Some startups build core technology with the sole purpose of making money by licensing it to others while other startups later discover they have something that could be licensed as a revenue enhancement opportunity. In either case, licensing your intellectual property (IP) is a fairly involved venture with significant downside risks, if done wrong. But if done correctly and with the right partners, magic can happen. This article explains the risks and opportunities with technology licensing deals from a business development and deal structuring perspective (rather than a purely legal perspective).
This article is written for the company that is licensing its technology (the licensor). But in various places I also provide the perspective of the licensee in order to help give a broader view, which should help during negotiations. Like I mentioned above, licensing deals are often fairly involved with no real “cookie cutter” templates to leverage because each deal is so unique. Because of this, it is critical that you engage an attorney that has experience with such deals.
The major sections of this article are as follows:
- Business Intent & Use
- Legal Stuff
Note: I use the terms “technology” and “IP” somewhat interchangeably throughout this article.
Warning: Negotiating and completing a technology licensing deal is involved and usually stressful, especially once the lawyers enter the picture. Prepare to pace yourself because these deals take weeks to complete, not days.
Business Intent & Use
Technology licensing deals usually start with two business people discovering that if the IP developed by one of them were integrated into the products, business model and sales channels of the other, magic things could happen. The “magic” usually takes one of three forms: revenue leverage, competitive differentiation or a proof point. As the technology licensor, it is imperative that you understand which form(s) of magic you will be facilitating for your partner because it will benefit you greatly during negotiations. For more information on this, see my article titled “A Secret to Securing a Strategic Partnership with a Major Player“. With that understanding, let’s start by exploring the concept of business intent and use of the technology that is being licensed.
What is Being Licensed?
Some companies start out with the intention of developing IP that can be licensed to others. Sometimes that IP includes physical components and sometimes not. But in either case the licensed “stuff” does not represent a complete product that can be sold to the ultimate buyer. That’s where the licensing deal with a strategic partner comes into play.
In other cases, a company develops a complete product and later discovers that a subset of their IP and/or physical components can be used by others to create or enhance a different type of product that can be sold into different markets.
The diagram below depicts the continuum of deals you could strike with a strategic partner. At one end is a pure IP licensing deal and at the other end is a traditional distribution deal in which the partner distributes a finished product that you produce. In between are various hybrids of the two. A hybrid deal involves licensed core technology plus some physical component(s) that you manufacture and provide but that is less than a complete product. Your strategic partner takes those and uses them to create some finished product that is taken to market under their brand name.
The focus of this article is pure licensing deals and the licensing subset of hybrid deals. For more information on traditional distribution deals, watch my video titled “Distribution Channels“.
Your strategic partner likely has other partners of their own. Do you want to allow your partner to sub-license your IP to those others? If so, under what conditions? It could dramatically extend the reach and range of your technology but allowing them to sub-license reduces your level of control and influence over the way the IP is used. That might be just fine to you or it might create big conflicts or threats. Part of the answer might lie with whether or not you have other licensees of your technology or perhaps you’re also using the technology in a complete product that you sell yourself.
I’m sure you have a roadmap of planned enhancements for your technology. Which, if any, should automatically be made available to your strategic partner and for how long? Would any such enhancements trigger a change to the license payments you receive? Regarding future technology enhancements, before getting into the legal implications first think on a business level while keeping in mind that things usually don’t play out like you expect. In other words, you might not have any revolutionary enhancements planned but that might be exactly what happens – or vice versa.
First time entrepreneurs and those that have never done licensing deals commonly focus first and most on the economics of the relationship. In other words, pricing-related terms. And it is true that deal economics are extremely important. But there’s an adage that says “tell me your price and I’ll tell you my terms”. Just keep that in mind that a “good deal” is one that provides you a healthy combination of favorable economics and fair terms.
Most IP licensing deals involve royalty payments from the licensee to the licensor. The actual royalty payment is usually influenced by the following factors:
- Volume – There are almost always different royalty amounts tied to pre-defined volume levels. Obviously, the higher the volume the lower the royalty payment.
- Gross Margin – The strategic partner needs to make a certain amount of gross margin on the product they are incorporating your technology into. That usually defines some upper limits on what they can afford to pay you in royalties. Of course, if your technology gives them a competitive advantage, they should be able to increase the price they charge their customers and that might give more room for higher royalty payments to you.
- Exclusivity and Other Special Rights – If you are granting your partner special rights such as exclusivity, sub-licensing or other things listed in the Legal section below, you have leverage to ask for a higher royalty payment.
Warning: A common technique used by experienced buyers is to get the licensor to quote a unit price for a very large quantity just to see how low they can possibly go. Then they set their sights on getting that price for a much lower quantity. I know, not fair. So before you provide such a price, make sure you’re convinced it is a viable scenario. And if they pull the trick I mentioned, you pull out a couple of tricks of your own: pre-payment and minimums (keep reading).
You might be able to convince your partner to issue a pre-payment of future royalties. Why would they do this? The most common reason is to lock in a royalty price based on a volume level that is higher than they will reach shortly after launch but likely achievable within a reasonable timeframe. That way, they minimize their impact to gross margins but they are also accepting some risk. And for you it looks like non-dilutive funding, which can be ideal since most startups and early stage companies are obsessed with their cash balance. But when negotiating a pre-payment, make sure to take the following things into consideration:
- Revenue Recognition – Most accounting guidelines (disclaimer: I’m not a certified accountant) don’t allow you to count a pre-payment as revenue but rather require you to wait until your partner has actually consumed the licenses (ie – sold their product that includes your technology to actual customers). In other words, if your partner gives you a pre-payment for 10,000 units but only consumes 1,000 units per month, you will be able to claim revenue associated with 1,000 units each month. The remainder sits on your balance sheet as a Liability.
- Expiration – Because of the revenue recognition issue, you might be able to negotiate an expiration date for consumption of the license pre-payment. If your partner hasn’t consumed all of the licenses before the expiration date, their pre-payment balance gets wiped out and you’re free to negotiate a new pre-payment or just switch to monthly/quarterly royalty payments based on their actual consumption. Better yet, any balance that gets wiped out can probably be counted as lump sum revenue (check with your accountant). Retailers do the same thing with gift cards.
There are “opportunity costs” with each strategic partnership or licensing deal. In other words, each such deal will consume time and energy from your company that could otherwise be spent doing something else, including working a different/better opportunity. So to make sure your time is well spent with a particular partner, you might impose minimums. It basically means that even if your partner doesn’t consume the stated minimum number of licenses for a given period, they must pay for that level anyway.
The minimums are usually tied to the volume level they committed to when negotiating the royalty price. For example, if they want the price associated with 10,000 units to be consumed over the course of 12 months, you might set a minimum of 2,500 per quarter. If they only consume 1,800 licenses for a given quarter, they still must pay for 2,500. For a newly-launched product you might consider starting lower and scaling up the quarterly minimums to better match your partner’s forecast (ie – 1K, 2K, 3K, 4K units by calendar quarter).
Non-Recoverable Expenses (NRE)
Often times, the IP being licensed isn’t 100% ready to be incorporated by the partner but rather needs some modification or customization to meet their unique needs. This means you’ll have to engage your engineering resources for that custom work. If the revenue opportunity is great enough, you might not have any problem doing so. But what if the partner squeezes you hard on the various economic and legal terms? One thing you could consider asking for is called “non-recoverable expenses” or NRE. You’re basically asking the partner to offset your costs for the unique work needed to get the technology ready for their use. This lowers your financial risk while also demonstrating the seriousness of your licensing partner.
The larger and more significant your licensing partner is the more likely they will request/require exclusivity. But don’t immediately freak out because there are dozens of shades of exclusivity and you might actually be able to negotiate better economic terms if you agree to some level of exclusivity. With licensing deals, your partner must spend time, money and resources to incorporate your technology into theirs before ever starting to generate revenue. If you think about this from their perspective, they don’t want to go through all of that effort and risk only to have direct competition from others using your same technology. This phenomenon mostly applies to the first licensing deal you do. And if your sole business model is based on licensing, you might not agree to any level of exclusivity.
For more information on granting exclusivity but with various limitations to mitigate your risks, see my article titled “Exclusivity – Run Away or Embrace?“. A brief recap of the possible limitations is listed below:
- Specific list of competitors versus all
- Time limit
- Performance requirements (ie – business results)
- Geographic limit (ie – country)
- Specific application use (use case)
- Ability to terminate or buyout the exclusivity if you are acquired
I mentioned at the start of this article that it is critical that you engage an attorney that has experience with licensing deals. Like other complex legal agreements, they are in place only partly for what is LIKELY to happen and just as much or more for what MIGHT happen. Rather than try to give you a bunch of specific legal advice, instead I will mention some topics that you want to make sure to understand and discuss with your attorney. For each, try to put yourself in the shoes of your licensing partner to make sure you are being fair and reasonable.
- Termination Rights – You need various ways to terminate the agreement if it’s no longer good for your business
- Indemnification – Your partner will need some sort of protection in the event you don’t actually own the technology you’re licensing to them or happen to be violating someone else’s patent. This legal provision gets a little scary, so make sure to have your attorney help you understand what’s typical and also what you’re on the hook for.
- Change of Control Provisions – What happens if your company is acquired? In fact, what if your acquirer happens to be a direct competitor to your licensing partner? It is fair for your partner to have some protection mechanisms, even if they only are guaranteed a specific amount of time to keep using your technology so they can implement an alternative.
- Dissolution – What happens if your company runs out of cash and is forced to dissolve? Your partner will want some protection and it might include asking you to place your technology (ie – source code or firmware) into escrow to be released to them following such a condition so that they can continue to service their customers and maybe only for a certain period of time.
- Most Favored Nation Pricing – This generally means that if you ever give another partner better pricing, you must offer it to partners that have this term
If done properly with the right partner(s), technology licensing deals can serve as fabulous leverage for your business. But since the economics and legal terms are more complicated than many other types of business contracts, I highly recommend that you adopt one of my favorite sayings: “measure twice, cut once”. And do so with an experienced attorney.
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