The License-Out as a Business Model

Bench to Market (article)This commentary in the Genomics Law Report’s ongoing series Bench to Market is contributed by Steve Newmark, Robinson, Bradshaw & Hinson, P.A.

The drive to create something new and useful is an almost universal trait of entrepreneurs. This passion, however, is not always accompanied by the same enthusiasm for managing the more mundane tasks of taking an idea from a research lab or academia and making it available in the marketplace. In addition to the fundamental need to raise capital, the commercialization process requires a number of time-consuming and less glamorous steps, such as forming a company, hiring employees, establishing accounting systems, drafting contracts, securing appropriate facilities and, if all goes well, marketing and selling products and services. The process can often be frustrating, difficult and even infuriating at times, particularly for scientists or researchers. So, what can an entrepreneur, who wants to maintain her day job as a professor, physician or other professional but doesn’t want her valuable innovation to sit idle, do?

One option that has gained popularity is the “license out” business model. Under this approach, an inventor takes the initial steps of creating a new product or process, but then passes the torch to a third party to use the underlying developments to make the products and services available to the appropriate market. The inventor is relieved of the burdens of commercialization but continues to retain ownership of her work, putting her in a good position to profit from its market value (albeit with the lion’s share of any such profit generally going to the business partner who takes on the commercialization responsibilities).

While this approach sounds simple and straightforward, there can be traps for an unwary inventor. A threshold concern is that an inventor can license only those rights she has the right to license. That sounds obvious, but inventors are surprisingly prone to overlook this concern. If software is involved, the inventor should carefully consider whether her software incorporates licensed third-party software or open-source software. If a new product is involved, the inventor should consider whether her invention is merely an improvement to an underlying invention owned by a third party. Purporting to license rights that are actually owned by a third party is a sure recipe for disaster.

Assuming the inventor actually has the right to license something of value, the first key decision will be the selection of an appropriate business partner to commercialize the technology. Sometimes the inventor will be aware of the likely candidates because of familiarity with the applicable industry. If not, technology transfer offices, venture capitalists, industry experts and attorneys can be useful resources to identify and vet potential business partners. It should go without saying that the “one stop” shops advertised on television are often not the best choice for a business partner.

Once a business partner is selected, the primary task shifts to preparing and negotiating the license agreement. The license agreement will often be the only contractual tie between the inventor and the business partner, and it contains the critical terms governing the relationship. Licenses can vary significantly, depending on the exact relationship the parties choose to create, and so the inventor is likely to be poorly served by simply downloading and using any type of “industry standard” license. (The license agreement is sometimes accompanied by a services or R&D agreement pursuant to which the inventor agrees to provide ongoing services, but that arrangement is beyond the scope of this article).

The heart of almost every license arrangement is defining the scope of the license grant. In a typical license, the inventor grants the licensee the right to use all of the inventor’s intellectual property rights in the new product or process, so that the business partner will have the legal authorization to make, commercialize and sell products and services incorporating those licensed intellectual property rights. The typical license would cover patents, unpatented inventions, proprietary know-how, copyrights and related documentation.

Assuming the inventor is willing to grant such a license in all of her intellectual property rights, there are still several decisions that must be made to define the scope of the license grant. First, is it exclusive or non-exclusive? In an exclusive arrangement, the inventor restricts her ability to allow anyone else to use her technology, and grants all of her rights to the business partner. Whether to grant exclusivity is something that must be carefully weighed by the inventor, although she should expect that her business partner will usually require it as a condition to making the investment. The inventor should negotiate protective provisions to ensure that the technology is actively marketed and that she has termination rights in the event that her expectations are not satisfied. If the license is non-exclusive, the inventor may not have the same concerns because she retains the discretion to license the technology to other partners if she becomes dissatisfied with the performance of the initial business partner.

Another issue is whether the license grant extends to all “fields of use.” For some technologies, this will not be an issue, because the new products or processes can be used only in a certain industry and the related intellectual property rights would have no relevance outside that particular industry. It is not uncommon, however, for an invention to have potential application in two or more industries, and a single business partner may not be best situated to take advantage of the commercial opportunity in each area. Instead, an inventor may desire to grant exclusive licenses to different business partners, with each license covering a specifically defined field of use. The drafting of field-of-use definitions is often heavily negotiated and requires precision to avoid future disputes.

The type and amount of consideration to be paid to the inventor are of course other critical components in the license agreement. Although the inventor may not plan to be significantly involved in commercializing the underlying technology, she expects to be fairly compensated for her contribution to the venture. The most common economic structure for licenses is the payment to the inventor of a royalty calculated as a percentage of the sale revenues or profits generated from the licensed technology. Various metrics can be used as the basis for the royalty calculation, including unit sales, gross sales, net revenues, and net profits. The percentage to be paid to the inventor can differ depending on the industry and the value and novelty of the licensed technology, and may fluctuate based on volume of sales. Because the data underlying such royalty calculations are under the control of the business partner, the inventor generally receives some form of audit rights to facilitate monitoring and confirmation of the royalty calculations.

Some inventors may prefer to negotiate a fixed payment amount, often through some combination of fixed upfront and periodic cash payments. This approach may be particularly attractive if the inventor is concerned about the challenge of monitoring the performance of the business, or if the technology is not being incorporated directly into the end product or service being sold to customers. The fixed payment has the additional benefit of discouraging any business partner from “parking” or “mothballing” the technology, which conceivably could be in its best interest if it gains access to another comparable technology under more favorable economic terms, including a replacement that it develops on its own. From an economic perspective, the fixed payment structure is more similar to an outright sale of the technology than a typical license, since the payments do not vary based on the success of commercialization; however, it is more favorable to the inventor than a true sale, since she will retain ownership of the intellectual property rights and will be better protected if problems arise.

Another approach is to combine a traditional sales-based royalty with a minimum payment (generally calculated on an annual basis). Typically, the minimum royalty is not an unconditional payment obligation and the consequence of the business partner’s failing to meet the minimum royalty thresholds is termination of the license grant. If this type of arrangement is properly negotiated, it can combine many of the benefits of a traditional sales-based royalty and a fixed-fee payment. The arrangement can provide the inventor with the expectation of a minimum annual payment while she retains the right to participate in the upside of successful commercialization and the right to terminate the arrangement if commercialization is unsuccessful.

The fact that the inventor will retain ownership of the technology raises other issues. In many cases, the inventor will have obtained (or at least applied for) basic intellectual property protection for her new product or process before seeking a business partner. However, the parties will still have to allocate the responsibility and costs of pursuing intellectual property protection. Deciding the appropriate scope of protection and allocation of costs can be particularly difficult in seeking patent protection, since it is not always clear where patent applications should be filed or what specific patents claims should be pursued, and the cost of prosecuting patents can be significant. Finally, the parties must decide who will control enforcement actions against alleged infringers.

In negotiating the license, the inventor also must take into account the evolving nature of technology. The likelihood is that any licensed product or process will be improved and enhanced as it moves towards commercial availability. Depending on the relationship of the parties, those improvements may be made by either the inventor or the business partner. The parties will need to negotiate the ownership of any such derivative works, improvements and enhancements to the technology. In any event, the inventor should insist that royalties be calculated with reference to sales of all products or services that are based at least in part on the underlying technology, even if the commercially available products or services have been significantly enhanced by improvements or additions developed by the business partner.

Finally, the inventor will need to consider the downside—what if the project goes badly off course? For example, what if the resulting product sold by the business partner is defective and injures consumers or what if another company claims, after development is completed, that sale of the developed product would infringe its patents? Parties typically allocate these risks through negotiated indemnification provisions. As a starting point, the inventor will generally request that the business partner provide comprehensive indemnification against any claims that might be brought against the inventor arising from the business partner’s commercialization of the technology. The business partner may reasonably request that certain claims be carved out from its indemnification obligations, and may even require the inventor to provide indemnification in certain circumstances.

We have mentioned only the typical key issues in this post. License agreements can be lengthy and complicated and will contain a host of other provisions that are important and can affect the relationship between an inventor and the business partner. It would be a mistake to view the license structure as a quick and simple answer to commercialization. On balance, however, the license model provides an attractive alternative to an inventor who wants to remain at her current position or continue to act primarily as a generator of new ideas while passing along the responsibility of commercializing the fruits of her labor.

Bench to Market Contributor

All Posts by Bench to Market Contributor