Don’t Sign a Licensing Agreement Without This Clause

When licensing your product idea to a company, there are many things to consider. One very important aspect is some type of performance clause. If you license the rights to manufacture and sell your concept to a company and, for some reason, it doesn't perform, you need to be able to get those rights back.

Worst-case scenario: What if the company fails to sell a single unit? Without some type of performance clause, that could very well happen. Essentially, without a performance clause, you have no recourse. You're basically giving your product away if you don't have a performance clause.

When negotiating the insertion of a performance clause into a licensing agreement, I always wait until much later on in the process. In fact I do not bring the issue up at all during the term sheet phase. That's way too early.

I'll be the first one to admit it: Asking for a performance clause is like putting a gun to their head. Understandably, then, most companies do not enjoy talking about performance clauses -- which is why I wait until other aspects of our agreement have been negotiated first. For example, after we've established that they want an exclusive. Pulling out becomes more costly later on because time, energy, and money have been invested.

Why should you trust me? During my career as a product developer, I licensed dozens of my own ideas. For about 15 years, I negotiated licensing agreements from behind-the-scenes on behalf of students who signed up for my program inventRight. Several years ago, I taught inventRight coach David Fedewa everything I know about getting a great deal. Since then, he’s negotiated countless agreements on behalf of inventRight students.

David is on the left; that's me on the right.

Performance Clauses: Understanding the Big Picture

Licensing your product innovation to another company will always require a number of guarantees, particularly if the license granted is going to be an exclusive one. I believe every license should include some form of a performance clause, including both nonexclusive agreements and exclusive agreements. It's simple. Granting a licensee rights to your technology will impact your future revenue. If the licensee doesn't perform, there's a cost associated with that.

In other words, if you grant an exclusive license and your licensee fails to perform, the perceived value of your asset will be diminished and valuable time may be lost.

Another consequence? It may be difficult for you to secure another license that will deliver the same degree of return on investment. So, it's unfair to have an exclusive license that lacks any obligation to perform. That's a well-accepted basic principal.

I also believe that if you give someone a nonexclusive, there should be some type of associated performance obligation. Why? Because you can no longer offer the technology exclusively to anyone else, meaning you have diluted the value of your asset.

Before I continue any further, please know that I am not an attorney. I do not have a law degree. I am writing from a business perspective, not a legal one. Why is that an important distinction? One of the quickest ways to derail a negotiation is by bringing in your lawyer. The minute you bring in yours, they will bring in theirs, and the whole process will slow down.

If you've never negotiated a licensing agreement before, please, find someone who has to help you. If that person is an attorney, make sure their specialty is licensing. Tell this person what is important to you. The legal field has a tendency to overprotect. You must determine what you're willing to accept and what you're not. Not your attorney.

If a potential licensee is asking for an exclusive license but will not agree to a performance clause, then I will offer them a non-exclusive license instead. That way you can still profit from your idea even if something ends up happening with the company.

If the company won't accept a non-exclusive, I would probably walk away from the deal. That's hard to do, I know, but may save you a lot of headache in the long run.

Common Performance Clauses

• Non-specific performance clauses. In a Business Development and Licensing journal article about performance clauses, Roger Davies of the Pharmaceutical Licensing Group in the UK writes, "The most widely accepted clauses fall under 'best efforts' and 'commercially reasonable efforts.' In practical terms, 'best efforts' are interpreted as meaning an obligation to do the utmost to achieve the desired results."

The question becomes, who gets to define ‘utmost’? Both of these clauses depend on subjective judgment, which is problematic. They're just too vague. Personally, I'm not wild about “best efforts” or “commercially reasonable efforts.” I prefer standards that are measurable.

• Development performance clauses. Some performance clauses are tied to the development of the product. After all, delays mean lost revenue, earlier competition, and increased development costs. I know from experience that unforeseen manufacturing challenges are commonplace. What if an outside contractor holds the product development process up? That's entirely plausible -- and one reason why staying close to the process during this stage can really help your product make it to market and succeed there. You'll be more aware of important deadlines and whether you're going to make them.

Personally I'm not wild about performance clauses tied to the development process either. It's all too easy for a third party to impact their delivery date. You're basically handing them an excuse!

• Sales and marketing performance clauses. Performance clauses based on sales are my favorite. Essentially, this kind of performance clause establishes the minimum royalty payment you're going to receive, which you should base on sales volumes.

To me, the key objective here is revenue generation. That's what you're after, isn't it? It's also very easy to track. But please realize: Your licensee very well may come up short! Breach of contract due to missed minimum guarantee payments is common enough.

Remember, contracts are living documents. It is wise to think about them like that. If your licensee breaches your contract because they aren't selling enough units, don't immediately overreact. You’ve actually been given is the opportunity to renegotiate more favorable terms.

So, what kind of minimum guarantees do I ask for? I make that first year low -- like maybe only 25 percent of projected sales. Surely your licensee can hit that number. You want to get a little momentum going! That second year, you might raise the minimum guarantee to 50 percent of expected sales. Then of course you can raise it again the third year, say to 75 percent of projected sales. This strategy works because it motivates your licensee to get moving.

If your licensee fails to perform, what are your choices?

Depending on how your contract is written, you can:

• Terminate your agreement.
• Allow the company to make a shortfall payment rather than to terminate your agreement outright.
• Change the license from an exclusive to a nonexclusive. I'm not particularly wild about this option, because when one of my agreements played out this way, I had difficulty encouraging another company to enter the market with the same product. In other words, not being able to offer an exclusive license to anyone else truly lessoned the value of my technology.

Negotiating the insertion of a performance clause can cause a lot of anguish on both sides because the focus is inherently on the negative -- you’re discussing a 'what if' scenario, after all. Frankly they can be difficult to negotiate.

Here’s my advice: Start with the math.

• Find out how many stores currently sell the company's products.
• Estimate that one unit is sold per week.
• Using low, medium, and high estimated wholesale costs, calculate what your royalty payments will be.

Now you have somewhere to start from -- somewhere real. You can begin discussing projected sales because this math is just common sense.

If less than one unit is sold per week, the product won't stay on the market long, and they know that.

If the company you're negotiating with is still unwilling to include any type of performance clause, ask them pointblank. At what point would they stop manufacturing your product? How low would orders have to be? In other words, what is the lowest number that would force them to stop manufacturing and decide to give you back the rights to your technology?

The point is that you absolutely must establish some kind of benchmark. Otherwise you are just giving your product away for free!

Inventors have a tendency to focus on royalty rates. To be honest, establishing a performance clause is much more important than your royalty rate.

Originally published on Inc.com.

I hope this article has been useful to you.

Prefer video? Check out the following on my YouTube channel inventRight TV.

• “Negotiating a Licensing Agreement Part 1”
• “Negotiating a Licensing Agreement Part 2”
• “Negotiating a Licensing Agreement Part 3”

Looking for help negotiating a licensing agreement? Contact inventRight at 1-800-701-7993 or set up an appointment with us.

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