You’ve invented a fantastic new widget but don’t have the funds, facilities or inclination to develop or manufacture it yourself. Licensing your intellectual property may be the way forward. Your Business looks at licensing and the potential loopholes you need to watch out for…
What is a license?
A license is a legal document that allows a licensee to use the intellectual property (IP) of the licensor in return for remuneration. Payment is usually in the form of royalties, but may also involve an upfront lump sum. Unlike an outright sale or assignment, a license allows the licensor to retain ownership rights of the IP.
The license agreement typically contains terms defining the length of time the license is valid, the markets or territory in which the licensee can use or sell the product, whether or not sub-licenses are permitted, the nature and amount of upfront fees and royalties and whether or not the licensor has rights to any improvements developed by the licensee.
“The major advantage of licensing is that the responsibility for manufacturing, selling, distribution and any further development of the technology, product or process can be transferred to the licensee, reducing the investment required by the inventor in commercialisation. But be careful,” says Anthony van Zantwijk of Sibanda & Zantwijk Licensing Attorneys “as many loopholes exist in standard license agreements.”
What should be included in a license agreement?
License agreements are complex and should be as comprehensive as possible to protect both licensor and licensee against all eventualities. Some of the key issues that need to be addressed during negotiations are:
- The details of the licensee’s plan for commercial development.
- Time limits on the development and release of the product onto the market by the licensee.
- Clear definitions of the intellectual property related to the license agreement.
- Clear definitions of the types of products the licensee is permitted to develop using the intellectual property.
- The term of the license agreement – in the case of patents this is often the lifetime of the patents.
- The payment amounts, structure and terms.
- The exclusivity and geographical scope of the license.
- Guarantees or warranties on the technology.
- Rights of the licensor to any improvements developed by the licensee.
Although many template license agreements are available, more often than not these require alteration and Van Zantwijk suggests that a legal specialist with expertise in the licensing of technologies should be advised. “Many of these proposed amendments initially appear innocuous, until one later falls through the resulting loophole,” he says.
Look out for loopholes
The first of these potential loopholes has to do with sub-licensees. According to Van Zantwijk, licensors should always be careful when granting licensees the right to sub-license the intellectual property (IP) rights.
“Consider that a standard royalty clause provides for a royalty calculated as a percentage (say 5%) of the licensee’s turnover. If the licensee sub-licenses a sister company to make and sell the licensed products for a similar royalty, the licensor will receive an effective royalty calculated at 0.25% of turnover (i.e. 5% of 5%).”
To safeguard against this, Van Zantwijk recommends that agreements include a royalty calculated on turnover relating to sales of licensed goods and a further, higher royalty applicable to sub-licensing income. Alternatively, the license agreement could permit the licensee to sub-license the rights on similar terms as those contained in the parent agreement. The next problem arises when the licensor has to administer sub-licensees. This should really be the licensee’s responsibility.
Also, what happens if the parent license is terminated or cancelled? Will all sub-licenses automatically terminate at the same time? Will termination or cancellation of the parent agreement expose the licensor to claims for damages by sub-licensees?
If payment in an international license agreement is made by sub-licensees directly to the licensor, who is the beneficial owner of the royalties and which double tax agreement (DTA) applies – the one applicable between licensee and sub-licensees or between sub-licensees and licensor? If an exclusive licensee sub-licenses its rights, can the licensee still join infringement proceedings as a co-applicant and claim damages? “Probably not,” says Van Zantwijk. If the sub-licensee defaults in paying royalties, would these royalties still be included in the licensor’s gross income and taxed, despite such amounts not having been received? These are only a few of the issues that should be considered and addressed before agreeing to grant the licensee the right to sub-license.
Van Zantwijk’s advice is the following. “Where a licensee is entitled to sublicense the rights, the licensee should preferably assume full responsibility for the sub-licensees. A spread of approximately 10% on royalties received and royalties on-paid is generally considered a reasonable consideration for these services. The balance of the sub-licensing income should flow back to the licensor without triggering any unintended tax consequences.”
Licensors should also beware if the licensee looks to restrict their right to bring infringement proceedings. This is normally done on the grounds that the licensee has formed sensitive relationships that could be damaged if the licensor threatens to take action against an infringement.
But if the licensor allows the restriction, he may find himself in a position where the licensee allows sister companies to “infringe” the licensed IP without sanction. In extreme cases, the licensee may never commercialise the licensed product and royalties may never be paid.
Don’t restrict yourself
According to Van Zantwijk, another common mistake is for licensors to grant unrestricted exclusive licenses, i.e. licenses without minimum performance/ royalty or early termination clauses. “Let’s assume that your invention relates to a new way of making a widget. The widget has features that will severely undermine the market for existing products. However, considering the tooling costs, your widget is expected to yield a margin significantly lower than the margin currently enjoyed by a potential licensee from making and selling his existing widget. If you grant this entity an unrestricted exclusive license, it may agree to a high royalty percentage but never commercialise the product, triggering no royalty payments. Your license finds its way into file 13 and your widget never sees the light of day. For this reason, exclusive licenses must include a minimum performance/royalty clause or a short initial period, renewable for further periods at your option.”
Merely inserting a “best endeavours” clause is woefully insufficient says Van Zantwijk. Licensors should watch out that an intermediary isn’t brought into play. For example, if the license provides for a royalty of 5% of turnover from the sales o f licensed products, the licensor must make sure that the licensee can’t sell the licensed products to a sister company at cost, which then on-sells the products at market value. The licensor would then only receive 5% of the cost instead of market price.
Beware, profits are easily manipulated
“Never conclude a license where royalties are calculated as a percentage of profits,” warns Van Zantwijk. “Profits are easily manipulated by drawing a larger salary or purchasing capital equipment.”
If royalties are calculated at an amount per product made or sold (i.e. R1.50 per widget) ensure that the license includes an escalation clause that increases the amount annually by at least CPI. Remember what was a sizeable paycheque a few years ago, won’t get you very far today.
Where possible, Van Zantwijk says don’t conclude a contract governed by laws you aren’t familiar with. “Many clauses permitted under South African law are regarded as anti-competitive or abusive in other countries. For instance, should you be found to have abused your rights in terms of US law, you may well find your exclusive license converted into an irrevocable, royalty-free, exclusive license.” It is also wise to consider South African exchange control regulations when concluding a license with a foreigner.
Finally, always ensure that you obtain access to associated know-how when licensing patents. This is particularly important when licensing process patents or product patents where tolerances are important. If access to the know-how isn’t provided for, the licensee may well find himself having to conclude a second license for the know-how for an additional royalty.
Once the license agreement has been signed, Van Zantwijk advises licensors to consider recording it on the intellectual property registers. “Doing so will convert the personal rights enforceable between the parties into real rights attaching to the intellectual property licensed.”
The inventing may start out as the hard part, but you’ll very quickly find that licensing your patent or product is also a serious undertaking. In order to profit from your invention, make every effort to secure the best possible licensing agreement.
Anthony van Zantwijk of Sibanda & Zantwijk can be contacted on 083 411 8630, firstname.lastname@example.org or visit: www.zaiplaw.co.za.