Technology Licensing Primer for Entrepreneurs – Part II: Financial Terms
February 22, 2015
Part I of this two-part series on technology licensing dealt with the non-financial terms of a typical technology 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 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 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 .
The 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.