties, particularly when the license is exclusive.  If the exclusive licensee is underperforming, the licensor will want to have the right to take back the license or terminate exclusivity; otherwise the licensed technology may never reach its potential.  The minimum could also be variable, increasing over time, e.g., $250,000 in the first year and increasing by $50,000 each year thereafter.  The licensee could try to negotiate for a license that becomes fully paid-up upon the payment of some agreed upon amount of aggregate royalties over the life of the agreement.

If you’re developing a product that requires certain technology that can’t be developed in-house (because of cost, time, human resources or complimentary assets), it might make good business sense to use technology that has already been developed by others and is available on the market. 

A technology license is essentially an agreement between the licensor (the owner of technology) and the licensee (the party that wants to use that technology), in which the licensee gets the right to use the technology and the licensor gets something of value in return.  I’ll deal with the value in return side in Part II of this two part blog series.

Technology licensing only occurs when one of the parties owns intellectual property, which gives that party the legal right to prevent others from using it, and so a technology license can be viewed as a consent by the owner to use the IP in exchange for something of value.

Although the key terms of a technology license agreement vary depending on what sort of technology is being licensed, similar issues arise in all transactions in which technology containing intellectual property rights is being licensed.  This Part I of a two part series on technology license agreements will cover non-financial terms.  Part II will cover financial terms.

Subject Matter

What exactly is the thing that’s being licensed?  This sounds pretty obvious, but it’s an underestimated issue that could lead to disputes if not identified accurately.  The technology being licensed could be a product, software program, formula, specification, protocol, documentation or a combination of these. The licensor will generally seek to narrow the definition of what’s being licensed, while the licensee will typically seek a broad definition of the technology.  In approaching this issue, think about whether you need only a patent license or rather the right to use a particular product or technology that practices the patent?  Also, if you need a license to use the name or logo of the technology or product in connection with the sale and distribution of your product, then you’ll need a trademark license in addition to the patent license.  This would be the case, for example, where the technology or product alone is not as valuable as the product distributed with a familiar trademark.

Scope

Scope deals with what it is that you’ll be permitted to do with whatever it is you’re licensing.  A broad scope will give you greater flexibility; a narrower scope will be less expensive.  The grant may include the right to reproduce the technology, display it, modify it, make derivative works from it, make it or have it made, distribute or sell it or sub-license it to others who may do any or all of the above. 

The scope of the license should conform to your needs. You may only need the right to distribute the technology in its existing form, for example a distribution license for a commodity product. On the other hand, you may need to make fundamental changes to the licensed technology, create new versions and distribute the new versions to groups of sub-licensees who will also have the right to reproduce and customize the technology.

Territory

IP rights are territorial, and the license agreement must specify whether your rights are worldwide or specific to designated countries or regions. In negotiating the territory, you need to consider where you plan to manufacture and sell. Also, where do you plan to distribute products bearing the mark or logo? The license agreement should be clear that you have the right to display the mark “in connection with” the sale of products throughout the territory.  If you plan to distribute products electronically or on the Internet, the license agreement needs to provide as much.

Exclusivity

Exclusivity is one issue on which it’s tough to reconcile the interests of the licensor and licensee.  The licensor will generally resist “putting all his eggs in one basket” with an exclusive license because it limits his freedom to expand through, and earn royalties from, other licensees.  It may also result in the technology never becoming commercially successful if the exclusive licensee underperforms. 

An exclusive license could be justified, however, when the licensee is making a significant investment to commercially exploit the technology, and where the investment cannot be used for a different purpose.  This would be the case, for example, if the licensee is investing in custom equipment, hiring specialized labor or setting up a business in a new territory.  In these situations, there are ways to mitigate against the exclusivity risk to the licensor. For example,exclusivity could be conditioned on the licensee achieving certain minimum royalty payments or product sales.  Also, exclusivity need not be made coterminous with the license period; instead, a “head start” provision can limit exclusivity to a shorter time period during which the licensee can establish his business. 

Somewhere in between exclusive and non-exclusive is a “sole license”, in which the licensor will not license any other licensees but has the right to continue using the technology himself. 

Sub-Licensing

The licensee may want the right to grant sub-licenses in the territory, particularly in an exclusive license. If so, this needs to be specifically negotiated and stated in the agreement. Two aspects of this issue that often get hotly negotiated are whether the licensor’s prior written approval is required for granting any sub-licenses (and the circumstances under which such prior approval would not be required), and whether or not the sub-license comes to an end when the primary license is terminated or expires for any reason.

Improvements

Very often, the licensor will continue research and development efforts during the term of the license agreement, which may lead to new versions, enhancements or new models of the technology.  The licensee would have legitimate concern that the licensor may come out with another release, version or product and offer it to a competitor of the licensee, or that the licensor’s new offering will render the “old” licensed technology product obsolete.

It’s important for the license agreement to define what is an “improvement”, and therefore covered by the license, and what is a new technology or new intellectual property, which is not covered and which may necessitate a new license agreement. Coverage for improvements could occur automatically, or the agreement could provide that there would be an option in favor of the licensee.

In Part II of this two part blog series, I’ll discuss the financial terms of license agreements.