Insight journal - Dealtalk

Strategic tips for adding value to licensing transactions

Posted on 27 November 2008

by Simon Rowell, James & Wells Intellectual Property

Website: James & Wells Intellectual Property

Introduction

A licence is permission to do something that would, in the absence of permission, infringe intellectual property rights. It is different to an assignment, which is a transfer of ownership of the intellectual property.

Using a house as an analogy for the intellectual property, renting the house is like granting an exclusive licence, while selling the house would be an assignment.

All forms of IP can be licensed, including patents, trade secrets (know-how), copyright, trade marks, designs and plant variety rights. The rewards obtained by the licensor for the grant of rights can include an upfront payment, ongoing royalties, milestone payments, equity, services, R&D funding and access to improvements.

The desirability of a licence arrangement has to be considered from two perspectives, that of the potential licensee ("licensing-in") and of the potential licensor ("licensing-out").

Licensing-in is an appropriate strategy when a protected technology could provide a significant competitive advantage, and it is either impossible to design around the protection, and/or it is more cost effective to pay a royalty for use of the technology than to create it from scratch or design around the protection.

Licensing-out is an effective strategy in circumstances where giving third parties access to the technology in return for a fee will generate greater revenue for the same or less risk as not granting access. For example, granting rights in foreign territories or in relation to non-core applications for the technology.

This paper focuses on licensing effectively to maximise value from the licensing-out perspective.

Reduce risk for licensee

The negotiation of a licence is essentially the allocation of risk and reward between the licensee and licensor. The more risk taken on by the licensee, the greater its portion of the reward from the innovation should be. This fundamental tenet should be remembered when a licensor is first seeking a licensee. The more risk the licensor can take out of the equation, the easier it will be to find a licensee and the better the licence terms will be for the licensor.

The types of risk that are involved in commercialisation of IP include:

  • R&D risk – is there proof of principle, will the product pass the regulatory hurdles?
  • Manufacturability risk – can the invention be scaled up for commercial production, can it be manufactured for a competitive price?
  • Marketing risk – do consumers want or need the end product, is there a suitable distribution channel?
  • Competitive risk – how will competitors react to the introduction of the end product, will it be superseded quickly by new technology?
  • Legal risk – can it be sold without infringing third party rights?

Accordingly, if the innovation is a mere idea without proof of principle, then the licence is a very risky proposition for the licensee. With proof of principle, there is less risk, and a working prototype will remove even further risk. If the licensor can demonstrate sales, then again, it has reduced the risk from the licensee's perspective.

With this in mind, the licensor must make a decision as to when will be best to licence the IP. Net present value calculations based on revenue forecasts for each scenario can be conducted to determine the optimum point at which to begin licensing.

For example, in a study of pharmaceutical companies' licensing practices, Kalamus, Pinkus and Sachs argue that big pharma would "capture the greatest expected value from preclinical licensing virtually 100 percent of the time because the greater risk of failure for preclinical compounds was more than offset by the low terms available early on" ("The new math for drug licensing", McKinsey Quarterly, 2002 No. 4). The authors went on to argue that the current reluctance of biotech companies to accept these low terms could be addressed by big pharma paying more for preclinical deals, stating "in most cases, they could pay 150 percent more at the preclinical stage for the rights to a drug" and still come out ahead, on the basis that they would take more bets earlier, creating a diversified portfolio out of which one or two compounds would generate super normal profits.

Carve up rights and select appropriate licensees

A licence does not have to cover all the rights enjoyed by the IP owner. The owner may licence the right to market products but not manufacture them for example, or market products in a particular country or for particular uses but not others. In this way, each exclusive right of the IP owner (for example, if we are talking about patent rights relating to a new vaccine, to make, use, exercise and vend) can be sliced and diced according to field of use (eg animal not human), region (Europe not the rest of the world), vertical markets (to wholesalers not retailers) and horizontal markets (over the counter not prescription).

In this way, each "slice" of rights can be granted to the most suitable company in the circumstances. This process of "picking horses for courses" should mean better licensee performance in each region/application/market and therefore greater return to the licensor.

Potential licensees can be located through industry knowledge, IP searching, internet searching or broker services. Investigations can be conducted into each potential licensee in terms of their financial position, previous or existing licence relationships and cultural and technological fit of the licensed product.

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 application. The licensor wants to avoid inadvertently granting rights to these undiscovered applications, which in the long term may be even more valuable than the known application.

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 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.
  • Charge upfront fees on a country by country basis.

Getting upfront payments

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. For the licensee, the upfront payment represents the sum most at risk.

Generally, the higher the upfront payment 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.

Other approaches to upfront payment calculations include:

  • List pricing – a figure (usually per licensed patent) set to recover the patent, administrative and licensing costs associated with the transaction
  • 10% of peak sales – a figure based on 10% of the forecasted peak product sales
  • Net present value of peak forecasted royalties
  • 25% of peak forecasted royalties.

If the licensee is unwilling to pay a significant upfront 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. Alternatively, payments of a sign-on fee could be staged over time, or milestone payments linked to significant events, such as regulatory approvals or hitting certain sales points, could be used.

Alternatively, the licensor could adjust other clauses in the agreement to relieve some of the financial burden on the licensor – such as making the licensee pay for filing, prosecution, maintenance and/or enforcement of IP rights, or increasing the minimum royalty payments.

Negotiating 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?

If possible, avoid 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. There are also published studies of royalty rates that can be accessed freely.

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.

Other factors that impact upon the setting of royalty rates include:

  • Territorial extent of rights
  • Exclusivity of rights
  • Level of innovation
  • Degree of competition in the relevant markets
  • Strategic need or portfolio fit
  • Stage of development
  • Royalty stacking issues
  • Other reward/compensation elements in the deal structure (eg research services, equity, milestones, etc).

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.

In a similar vein, the parties could provide for a step-down in the patent royalties in the event the patent is subjected to a challenge which indicates it may be invalid (but, for example the challenge is settled before the patent is actually revoked).

There may be issues where a product is protected by patent claims in some regions 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.

A licensee may legitimately argue that it has to bring a number of technologies from different licensors together to create the final product, and that there is a ceiling total royalty payable on the final product beyond which it is no longer economically viable to sell. In these royalty stacking situations, the licensee may negotiate an adjustment mechanism for the royalty rates in existing agreements, where a new licence required pushes the total royalty rate over the ceiling rate.

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 products 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.

Other licence consideration

Milestone payments

Milestone payments reflect the diminishing risk associated with the licence and reward the licensor for success of the technology. Typical events used to trigger a milestone payment include:

  • Filing a patent
  • Grant of a patent
  • Completion of clinical trials (pharma) or other testing (eg beta testing of software)
  • Grant of regulatory approval
  • Product launch
  • Sales thresholds

Equity investment

Upfront fees and milestone payments are sometimes taken in the form of equity investment. Equity can give the licensor some control in relation to the technology commercialisation, and may result in a closer relationship between the licence partners. As the licensor will benefit from increased profits of the licensee in the form of dividends and/or capital appreciation, the provision of equity may also facilitate a lower ongoing royalty rate.

CONCLUSION

When licensing intellectual property, the value of the transaction to the licensor is affected dramatically by the future performance of the licensee. Strategies to mitigate this risk include careful selection of licensees, carving up the licensable property and granting rights to areas in which licensees have proven track records. Careful use of royalty and payment provisions, performance obligations and other incentives will also maximise the value of the transaction.

by Simon Rowell, James & Wells Intellectual Property

Website: James&Wells Intellectual Property

Questions may be directed to the author.

 

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