The two biggest questions facing licensors
Dave Tyrrell, Vertex Intellectual Property Strategies Inc.
Licensing is the process that involves the sale and transfer of technology from the owner, or licensor, to the receiver, or licensee, in an agreed upon fashion with agreed upon rights for an agreed upon compensation. There are many good reasons to support a technology licensing.
Once a business, a university or inventor has determined that licensing would be an advantageous approach to meeting their business and technology commercialization goals, the two most common questions asked are: "Who?" and "How Much?". That is, who is the most suitable licensee and what price tag should be placed on the licensing offering. As simple as these questions sound, considerable market research and analysis is required in most cases to develop a plan that will yield the most profitable results and meet other non-financial objectives.
Who to Approach
Whether the licensor is attempting to license a specific technology to a single ideal licensee, a small select group of licensees, or a large number of non-exclusive licensees (as in the case of licensing computer software), adequate market research is essential to enable the development of the best licensing strategy and to identify the target licensees. In the case in which the licensor is seeking a large number of non-exclusive licensees, market research needs to focus on the needs and characteristics of the specific end-users being targeted. The apparent or most obvious licensee that may have been identified early in the licensing process may not be the best business solution. There are several fundamental questions to be answered before the best prospective licensees can be identified.
In general developing a short list of businesses that can most effectively apply the technology being offered will shorten the license proposal and negotiation process, and will yield the best financial results. Businesses that can profit most from the acquisition of the technology will generally produce the largest royalty payments.
Before suitable licensees can be identified, it is necessary to develop a 'market segmentation strategy'. The market for a technology can be divided in a variety of ways. Field of use and geographical market segmentation are the most common. Licensors need to examine all of the potential applications or fields of use for their technology. If the technology can be utilized in more than one industry, licensors should segment the potential market for their products by industry and seek licensees in each industry. There may be one industry that should be targeted from the outset, but other industries could also yield profitable returns in the future. By having field of use restrictions in the license agreement, non-competing future applications can also be licensed.
Similarly, if the technology can be utilized in more than one specific geographic area and it is unlikely that one business can serve all of these areas; individual licensees should be sought for each of these areas. Thus license agreements need to be restricted to specific geographic territories. Depending on the technology, there may be one geographic area to tackle first - usually the area closest to home.
Licensors next need to gain a thorough understanding of the distribution channels for the target industry for the specific products to be developed from their technology. What value is added at each transaction point of the 'value-added' chain? What businesses are involved at each point? What value do they bring their customers? For business-to-business transactions, the chain is typically shorter and less complicated than that for consumer products. The figure below illustrates a typical value added chain.
Once a clear picture of the marketplace and businesses involved has been developed, a determination of the most desirable licensee profile can be made. Thereafter, candidate companies that possess all or most of the desirable characteristics of an ideal licensee can be contacted.
For example, perhaps the analysis has shown that the potential licensee should have all or some of the following characteristics:
- Manufacturing Capabilities - Has access to the capabilities to manufacture the products derived from the technology.
- Packaging - Has the ability to assemble consumer-oriented products in an attractive, retail-ready package; often overlooked in the assessment of manufacturing capability.
- Established Distribution Network - Has in place established distribution channels that will make the product as accessible as possible to consumers.
- Tradename / Reputation in the Industry - While not necessarily a requirement for a potential licensee, a recognized name will immediately instill confidence in a new product. Companies that have a reputation for successfully introducing new products may represent particularly attractive licensing candidates.
- Wide Market Reach - Ideally, the licensee will have a market reach that addresses the needs of the markets granted.
The more you know about the market place and the businesses involved, the more effective the licensing decision that can be made.
How Much - Setting the Royalty Rate
Generally, the compensation for a license is primarily financial and takes the form of royalty payments. The royalty rate is one of the key components negotiated in a license agreement and depends on many factors.
There is no such thing as a typical or standard royalty rate. However, there is a rule of thumb for the division of profits or the sharing of cost savings. Specifically, the licensor receives approximately 20% of the total benefits through a royalty payment, while the licensee retains 80% of the profits or cost savings. This results in a royalty of typically approximately 2% to 10% of gross sales. The lower levels generally apply to the less significant, older or softer technologies, while the higher levels generally apply to the newer, revolutionary or highly differentiated technologies.
The royalty rate reflects the risk involved by both the licensor and the licensee and the attractiveness of the business opportunity for the licensee (i.e. the size of opportunity, expected profit margins, etc.). Experience gained from other licensing agreements within the same industry can provide useful guidelines to establish a royalty rate. However, license agreements have many variations that will impact the royalty rate. Since the details of license agreements are generally not made public, one should be wary of using the exact percentages or amounts that are publicly quoted.
Licensors should not approach the evaluation of a technology from a cost-of-investment point of view (e.g. R&D expenditures), because new technology is generally developed for internal use and no consideration is often given to the potential value to be derived from licensing. This approach could result in the true value of the technology not being recognized during a licensing negotiation, or alternatively, a failure to license a technology that would provide worthwhile return. The development cost is only an indication as to what it would cost for another business with similar skills and capabilities to duplicate the technology being licensed.
Some of the major factors which one needs to consider when pricing license agreements are:
- The inherent quality of the technology,
- The market potential of the technology,
- The fit with the licensee's business,
- The ability to assure the licensee protection for unauthorized use of the technology, and
- The risk involved in the agreement (technology, business etc.).
As mentioned, license royalty payments or fees are generally a combination of both an initial payment and a running royalty. To reduce risk to the licensor, an attempt should be made to maximize the initial payment in the royalty compensation negotiations. Conversely, to protect the licensee, running royalties should form as much of the total royalty payment as possible.
In either case, running royalties should be based on a measurable aspect, such as the number of units, or the weight of product produced or sold. Minimum annual royalties should be specified to assure that the licensee is diligent in utilizing the technology. Royalty payments can also take other forms, such as a provision of equity or profit sharing, or a payment in kind, such as a cross license.
As you can see the negotiation of a suitable license fee is a complex matter with many variables and requires a great deal of research, consideration and analysis. Both parties must prepare carefully in order to determine the royalty rate that will produce a license agreement that will be beneficial to both the licensor and the licensee.