This series addresses the needs the legal community has for licensing technology knowledge by laying out the basic concepts that one should understand, identifies traps for the unwary and offers drafting and negotiating tips. Click here to read parts one and two.

Royalty obligations should provide a clear description of the licensee’s activities for which royalties are to be paid and should be carefully coordinated with the license grant provisions. The royalty obligations can take different forms depending on the nature of the intellectual property, such as whether it is a machine, a process or a composition of matter. They also may vary based on the licensee’s intended use, e.g., use for manufacturing purposes or sales of patented products.

  1. Royalty Structures

Royalties can be one-time or ongoing. They can include upfront payments, milestone payments or running royalties based on use of the licensed IP.

Running royalties can be based on a percentage of sales revenue (customarily referred to as “net sales”), a percentage of net profits, or a fixed dollar amount per unit. Basing royalties on net profits is difficult, however, and can lead to disputes regarding overhead and other expenses. Also, the licensee may not want to open its books. If the parties do choose net profits, it is essential that the license agreement contain a clear, complete and unambiguous methodology for calculating the net profits.

Drafting Tip: If sales through distributors or sublicensees are involved, then consider a fixed dollar amount per unit sold. The licensor generally does not want to be paid a percentage of a percentage.

  1. Royalty Base

Inexperienced parties sometimes put too little thought into defining the royalty base against which a percentage royalty is applied. When determining the royalty base, key questions include:

  • What is the applicable product unit (e.g., is it a narrow component or the whole device)?
  • Will there be any exclusions, such as standard components (e.g., chips, brackets, belts or hoses), other royalty-bearing products, or shipping, taxes and other necessary payments to third parties?

Drafting Tip: If your client already has locked in an unfavorable royalty rate, it may be possible to significantly improve the economics by focusing on expanding or contracting the royalty base.

  1. Scope Considerations

In certain transactions, it is desirable to limit the royalty base to only activities that would otherwise infringe a valid patent claim. In other transactions it will be more appropriate to include articles outside the scope of the licensed patents. The latter approach would be suitable, for example, if the licensor is providing access to technology or trade secrets beyond the patent rights.

Drafting Tip: The licensor’s counsel needs a clear understanding of the patent misuse doctrine when drafting any royalty base provisions that potentially cover articles beyond the specific patent claims.

  1. Special Dispositions

In the normal course of its business, a licensee may dispose of royalty-bearing products other than by sale at fair market value. The smart licensor, therefore, will have an agreement that addresses:

  • Demos/samples/internal use
  • Bundling/package sales
  • Payments in kind
  • Related party sales
  • Promotional giveaways
  • Loss leaders

Drafting Tip: Depending on the circumstances, possible ways to address the foregoing special dispositions include:

  • Using an assumed price (e.g. list price)
  • Setting a fixed dollar royalty amount per unit
  • For bundled products, pro rata allocations based on list prices
  • Making the royalty a percentage of total bundled product price
  • Including a floor dollar amount per unit in percentage royalty deals
  1. Audit Rights

Audit rights provisions are not just boilerplate and should not be overlooked. The parties will benefit from a careful analysis of how these rights could be exercised in practice.

Drafting Tip: Some licensors may be tempted to omit audit provisions due to a fear of offending the licensee or a feeling that they would never be exercised. This is generally unwise. A licensee intending to operate in good faith should not be offended by an appropriately drafted audit provision. Also, licensors should consider that license agreements often last for many years and the circumstances may change.

  1. Tax and Currency Issues

Take care not to overlook the tax and currency issues because the consequences can be significant. For example, in a cross-border license, the structure of the transaction and geographical locations of the applicable parties can affect the tax withholding requirements, the recovery of value-added taxes or the applicability of certain sales or excise taxes.

Drafting Tip: Get your internal tax and finance resources fully engaged early on. Then, if necessary, hire outside experts as needed to assist with, for example, the international tax and/or local country applications.