License Agreements - The Basics

Among the many types of business relationships one encounters in the modern world of transactions is the concept of a license agreement, whereby one party grants to another the right to use in a business context a right, trade name, method or product or some other asset owned for mutual benefit. The person or entity granting the right is termed the “Licensor.” The person or entity receiving the right is termed the “Licensee.”

This article shall outline the basic requirements for a successful license arrangement. Competent legal and tax advice is required before culminating a license agreement in the United States.

The reader should first review the articles on Contracts, on Limited Liability Entities, and on Intellectual Property: What it is and How to Protect It before reading further since it will be assumed in this article that the information in those articles is known to the reader.

The Basic Concept of License:

To license is simply to grant another person the right to use some asset one owns for a particular purpose and, usually, for a particular payment or series of payments termed a “royalty.” Most commonly, a party licenses the right to sell or exploit some business asset one owns, such as intellectual property, a product or a methodology. A few examples are a license to develop and promote a patented product and sell same in a particular territory; a license to use one’s product as part of a blend of products that are sold; a license to utilize a trade name or logo to sell a product in a particular locale; the license to publish a copyrighted work one has written, etc. etc.

The license is usually reduced to a written contract specifying the rights, duties, and payments that are part of the license. A license can give all rights to exploit the asset to the licensee (“exclusive license”) or only some of the rights or rights to use in conjunction with other persons (“nonexclusive” or “limited” license.) The license normally grants full rights to the licensee to exploit as the licensee sees fit but may have certain performance criteria or the license lapses or becomes non exclusive.

Normally, the theme of a license is that the licensor is passive, merely receiving royalty payments, while the licensee engages in the business or development and is free to exploit so long as royalties are paid and other criteria met. Failure to abide by the license agreement by the licensee normally results in termination of the license as well as payment of damages to the licensor.

Unlike the sale of an asset, the licensor continues as the ultimate owner of the asset or methodology; limited rights to use what the licensor owns are transferred, not ownership. The alternative to a license is the actual sale of the asset to the purchaser but most licensors wish to continue as owners so that they may exploit the asset in the future or in other territories or applications. It is vital for the licensee to realize that unlike full ownership, the license is merely a group of rights that the licensee obtains with ownership of the whole remaining in the licensor.

Typical issues to Confront:

1. Who Owns What? It is vital to define precisely what rights are being licensed and for how long and in what context. If the licensor owns other assets or concepts that the licensor is exploiting on its own or transferring to third parties, it is important to make full disclosure so that the licensee does not claim that it is facing competition from licensor’s other activities and that the license is valueless. Related to this are variations and improvements on the product or concept, discussed below.
2. How Long, What Price? What does the licensor get from the license? What payments are due when? Is there any guaranteed amount or just a percentage of sales? How are sales computed? How long does it last? What performance criteria must the licensee accomplish to maintain the license? How can the licensee abandon the license and move on to other products and can either the licensor or licensee compete with the product or method with their own or a third party’s product or method?
3. Who Defends What? Particularly with trade names or intellectual property, it is important to define who has the duty to defend against third parties violating rights to the intellectual property and that can be an expensive process. For example, if the licensor licenses a software design that a third party claims was stolen, who must defend the claim and pay any damages? This should all be defined precisely in the agreement.
4. Improvements and Changes. Assuming that the licensor develops an improvement or the next generation of product, does the licensee have the right to exploit that improvement? This is vital to consider since the licensee may create a thriving business only to discover that the licensor has licensed a new product which utterly undercuts the business created by the licensee. Further, if the licensee comes up with a variation or improvement, does that generate any rights in the licensor?
5. Role of Other Licensees. If the license is non exclusive, what protections may exist to stop the other licensee from interfering with sales of the current licensee? How are disputes between the licensees resolved?
6. Right to Assign? Right to Co Venture? Often the licensee will wish to bring in other entities to assist in its efforts to promote the product or service or will seek to sell its own license to another party. What rights does the licensor have to object or approve of such steps?
7. Right of Licensee to Alter the Product or Service. Typically a licensee comes up with its own ideas or variations to the licensed product, either alone or in conjunction with third parties or a customer requests a customized variation. What rights does the licensee have to alter the product or service?
8. Advertising and Promotional Materials. Often a licensor will want approval rights as to all marketing, training, and advertising materials. Often the licensee wants freedom of action and does not want the licensor who may not be well versed in marketing or local conditions, to have a veto power.
9. Indemnity Provisions: Most licensors want full protection, including insurance coverage, for the activities of the licensees. Most licensees want product liability carried by the licensor. The extent of such provisions is often an area of some tense negotiations.
10. Local Regulations and Laws. Many locales, especially Europe, have extremely strict regulations as to products and services and restrictions on right to trade and sell. Indeed, often local law can void contrary provisions in the license agreement. Some products considered safe and legal in a particular jurisdiction are illegal in others. A good example is alcohol sold in some Arab nations. It is vital to check applicable laws and regulations.
11. Taxes and Licenses. It is equally vital to allocate who is responsible for what taxes that may accrue. Normally, the licensor wants to have no involvement in sales or employment activities and wants to be held harmless from all such liabilities, but to achieve that careful attention must be paid to the structure created in the agreement since some jurisdictions may impose pseudo employment taxation in certain license arrangements and, of course, local business licenses must be paid and kept up to date by the licensee.
12. Standard Contract Issues. In addition to the numerous applicable issues that a particular project must consider, the standard terms and conditions and issues relating to them in any business contract must be considered.

Why License?

There are numerous other methods to join efforts to promote and sell a product or service, ranging from joint ownership of a single entity to joint ventures (partnerships of two or more entities) to distribution and sales representative arrangements. In most cases, a license is the method preferred by a person or entity who simply wants an entirely passive role, to wit receiving royalties, with no involvement in the day to day or even strategic marketing decisions. As one client put it, “I just want to sit back and cash my royalty checks.”

But it is seldom that simple, with the activities of the licensee being a matter that must be of keen interest to any wise licensor, since a bad or poorly performing licensee can result in a product or service that could have developed a good cash flow being useless while other competing products come to dominate the field. Further, most licensees need guidance and assistance from the licensor, so inevitably more than “cashing the checks” is involved. While many inventors have a dream of licensing their product to some multinational that will simply pay a great deal of money over time, the average license involves two relatively small businesses who have to work together to make the process successful.

Conclusion:

Licensing a product or service can be an excellent way to generate good cash flow if the document is properly created with a clear understanding of the goals and duties of the parties. More often than not, a license is limited in scope so that the licensor is free to develop certain markets or work with more than one licensee. It is vital to keep not only good legal advice in mind, but to get good tax advice and local knowledge before commencing the relationship. If well done, it can be a way for an inventor or developer of a product or service to minimize the involvement in the work of marketing and providing the service or product while still receiving a good income.