Strategic Licensing Leveraging Technology Through Alliances

It takes more than great technology to make a successful product. In an era marked by short product cycles, technical interdependence of products, fluid industry standards and globalization of markets, few companies can field all the resources needed to exploit the full potential of a new invention before it becomes obsolete. Strategic alliances have become the preferred way for emerging technology companies to assemble these resources and to close the gap between promising prototype and popular product.

Intellectual property licensing is at the heart of most technology-based alliances. This article discusses the key legal and conceptual tools available in the licensing context, and how they can be used in an alliance to amplify the value of a new technology.

Why Ally?

Strategic alliances occupy the center of the make-or-buy continuum: through an alliance, a company can access strategic assets ' whether complementary technology, R&D funding, an installed base of compatible products, a distribution network or manufacturing capacity ' faster and cheaper than it could create these assets internally, and with more control and flexibility than traditional contract models offer. In an alliance, the parties blend their complementary strengths to pursue a defined market, in a structure that aligns the economic interests of both parties with the success of the venture. The immediate result is that products are developed and deployed faster and to a wider audience. Over the long term, the alignment of interests promotes cooperation in the face of adversity, an adaptive approach that changing markets demand.

The classic strategic alliance is the equity joint venture, where a new entity is created to occupy a market niche that neither venturer can exploit alone. The venture may license technology from one or both parties, and contract with the parties for additional R&D, manufacturing, or marketing, or take these functions in-house. Interests are aligned through shared investment in the venture and a mutual commitment to approach the defined market only through the venture.

More common today is the contractual alliance, a virtual enterprise created through a series of related long-term contracts. A typical example is an alliance between an emerging technology company and a larger, established participant in the target industry. The emerging company obtains access to the established company's installed base and marketing channel, and neutralizes a potential competitor, in exchange for an exclusive or preferential license of its technology; the established company gets a new product or add-on with no development costs or lead time. Often the larger company will take an equity position in its partner, in order to participate in the success it expects to foster.

The Role of the License

A license agreement can be simple, but the choices leading to that agreement seldom are. The set of tools for controlling the use of licensed technology, the economics of its exploitation, and the future of its development is so robust that an inventory of the licensing options can serve as a checklist for the structure of an alliance. License terms can even function as surrogates, in some contexts, for entity-level issues such as governance, profit sharing, and equity contributions. (For a review of interactions between technology-transfer issues and structural and governance issues in alliances, see Killingsworth, “Form, Function and Fairness: Structuring the Technology Joint Venture,” The Computer Lawyer, March 1998, p.1, and April 1998, p. 8. In general, every restriction on the scope of the license functions analogously to a governance-based veto power over certain potential activities of the alliance, but without concomitant fiduciary duties.)

For these reasons, the alliance's essential character is often forged in the license negotiations. Since each term can be either an opportunity or a pitfall for the entrepreneur entering a strategic alliance, it is critical to understand licensing options and their implications before negotiations begin. The following issues are among the most important.

Exclusivity, Scope and Competition

Most alliances receive some type of exclusive rights to the technology. Depending on the opportunity at hand, this exclusivity may be defined geographically, by field of use, by specific products or trademarks, or even by distribution channel. Exclusivity not only confers a competitive advantage against unlicensed third parties, it also ensures that the licensor-owner cannot use the licensed technology to compete against the alliance within its domain. Hence the scope of exclusivity defines both the primary niche or opportunity the alliance will pursue, and a zone free of any conflicting interest of the licensor.

This latter point is structurally important. The alignment of the parties' interests within the venture should be reinforced by the elimination of conflicting temptations outside it, and an exclusive grant does just that.

Conversely, the owner must take care that the scope of the license does not allow the licensee to use the licensed technology to invade whatever market the owner has retained for itself. For example, with territorial exclusivity, the possibility of transshipment should be considered, and where field-of-use exclusivity is concerned, the licensed and retained fields need to represent truly non-fungible applications or wily customers will arbitrage the products against one another on the basis of price. Unfortunately, the newer the technology and the broader its possible applications, the more field-of-use definition amounts to educated guesswork. It may be prudent to begin with a narrow scope and build in a mechanism for future expansion.

In joint ventures, the competitive detente between the owner and the licensee-venture is usually rounded out with a corresponding non-compete obligation on the other venture partner. To prevent future competition from unexpected quarters, the licensor should also consider restricting transfer of the license itself, including transfers as a result of merger and acquisition activity.

Obligation to Exploit

An exclusive license should include a reciprocal obligation to exploit; otherwise, the licensor may find its technology abandoned and its revenue stream dried up. This obligation can take many forms: minimum royalties, minimum unit sales, a commitment to bundle the technology with another product, defined marketing efforts or promotional budgets, or good old “best efforts.” (Not only is the meaning of “best efforts” unclear, it also varies between jurisdictions.) The licensee is likely to prefer a standard based on effort; the licensor, on results. Negotiations on these points often bring a depressing clarity to the distinction between what the licensee intends to do, and what it will legally commit itself to do.

As important as the obligation itself are the carrots and sticks attached to it. A mandatory royalty payment is a powerful “stick”, but other remedies such as termination, loss of exclusivity, or, in the case of a joint venture, transfer of control, may be more appropriate in some circumstances, particularly if the product is new and its market uncertain. To motivate the licensee to achieve better-than-expected results, the licensor may also offer incentives such as expansion of license scope or territory, access to additional technology, an extension of the license term, or declining royalty rates.

Royalty Type

Whether by design or by default, every royalty formula involves allocation of various risks and rewards between the parties to the license. If there were no uncertainties about future sales volume, market price, or the effect of competition, the value of the technology would be known and a fixed royalty would carry no risk. In real life, a fixed royalty imposes all the market risk on the licensee in exchange for all of the upside potential. But with running royalties, the parties share the risks and the rewards of these uncertainties by bringing market feedback into the picture – if the technology proves itself more valuable than anticipated, the licensor receives more; if the technology flops, the licensee pays less. This sharing of market risks and rewards harmonizes the parties' interests; moreover, compared to a fixed royalty, a running royalty increases the range of market outcomes that will be acceptable to both parties.

Different running-royalty formulas allocate risk and reward differently. A fixed payment per unit sold divides the risks and rewards associated with unit sales volume, but allocates the risks of a low selling price and the rewards of a high price to the licensee. This may be appropriate where the technology represents a small percentage of the value of the end-product, but if the royalty is substantial, a per-unit formula gives the licensee a perverse incentive to maximize sales price at the expense of volume.

By contrast, with percentage-of-revenue royalties the parties share the risks and rewards associated with both unit sales volume and selling price. This formula is popular when the technology represents a large part of the value of the end-product, and that value is uncertain – the usual case in strategic alliances. Royalties can also be based on profits, giving the licensor a stake in the costs of production; this is essentially the same as non-voting equity in the venture, and is seldom preferable to true equity.

Royalty Structure

Revenue-based royalties call for explicit and detailed attention to the underlying business model, since the licensor's return can vary widely depending on how the product is packaged and marketed. Whether the licensee will sell direct or through resellers may affect the price (and royalty) per unit by 50% or more, raising the question whether the licensor is willing to trust the licensee to make it up on volume. How is distribution through the licensee's affiliates handled? What are the boundaries of the “product” for purposes of revenue calculations? If the product is sold both separately and in a bundle, how are royalties computed on the bundled sales? If the product is sold as an add-on to non-royalty-bearing products, what keeps it from being used as a loss-leader? If sublicensing is permitted, how are royalties calculated in that context?

Once the basic royalty parameters are set, it may be appropriate to adjust the payment structure to achieve particular goals, such as using minimum royalties to encourage aggressive marketing. Royalty concessions up front can be used to jump-start a marketing campaign, or, in the joint venture context, as a contribution towards the licensor's equity in the venture. Royalties that decline as a function of total sales can give the licensor a preferential return until its R&D costs are covered, while motivating the licensee to maximize sales volume in order to increase its margins. The licensee may request declining royalties, or even a cap, on the grounds that the competitive edge provided by the technology may decrease over time, but the licensor may counter that the momentum value of established market share and brand recognition will more than compensate for this.

The licensee may also want adjustments to the royalties for contingencies such as failure of a patent to issue, invalidation of a patent, infringement claims, publication of trade secrets, and the like; this may require careful assessment of the relative values of various components of the licensed technology.

Improvements and Joint Development

Improvements on the licensed technology present some of the thorniest intellectual property issues, particularly if both parties will be contributing technology to create a hybrid product. What options, if any, does the licensee have to acquire new technologies, and how is the price determined? Are improvements covered by the original license (and the agreed royalty), and if so, how are “improvements” distinguished from “new products” that are fair game for a separate license, or for licensing to someone else?

The licensor has a strategic interest in getting grant-back rights to any improvements the licensee invents. Besides leveraging the licensor's continued R&D, a grant-back also eliminates the ominous prospect that licensee intellectual property rights may “block” the licensor's future development path. Grant-backs and ownership issues are very difficult, though, where the improvements occur at the intersection of the parties' two technologies, and therefore could be considered improvements of either one – especially if the improvements are created through a joint effort. These issues should be addressed in advance, with an eye on the anticipated method and direction of ongoing development. Some form of cross-licensing of improvements is often adopted, and in the joint venture context, an auction between the parties of venture-developed technology may make sense when the venture terminates.

Joint ownership, often suggested and adopted as the simple solution to these problems, is usually the wrong answer. Joint ownership has different consequences under patent law than under copyright law – for example, as to whether one owner must account to the other for income received from the property – so what do you do with an improvement consisting of copyrightable software embodying a patented method? Also, all joint owners may be necessary parties to any infringement claim, and, in some countries, the consent of all owners may be necessary to grant a license.

A strategic license will involve many additional issues, such as performance and infringement warranties, liability limitations, support obligations, and termination and transition provisions. But negotiating the key points discussed above will force the parties to flesh out the alliance's business model and bring into focus the issues vital to its success.

It takes more than great technology to make a successful product. In an era marked by short product cycles, technical interdependence of products, fluid industry standards and globalization of markets, few companies can field all the resources needed to exploit the full potential of a new invention before it becomes obsolete. Strategic alliances have become the preferred way for emerging technology companies to assemble these resources and to close the gap between promising prototype and popular product.

Intellectual property licensing is at the heart of most technology-based alliances. This article discusses the key legal and conceptual tools available in the licensing context, and how they can be used in an alliance to amplify the value of a new technology.

Why Ally?

Strategic alliances occupy the center of the make-or-buy continuum: through an alliance, a company can access strategic assets ' whether complementary technology, R&D funding, an installed base of compatible products, a distribution network or manufacturing capacity ' faster and cheaper than it could create these assets internally, and with more control and flexibility than traditional contract models offer. In an alliance, the parties blend their complementary strengths to pursue a defined market, in a structure that aligns the economic interests of both parties with the success of the venture. The immediate result is that products are developed and deployed faster and to a wider audience. Over the long term, the alignment of interests promotes cooperation in the face of adversity, an adaptive approach that changing markets demand.

The classic strategic alliance is the equity joint venture, where a new entity is created to occupy a market niche that neither venturer can exploit alone. The venture may license technology from one or both parties, and contract with the parties for additional R&D, manufacturing, or marketing, or take these functions in-house. Interests are aligned through shared investment in the venture and a mutual commitment to approach the defined market only through the venture.

More common today is the contractual alliance, a virtual enterprise created through a series of related long-term contracts. A typical example is an alliance between an emerging technology company and a larger, established participant in the target industry. The emerging company obtains access to the established company's installed base and marketing channel, and neutralizes a potential competitor, in exchange for an exclusive or preferential license of its technology; the established company gets a new product or add-on with no development costs or lead time. Often the larger company will take an equity position in its partner, in order to participate in the success it expects to foster.

The Role of the License

A license agreement can be simple, but the choices leading to that agreement seldom are. The set of tools for controlling the use of licensed technology, the economics of its exploitation, and the future of its development is so robust that an inventory of the licensing options can serve as a checklist for the structure of an alliance. License terms can even function as surrogates, in some contexts, for entity-level issues such as governance, profit sharing, and equity contributions. (For a review of interactions between technology-transfer issues and structural and governance issues in alliances, see Killingsworth, “Form, Function and Fairness: Structuring the Technology Joint Venture,” The Computer Lawyer, March 1998, p.1, and April 1998, p. 8. In general, every restriction on the scope of the license functions analogously to a governance-based veto power over certain potential activities of the alliance, but without concomitant fiduciary duties.)

For these reasons, the alliance's essential character is often forged in the license negotiations. Since each term can be either an opportunity or a pitfall for the entrepreneur entering a strategic alliance, it is critical to understand licensing options and their implications before negotiations begin. The following issues are among the most important.

Exclusivity, Scope and Competition

Most alliances receive some type of exclusive rights to the technology. Depending on the opportunity at hand, this exclusivity may be defined geographically, by field of use, by specific products or trademarks, or even by distribution channel. Exclusivity not only confers a competitive advantage against unlicensed third parties, it also ensures that the licensor-owner cannot use the licensed technology to compete against the alliance within its domain. Hence the scope of exclusivity defines both the primary niche or opportunity the alliance will pursue, and a zone free of any conflicting interest of the licensor.

This latter point is structurally important. The alignment of the parties' interests within the venture should be reinforced by the elimination of conflicting temptations outside it, and an exclusive grant does just that.

Conversely, the owner must take care that the scope of the license does not allow the licensee to use the licensed technology to invade whatever market the owner has retained for itself. For example, with territorial exclusivity, the possibility of transshipment should be considered, and where field-of-use exclusivity is concerned, the licensed and retained fields need to represent truly non-fungible applications or wily customers will arbitrage the products against one another on the basis of price. Unfortunately, the newer the technology and the broader its possible applications, the more field-of-use definition amounts to educated guesswork. It may be prudent to begin with a narrow scope and build in a mechanism for future expansion.

In joint ventures, the competitive detente between the owner and the licensee-venture is usually rounded out with a corresponding non-compete obligation on the other venture partner. To prevent future competition from unexpected quarters, the licensor should also consider restricting transfer of the license itself, including transfers as a result of merger and acquisition activity.

Obligation to Exploit

An exclusive license should include a reciprocal obligation to exploit; otherwise, the licensor may find its technology abandoned and its revenue stream dried up. This obligation can take many forms: minimum royalties, minimum unit sales, a commitment to bundle the technology with another product, defined marketing efforts or promotional budgets, or good old “best efforts.” (Not only is the meaning of “best efforts” unclear, it also varies between jurisdictions.) The licensee is likely to prefer a standard based on effort; the licensor, on results. Negotiations on these points often bring a depressing clarity to the distinction between what the licensee intends to do, and what it will legally commit itself to do.

As important as the obligation itself are the carrots and sticks attached to it. A mandatory royalty payment is a powerful “stick”, but other remedies such as termination, loss of exclusivity, or, in the case of a joint venture, transfer of control, may be more appropriate in some circumstances, particularly if the product is new and its market uncertain. To motivate the licensee to achieve better-than-expected results, the licensor may also offer incentives such as expansion of license scope or territory, access to additional technology, an extension of the license term, or declining royalty rates.

Royalty Type

Whether by design or by default, every royalty formula involves allocation of various risks and rewards between the parties to the license. If there were no uncertainties about future sales volume, market price, or the effect of competition, the value of the technology would be known and a fixed royalty would carry no risk. In real life, a fixed royalty imposes all the market risk on the licensee in exchange for all of the upside potential. But with running royalties, the parties share the risks and the rewards of these uncertainties by bringing market feedback into the picture – if the technology proves itself more valuable than anticipated, the licensor receives more; if the technology flops, the licensee pays less. This sharing of market risks and rewards harmonizes the parties' interests; moreover, compared to a fixed royalty, a running royalty increases the range of market outcomes that will be acceptable to both parties.

Different running-royalty formulas allocate risk and reward differently. A fixed payment per unit sold divides the risks and rewards associated with unit sales volume, but allocates the risks of a low selling price and the rewards of a high price to the licensee. This may be appropriate where the technology represents a small percentage of the value of the end-product, but if the royalty is substantial, a per-unit formula gives the licensee a perverse incentive to maximize sales price at the expense of volume.

By contrast, with percentage-of-revenue royalties the parties share the risks and rewards associated with both unit sales volume and selling price. This formula is popular when the technology represents a large part of the value of the end-product, and that value is uncertain – the usual case in strategic alliances. Royalties can also be based on profits, giving the licensor a stake in the costs of production; this is essentially the same as non-voting equity in the venture, and is seldom preferable to true equity.

Royalty Structure

Revenue-based royalties call for explicit and detailed attention to the underlying business model, since the licensor's return can vary widely depending on how the product is packaged and marketed. Whether the licensee will sell direct or through resellers may affect the price (and royalty) per unit by 50% or more, raising the question whether the licensor is willing to trust the licensee to make it up on volume. How is distribution through the licensee's affiliates handled? What are the boundaries of the “product” for purposes of revenue calculations? If the product is sold both separately and in a bundle, how are royalties computed on the bundled sales? If the product is sold as an add-on to non-royalty-bearing products, what keeps it from being used as a loss-leader? If sublicensing is permitted, how are royalties calculated in that context?

Once the basic royalty parameters are set, it may be appropriate to adjust the payment structure to achieve particular goals, such as using minimum royalties to encourage aggressive marketing. Royalty concessions up front can be used to jump-start a marketing campaign, or, in the joint venture context, as a contribution towards the licensor's equity in the venture. Royalties that decline as a function of total sales can give the licensor a preferential return until its R&D costs are covered, while motivating the licensee to maximize sales volume in order to increase its margins. The licensee may request declining royalties, or even a cap, on the grounds that the competitive edge provided by the technology may decrease over time, but the licensor may counter that the momentum value of established market share and brand recognition will more than compensate for this.

The licensee may also want adjustments to the royalties for contingencies such as failure of a patent to issue, invalidation of a patent, infringement claims, publication of trade secrets, and the like; this may require careful assessment of the relative values of various components of the licensed technology.

Improvements and Joint Development

Improvements on the licensed technology present some of the thorniest intellectual property issues, particularly if both parties will be contributing technology to create a hybrid product. What options, if any, does the licensee have to acquire new technologies, and how is the price determined? Are improvements covered by the original license (and the agreed royalty), and if so, how are “improvements” distinguished from “new products” that are fair game for a separate license, or for licensing to someone else?

The licensor has a strategic interest in getting grant-back rights to any improvements the licensee invents. Besides leveraging the licensor's continued R&D, a grant-back also eliminates the ominous prospect that licensee intellectual property rights may “block” the licensor's future development path. Grant-backs and ownership issues are very difficult, though, where the improvements occur at the intersection of the parties' two technologies, and therefore could be considered improvements of either one – especially if the improvements are created through a joint effort. These issues should be addressed in advance, with an eye on the anticipated method and direction of ongoing development. Some form of cross-licensing of improvements is often adopted, and in the joint venture context, an auction between the parties of venture-developed technology may make sense when the venture terminates.

Joint ownership, often suggested and adopted as the simple solution to these problems, is usually the wrong answer. Joint ownership has different consequences under patent law than under copyright law – for example, as to whether one owner must account to the other for income received from the property – so what do you do with an improvement consisting of copyrightable software embodying a patented method? Also, all joint owners may be necessary parties to any infringement claim, and, in some countries, the consent of all owners may be necessary to grant a license.

A strategic license will involve many additional issues, such as performance and infringement warranties, liability limitations, support obligations, and termination and transition provisions. But negotiating the key points discussed above will force the parties to flesh out the alliance's business model and bring into focus the issues vital to its success.