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Licence terms

Licence terms: Exclusivity

In most cases a licensee will request an exclusive agreement.  Exclusivity involves certain risks for the licensor, in particular, the risk that the licensee will be a poor performer and will effectively tie up the technology, resulting in a low return for the licensor.

As there is more risk for the licensor, the licensor can charge a premium royalty for an exclusive licence.

The licensor, before agreeing to exclusivity should impose definite performance obligations upon the licensee, which if not met, will entitle the licensor to either terminate the agreement or convert it to a non-exclusive licence.  These may include minimum royalties, best efforts clauses and such like.  See the section below on performance obligations for more detail.

The licensor need not make all the rights granted exclusive.  For example, the right to manufacture may be exclusive, while the right to market may be non-exclusive; the rights in New Zealand may be exclusive, while elsewhere the rights are non-exclusive; or the rights to one field of use are exclusive, while others are non-exclusive.

A final point to note with exclusive licences: the licensee may have certain statutory rights to take infringement action in its own name (for example, under the Patents Act 1953, Trade Marks Act 2002 and Copyright Act 1994).  These rights can and should be contracted out of in the licence agreement, if possible.

Licence terms: Field of use

If a product or process has or may have more than one potential use/application, the licensor should only grant rights to the licensee in respect of the uses/applications in which the licensee can demonstrate the necessary experience and competence.

Even if the licensor believes there is only one use/application for the product or process, the licence should be drafted to grant rights to that particular use/application.  There have been numerous examples in history of a product that was first thought to have only one use actually performing better in another use.  The licensor wants to avoid inadvertently granting rights to these undiscovered uses/applications, which in the long term may be even more valuable than the known use/application.

Licence terms: Territory

Very few companies truly have manufacturing and marketing capabilities in all countries of the world.  A licensor should avoid granting worldwide rights unless the licensee is one of these multinational companies.

While there is always a temptation to try to do one mega-deal for the entire world, this may not be the best approach.  Picking the best possible licensee for each region of the world will usually result in the maximum return to the licensor, even though it involves more negotiation and deal making and relationships with multiple licensees.

If the extent of the territory is an issue for the licensee, the licensor could consider a number of alternatives to give the licensee some concession while minimising the licensor's exposure to risk of poor performance:

• Grant worldwide rights (or a large territory) but include the ability to terminate the rights on a country by country basis in the event there is no or insufficient activity in the country after a certain period of time.
• Grant rights to a limited territory, but grant a right of first refusal to additional territories.
• Impose minimum royalties on a country by country or region by region basis.

Licence terms: Duration

A licence is usually for a fixed term not exceeding the life of the IP being licensed, except where the IP has an indefinite life span, such as trade marks and trade secrets.  Agreements having 5 or 10 year durations are common.

It is also relatively common to provide for rights of renewal.  However, we recommend inserting a provision to prevent a licensee from exercising a right of renewal if the licensee has been in breach of the agreement at any point during the initial term.

Any licence of a patent can be terminated upon giving three months written notice in the event that the patent ceases to remain in force, even if the contract itself provides otherwise, by virtue of s67 of the Patents Act 1953.

In Europe, a licence of a trade secret or know how that purports to remain in force after the information is publicly available, or patent licence imposing royalties after expiration of the licensed patent, may fall foul of Article 81(1) of the EC Treaty.

Where an agreement does not provide a term, and accordingly there is apparently no way out of the agreement without breaching it, the courts have implied into those agreements a term permitting termination on reasonable notice.  Very explicit wording would be required before a court would conclude that an agreement was truly intended to be perpetual.

Licence terms: Sign-on Fee

A licensor will often require a lump sum initial payment (or sign-on fee) as part of the consideration for the licence.  Degnan and Horton indicate that 60% of licences have upfront fees (Degnan, S. and Horton, C. "A Survey of Licensed Royalties" les Nouvelles June 1997).

The payment is designed to create immediate commitment to the relationship on the part of the licensee.  The money is useful to the licensor as it may provide funds for further IP protection, or represent recovery of a portion of R&D costs.

Generally, the higher the sign-on fee the lower the ongoing royalty.

One author suggests that the upfront fee should be about 15% of the "modified replacement cost" of the technology (Betten, P. "Valuing Upfront License Fees" les Nouvelles March 2000).  The modified replacement cost is based on the time, materials and equipment the inventor would need (knowing what he/she now knows about the invention) to rediscover or create the technology, with an adjustment depending upon how easy it would be for an independent person to invent around the technology.

If the licensee is unwilling to pay a significant sign-on fee, and the licensor requires funds in the short term, consider using a sign-on fee that is credited against the licensee's royalty account (i.e. prepaid royalties).  The licensor should be careful to provide that the sum is non-refundable, even if actual royalties do not use up the entire credit.

Licence terms: Royalties

Royalty base
The key definition in the royalty provisions is not the size of the royalty rate, but the base to which the royalty rate is applied.  Should the royalty be a percentage of the invoiced sale price of the product, the manufactured cost or profit margin?  Should the royalty be a piece rate - that is a set figure per product sold or manufactured?

We recommend avoiding profit as a royalty base, because profit figures can be manipulated by skilful accounting.  It is much harder to manipulate the sale price.  When defining what constitutes a royalty bearing sale, consider using terminology familiar to accountants, as it is usually accountants who will calculate the royalty payments, and conduct audits on behalf of the licensor.

Give consideration to other means of disposing of the product, such as by lease, hire, gift, internal use and such like.  Also consider how transfers between related companies will be dealt with.

Piece rates are easy to calculate, although over time can become eroded by inflation.  Accordingly, if a piece rate is used, then an inflation adjustment provision should be included.

Royalties for processes can be based on throughput, time used, or degree of cost saving (e.g. output of waste) and such like.

Software is often licensed for a fee, either a one off payment or a continuing payment (e.g. an annual fee), and the quantum of payment is sometimes tied to the number of users or size of the user organisation.

Royalty rate
Once the royalty base is determined, then the licensor must negotiate the royalty rate (e.g. the percentage applied to the royalty base).  Determination of the royalty rate should have regard to two main factors:

• Industry norms
• Projected profits

Royalty rates for various groups of technologies based on established and successful licensing arrangements are of interest as a check in relation to costs within industries and the profit margins of efficiently run businesses.  This benchmarking against similar products or technologies relies on the availability of sufficient public information.  Where such information is not so readily available, research companies may for a fee, provide royalty information on products and industries, based on their surveys and data compiled from various sources.  Royalty Source is one such company. There are also published studies of royalty rates that can be accessed freely. 

We have set out below a table from a study conducted by Rose Ann Dabek, which illustrates the spread of royalty rates across various industries (in 1991) for in and out-licensing activities:

Table 1

Royalty Rates for In-Licensing by Industry

  

Table 2

Royalty Rates for Out-Licensing by Industry

There are a number of rules of thumb which can used to find an appropriate royalty rate.  One well known rule of thumb is the so-called "25% Rule" (see Goldscheider, R. Jarosz, J. and Mulhern, C. "Use of the 25 Per Cent Rule in Valuing IP" les Nouvelles December 2002).  Under this rule projected profits to the licensee are the starting point, with the core assumption being that the innovator should be entitled to approximately 25% of the gross operating return from the innovation.  In addition to the cost of sales, some proponents of the rule advocate deducting non-manufacturing operating expenses.  The operating profit to be used should be pre-interest and tax. 

Revenues	$100
Cost of sales	$60
Gross Margin	$40
Operating expenses	$20
Operating profits	$20
Royalty rate	5% ($20*25%/100)

 

The application of the 25% rule will in most instances give an unrealistically high figure and other factors may be taken into account to adjust the royalty rate downwards.

Adjustments to a royalty established under the 25% rule should be made having regard to factors such as:

• Licensee competencies resulting in low cost of sales relative to competition
• Strength and breadth of the IP protection
• Availability of viable substitutes

Royalty reporting issues
The licensee is required to keep books of account relating to the sale of the licensed products or use of the licensed process, for the purpose of calculating royalty payments due to the licensor.  It is advisable to require that these accounts be kept separate from general accounting records, to make auditing the royalty payments easier. 

The licensee will generally be required to provide the licensor with periodic reports (usually coinciding with the royalty payment dates) setting out information including the number of products manufactured and sold, the invoiced price of each sale, and the royalty calculation.

The licensor should reserve the right to enter upon the licensee's premises for the purpose of auditing the accounts, and to view and take copies of the accounts, and this right should extend to the licensor's duly appointed accountant.  The issue of how long records should be kept and how far back audits may go should also be explicitly addressed.  Where the audit reveals a discrepancy in the amount paid versus the amount actually payable (and the discrepancy is over a certain threshold, such as a 5% error or $50,000 or more), then the licensee is required to make up the shortfall and pay the costs of the audit.  The licensee should be required to provide all reasonable assistance and answer all reasonable questions to assist in the audit process.

Licensors should make it clear from the outset of the relationship that it will conduct a compliance program, by randomly selecting licensees to audit and review.  This way the relationship is preserved, because the process is standard practice, the licensee does not feel picked on.

The licensor should also make a habit of monitoring the royalty reports and analysing them for trends and unusual items.

Other royalty issues
Where a licensed product is the subject of patent rights, copyright protection and trade mark protection, the licensee should consider apportioning the total royalty rate between these various forms of protection.  In this manner, if a patent lapses or is invalidated, there is less likely to be a dispute as to whether the agreement should be renegotiated or terminated.  It may also make accounting for tax easier as different tax rules can apply to different IP types.

There may be issues where a product is protected by patent claims in some region of the licensed territory but not in others.  The licensee may refuse to pay a royalty in non-patent protected countries (unless there is some valuable know how that forms part of the licence).  However, there are possible justifications for paying a royalty across the board regardless of the patent position in individual countries.  For example, the licensee will develop know how in the course of manufacturing and selling the patent territories that will be applied in non-patent territories, it benefits from the significant R&D expenditure of the licensor relating to the product in all countries (without the licence it would have to incur this expense itself) and so on.

Where there is a differential royalty rate depending on the protection in a country, care has to be taken that the licensee cannot make and sell product in a low royalty rate country and then have the purchaser resell into a high royalty rate country without paying the differential.

Where products are bundled together and sold as a single unit (A joined with royalty bearing B to form AB), there is the potential for either the licensee's accounting system to fail to recognise the sale of AB as the sale of a royalty bearing B, or for the licensee to code it as a sale of A and a free B, thereby avoiding a royalty (unless the definition of "sale" is made to include using or transferring title to B).  Some definitions of "net sales" will specifically exclude product that is given away in the course of a promotion.

Similarly, where a royalty bearing product is provided as part of a service, there may be potential for the licensee to charge little for the product and give the service the bulk of the price weighting, thereby minimising any royalty due.

There may be issues where the licensee argues some royalty bearing stock has become obsolete and is scrapped or written off.

The royalty clause should be drafted carefully so as to properly capture sales made by a sublicensee (if sublicensing is permitted).

Finally, where substantial royalties are expected and the royalty is paid relatively infrequently (eg quarterly), then consideration should be given to securing the royalty payment using a general security agreement which is registered (in New Zealand) under the Personal Property Securities Register.  In other countries a debenture or charge may be used.

Licence terms: Improvements

It is not uncommon for each party to be required to disclose new improvements to the other party.  Where the improvements are devised by the licensor and fall within the claims of the licensed patents, they may just automatically form part of the licensed rights.  Where they are severable improvements of the licensor, a separate agreement might be entered into.

Where the improvements are devised by the licensee, sometimes the licensor will require they either be assigned or licensed back to the licensor.  Clauses such as this may fall foul of competition regulations, for example in Europe.

Licence terms: Sublicensing

A decision must be made as to whether the licensee will be permitted to grant sublicenses and on what terms.  For example, the licensor may require at a minimum that any sublicence is at its discretion, that it preview the sublicence agreement and that there are restrictions on sub-sublicensing.  It may also require the right to audit the sublicense.  The issue of what happens to sublicensees in the even the head licence is terminated should also be addressed.

Licence terms:  Performance obligations

Often terms such as "best efforts" or "reasonable endeavours" are used in licence agreements.  These terms are rather ambiguous and therefore are a potential source of dispute.  While the courts will determine in a particular case what is and is not "best efforts" or "reasonable", the result depends entirely upon the surrounding circumstances.  There is no certainty for a licensee or licensor to say the licensee has fulfilled its obligations.

We prefer for the parties to agree to meet annually (or more frequently) to agree upon a marketing plan for the forthcoming year.  The plan will set out the actions and initiatives required of the licensee (for example, what trade shows will be attended, how many sales and marketing staff will be employed, what percentage of sales will be spent on marketing, etc).  The end result is a defined action plan against which performance can be readily measured.

Where a licence is exclusive, it is always a good idea to require the licensee to pay minimum royalties.  These can be set out on a country by country basis, or a global figure.  A clause can be inserted into the agreement so that if the licensee only manages to pay the minimum royalties in any, say, two consecutive years, then the licence will be terminated or converted to become non-exclusive (at the licensor's option).

The licensor should require the licensee to comply with all regulations and laws associated with the manufacture and marketing of the licensed product/process in each country of the licensed territory.  It may also impose particular requirements in terms of the quality of product sold (particularly if the licence involves trade mark rights).