Licensing Agreements: Economic Terms

There are three main types of clauses in licensing agreements: economic terms, boiler plate, and what I call “oh crap”.?For those of you experienced with licensing this and the next two posts are refreshers you may want to skip. For those new to licensing, here are some basic things you need to know.

The economic terms are the substance of the deal. They specify what is being transferred for how much, paid when.?

What is being transferred is, at a minimum rights in IP. (If you don’t own it, you cannot sell it.)?In a license, as opposed to an assignment, you are only transferred some of your rights to the IP. So the focus here is on the definition of the IP, the good for which rights are being transferred, and the specific rights which are transferred. If there is a patent or a registered copyright or trademark, defining the IP is easy. You say this patent, this copyright, this trademark. If not, be very careful how you define the IP so you only give rights to stuff you want to transfer rights in.

Sometimes other things are transferred as well. Almost always there is some know-how (which may or may not be trade secret). Documents, materials, equipment, etc. necessary to use the IP being licensed may also be transferred as part of license -- although that is less common and if it occurs, it is done through an accompanying services and/or sales contract.

The IP rights transferred are typically sliced in 5 ways, but other ways can be used as well:

1)?????By what you can do, i.e., make, use, sell, transport, and sublicense. Lots of variants on these so lots to things about. For example, a university of research institute worth its salt will always retain at least the right to use the IP for non-commercial research purposes. That may seem reasonable, if you are in business, until you realize that research use could lead to a new invention and thus to patents which directly compete with the patent you are licensing. So maybe, if you are a business licensee, you want to negotiate for the addition of the term “non-competitive” before research rights and an automatic royalty-free license to any improvements relating to the patent you are licensing. You may also want to negotiate a call option to buy all the IP rights.

Another example: from the research organization side, sublicensing may seem reasonable, especially if the license is to a spin-out or research company which will spin-up the technology and then sublicense it. But what if the licensee sublicenses it to a patent troll. (A patent troll is a “non-operating” company that uses patents solely for the purpose of suing for infringement.) What if they sublicense it to a company that has no chance of ever selling anything but hot air. You may want to require your prior approval before a sublicense can issue.

2)?????By exclusivity, i.e., exclusive (all rights enumerated transferred only to the licensee), sole (all rights enumerated transferred to the licensee by they are also retained by the licensor), or non-exclusive (all rights enumerated can be transferred as many times as the licensor desires). ?Again, creative folks can come up with variants.

3)?????By field of use, i.e., in what applications can the rights be applied to. Suppose I license a spectrometer. It can be used in medicine, space science, manufacturing, water quality, etc., etc. Each is a separate field of use.

4)?????By geography, i.e., only North America, only the USA, only the State of Washington, only Seattle, only the Queen Anne Hill neighborhood, only this block of this street, only this house, only the first bedroom on the right on the second floor. Of course, usually the geography is one or more jurisdictions where laws covering IP are promulgated, such as Japan or the European Union, or a region such as North America. But again, the parties to a license agreement can cut up the world however they want.

5)?????By time, i.e., for the life of the patent, for 10 years, for 1 day, whatever.

Bottom line, what the licensor is selling in a license is a multidimensional slicing and dicing of a series of specific rights in one or more pieces of intangible property. ?These slices or pieces are defined as part of the economic terms.

What the licensee gives as its consideration is the other part of the economic terms. While we usually think of money or equity or some combination of these, the consideration does not have to be. The consideration might be performing R&D to mature the IP or acting as a location for Master student practicums. As with any contract (and licenses are a special kind of contract), the parties can define the consideration however they want.

Usually, however, licenses involve between one and three types of payments of cash.

The first is upfront payments. These are paid on signing the license. They are often used by research institutions to over the sunk costs of obtaining and maintaining IP protection. They are also used, by any licensor, to make sure the licensee has skin in the game so they are likely to go ahead and commercialize the IP. The upfront may also represent remuneration for know-how transfer or transfer of equipment, materials, or other goods from the licensor to licensee.

The size of the upfront is also related to whether, and how large, are the next two types of payments – milestone payments and royalties. (If you are thinking, “another thing to negotiate”, you’re right.)

Equity is usually transferred as an upfront payment. There are a ton of different ways to describe the equity. It can be preferred stock as opposed to common stock. That way ownership and rights to dividends are transferred by not voting rights. It can be non-dilutable until some event, such as obtaining Series A or B funding. It can be some special subclass of either. It can also be a right to have stock in the future, as is the case with a convertible debenture. Equity might come with options to buy more equity. Yep, there is always another thing you can negotiate.

Milestone payments, as the name implies, are made with a milestone is reached. I recommend tying them to the milestones in whatever new product development process is being used by the licensee. While some people insist on milestone payments as a way to garner income as the licensee moves towards commercialization, I do not as I do not want to disincentivize my licensee from hitting a milestone (hopefully early). For me, they reflect payment for consulting services or know-how transfer required to hit the milestone. Otherwise, I only ask for late fees if a milestone is not reached and the licensee cannot justify why they failed to hit the agreed upon target.

Finally, royalties. These are typically paid when revenues are received by the licensee. But as with anything in a license, that is open to negotiation. You can tie royalties to volumes produced. For example, for each liter of this chemical produced you pay so many cents or Euros whether or not it is sold.

When royalties are tied to payments, they are usually tied to net sales (sales minus discounts and returns), which means they are tied to the money received by the licensee. Sometimes they are tied to Gross Profit, which is net sales minus cost of goods sold (COGS). Since it is possible to go back and forth if the COGs can be reasonably well estimated, I don’t like basing royalties on GOGS as Net Revenues are much easier to monitor and audit if need be. ?

By the way, when defining Net Sales (or any other such financial terms in a licensing agreement, use the definition of the International Financial Reporting Standards, Generally Accepted Accounting Practices, or whatever formal and recognized standard your licensee follows. That way they calculate what your royalty payments are using the same accounting method deployed for their internal and government compliance purposes. ?According to Investopedia: “Generally accepted accounting principles (GAAP) refer to a common set of accounting rules, standards, and procedures issued by the Financial Accounting Standards Board (FASB). Public companies in the U.S. must follow GAAP when their accountants compile their financial statements. GAAP is guided by ten key tenets and is a rules-based set of standards. It is often compared with the International Financial Reporting Standards (IFRS), which is considered more of a principles-based standard. IFRS is a more international standard, and there have been recent efforts to transition GAAP reporting to IFRS. GAAP: Understanding It and the 10 Key Principles (investopedia.com).

Ok, so when are payments made? Again, something to negotiate. I prefer quarterly as like to see the money coming in. Plus, if something outside the licensee’s control happens, like a Silicon Valley Bank failure or the US Government runs out of money and your licensee is a government contractor who is not getting paid, at least all the royalties due before that quarter have been paid. That said, annual are acceptable. ?

That’s a quick overview on economic terms. Next post we look at boilerplate.