Derivative Applications for Patent License Agreements

Successful patent licensing transactions provide 'win-win' outcomes for both the licensor and the licensee; that is, both negotiating parties realize a benefit under the consummated transaction. However, defining mutually agreeable terms and royalty structures can present challenges for licensors and licensees alike, particularly when the commercial potential for the patents under consideration is unproven or unknown at the time of the negotiation. The dilemma of successfully pricing early stage technology is further exacerbated when one or both of the negotiating parties are resource constrained or lack experience in the relevant market. The authors propose that the application of derivative provisions, such as those commonly found in the financial markets, to patent license agreements may mitigate licensing risk and provide attractive alternatives to those interested in altering the inherent tradeoffs of traditional licensing structures.

Derivative Instruments

In the financial marketplace, securities instruments may be broadly characterized as fundamental, underlying assets, such as stocks and bonds, or derivative assets, such as options. As their name implies, derivatives are financial instruments that derive their value and payoffs from underlying assets. Two common forms of derivatives are call options and put options.

The owner of a call option has the right, but not obligation, to buy the underlying asset at a predetermined strike price within a specified time period. For example, a one-year call option on one share of IBM stock with a strike price of $100 would provide its owner with the right, but not obligation, to buy the IBM stock for $100 for a period of one year. If over the course of the ensuing year, the price of IBM stock appreciated to $120 per share, the call option would be 'exercised' by its owner, netting $20 of profit (i.e., the $120 stock would be bought for only $100 under the terms of the call option). Alternatively, if over the course of the ensuing year, the price of IBM stock fell to $80 per share, the call option would not be exercised by its owner; rather, the call option would expire worthless.

Conversely, the owner of a put option has the right, but not obligation, to sell the underlying asset at a predetermined strike price within a specified time period. For example, a one-year put option on one share of IBM stock with a strike price of $100 would provide its owner with the right, but not obligation, to sell the IBM stock for $100 for a period of one year. If over the course of the ensuing year, the price of IBM stock fell to $80 per share, the put option would be exercised by its owner, netting $20 of profit (i.e., the $80 stock would be sold for $100 under the terms of the put option). Alternatively, if over the course of the ensuing year, the price of IBM stock appreciated to $120 per share, the put option would not be exercised by its owner; rather, the put option would expire worthless.

Call and put options are commonly used in the financial markets to manage the risk and uncertainty associated with owning underlying assets. The owner of IBM stock could 'insure' his investment in IBM stock by buying a put option that would allow for the sale of the stock at a 'locked-in' price in the event of a market downturn. The same owner could buy a call option to preserve his ability to purchase IBM stock in the future at a 'locked-in' price in the event of a market upswing. Similar strategies for risk transfer and management could be employed by licensing professionals and technology managers in order to mitigate the uncertainty associated with licensing early stage technology.

Existing Patent License Structures

Typical patent license royalty structures ' comprised of some combination of lump sum and/or running-royalties ' confront would-be licensors and licensees with uncertainty and tradeoffs. Under a lump sum structure, the licensor would receive upfront royalty compensation but would not participate in future success of the licensed technology. In this scenario, the licensee would bear the risk and rewards associated with the future commercialization of the technology, and the licensor's payoff would remain fixed irrespective of the future commercial success or failure of the licensed technology. Conversely, under a running-royalty structure, the licensor would receive ongoing royalty compensation in the event of a successful technology commercialization, but would also bear the risk of payment default in the event of an unsuccessful commercialization. Traditionally, licensors and licensees have attempted to manage the lump sum/running royalty tradeoff by negotiating additional payment provisions, such as guaranteed maximum or minimum payments, periodic milestone payments, or equity-based compensation. However, as will be discussed below, the authors propose that such provisions do not provide as comprehensive a solution as a derivative-based license structure.

Derivative-Based License Structures

Call Option Provision

The inclusion of a call option provision on a running-royalty license agreement could provide the licensee with the right, but not obligation, to purchase the licensed patent outright from the licensor for a predetermined strike price within a specified time period. A callable license would provide the licensee a means of relieving itself from burdensome, future running royalty payments in the event of a successful technology commercialization. A callable license may also be attractive from the perspective of a licensor in that it would allow for participation in the future upside of the commercialization effort while simultaneously encouraging licensee investment in the subject technology and discouraging licensee design-around efforts. Resource constrained licensees could use callable provisions to forego costly upfront payments and to provide more latitude for payment of higher running royalty rates.

To illustrate, assume a license agreement with a 10% running royalty and a three-year call option with a strike price of $5 million. Under such a scenario, the licensee would pay a 10% royalty but would have the option to purchase the patent outright for $5 million at any time over the next three years. While the financial payoffs of structuring an agreement in such a way are similar to those achieved by the inclusion of a maximum royalty provision, the execution of a call option would also convey the right of patent ownership to the licensee. As a result, the use of a call option would likely provide a greater incentive to the licensee to invest in and commercialize the technology in that the agreement would provide, at the option of the licensee, all of the benefits associated with ownership of the patent including, but not limited to, the ability to enter license agreements and collect royalties from third parties. Furthermore, because the option price is set at a predetermined level that is not influenced by the extent to which the technology is commercialized, investments made by the licensee would serve to significantly increase the value of its call option. From the licensor's perspective, although such a license structure does not guarantee a minimum payoff, as a result of the control conferred to the licensee and the duration of the option, the negotiated strike price would likely be set at a rate in excess of any guaranteed minimum royalty payments that the licensor might be able to negotiate. Moreover, any additional investment made by the licensee into the subject technology would serve to increase the likelihood of achieving the $5 million payment ceiling.

Put Option Provision

The inclusion of a put option provision on a running-royalty license agreement could provide the licensor with the right, but not obligation, to sell the licensed patent outright to the licensee for a predetermined strike price within a specified time period. A putable license would provide the licensor a means of monetizing uncertain future running royalty payments independent of the success of the technology commercialization. Like its callable counterpart, a putable license would simultaneously encourage licensee investment in the subject technology and discourage licensee design-around efforts. Put option provisions may also be attractive from the perspective of a licensee in that they would place downward pressure on negotiated running royalty rates.

To that point, assume a license agreement with a 10% running royalty and a three-year put option with a strike price of $5 million. While the benefits of structuring an agreement in such a way are similar to those achieved by the inclusion of a guaranteed minimum royalty provision, the use of a put-option also allows for the patent holder to 'wash his hands' of the technology by forcing a sale to the licensee. In such an event, the licensor would no longer be responsible for the management of the portfolio, payment of maintenance fees, or any other activity required to maintain the technology for the purpose of complying with the terms of the license agreement. Furthermore, because structuring the agreement in such a way would both guarantee the licensor a minimum payment and provide an opportunity to benefit from the upside in the event that the commercialization of the technology exceeds the parties' expectations, it would be expected that the licensee would have significant leverage to negotiate a lower royalty rate.

Conclusion

Because successful patent licensing transactions provide 'win-win' outcomes for both the licensor and the licensee, it is important to find deal structures that anticipate the ever-expanding goals and objectives of the negotiating parties. The application of derivative provisions, such as those commonly found in the financial markets, to patent license agreements may provide an attractive alternative to negotiating parties interested in altering the inherent tradeoffs of traditional licensing structures.

Kevin Arst and Michael Milani are managing directors in Ocean Tomo, LLC's Expert Services division. Their practices are focused on assisting clients and counsel with the determination of damages in IP infringement litigation. They are based out of the firm's San Francisco and Chicago offices respectively.

Successful patent licensing transactions provide 'win-win' outcomes for both the licensor and the licensee; that is, both negotiating parties realize a benefit under the consummated transaction. However, defining mutually agreeable terms and royalty structures can present challenges for licensors and licensees alike, particularly when the commercial potential for the patents under consideration is unproven or unknown at the time of the negotiation. The dilemma of successfully pricing early stage technology is further exacerbated when one or both of the negotiating parties are resource constrained or lack experience in the relevant market. The authors propose that the application of derivative provisions, such as those commonly found in the financial markets, to patent license agreements may mitigate licensing risk and provide attractive alternatives to those interested in altering the inherent tradeoffs of traditional licensing structures.

Derivative Instruments

In the financial marketplace, securities instruments may be broadly characterized as fundamental, underlying assets, such as stocks and bonds, or derivative assets, such as options. As their name implies, derivatives are financial instruments that derive their value and payoffs from underlying assets. Two common forms of derivatives are call options and put options.

The owner of a call option has the right, but not obligation, to buy the underlying asset at a predetermined strike price within a specified time period. For example, a one-year call option on one share of IBM stock with a strike price of $100 would provide its owner with the right, but not obligation, to buy the IBM stock for $100 for a period of one year. If over the course of the ensuing year, the price of IBM stock appreciated to $120 per share, the call option would be 'exercised' by its owner, netting $20 of profit (i.e., the $120 stock would be bought for only $100 under the terms of the call option). Alternatively, if over the course of the ensuing year, the price of IBM stock fell to $80 per share, the call option would not be exercised by its owner; rather, the call option would expire worthless.

Conversely, the owner of a put option has the right, but not obligation, to sell the underlying asset at a predetermined strike price within a specified time period. For example, a one-year put option on one share of IBM stock with a strike price of $100 would provide its owner with the right, but not obligation, to sell the IBM stock for $100 for a period of one year. If over the course of the ensuing year, the price of IBM stock fell to $80 per share, the put option would be exercised by its owner, netting $20 of profit (i.e., the $80 stock would be sold for $100 under the terms of the put option). Alternatively, if over the course of the ensuing year, the price of IBM stock appreciated to $120 per share, the put option would not be exercised by its owner; rather, the put option would expire worthless.

Call and put options are commonly used in the financial markets to manage the risk and uncertainty associated with owning underlying assets. The owner of IBM stock could 'insure' his investment in IBM stock by buying a put option that would allow for the sale of the stock at a 'locked-in' price in the event of a market downturn. The same owner could buy a call option to preserve his ability to purchase IBM stock in the future at a 'locked-in' price in the event of a market upswing. Similar strategies for risk transfer and management could be employed by licensing professionals and technology managers in order to mitigate the uncertainty associated with licensing early stage technology.

Existing Patent License Structures

Typical patent license royalty structures ' comprised of some combination of lump sum and/or running-royalties ' confront would-be licensors and licensees with uncertainty and tradeoffs. Under a lump sum structure, the licensor would receive upfront royalty compensation but would not participate in future success of the licensed technology. In this scenario, the licensee would bear the risk and rewards associated with the future commercialization of the technology, and the licensor's payoff would remain fixed irrespective of the future commercial success or failure of the licensed technology. Conversely, under a running-royalty structure, the licensor would receive ongoing royalty compensation in the event of a successful technology commercialization, but would also bear the risk of payment default in the event of an unsuccessful commercialization. Traditionally, licensors and licensees have attempted to manage the lump sum/running royalty tradeoff by negotiating additional payment provisions, such as guaranteed maximum or minimum payments, periodic milestone payments, or equity-based compensation. However, as will be discussed below, the authors propose that such provisions do not provide as comprehensive a solution as a derivative-based license structure.

Derivative-Based License Structures

Call Option Provision

The inclusion of a call option provision on a running-royalty license agreement could provide the licensee with the right, but not obligation, to purchase the licensed patent outright from the licensor for a predetermined strike price within a specified time period. A callable license would provide the licensee a means of relieving itself from burdensome, future running royalty payments in the event of a successful technology commercialization. A callable license may also be attractive from the perspective of a licensor in that it would allow for participation in the future upside of the commercialization effort while simultaneously encouraging licensee investment in the subject technology and discouraging licensee design-around efforts. Resource constrained licensees could use callable provisions to forego costly upfront payments and to provide more latitude for payment of higher running royalty rates.

To illustrate, assume a license agreement with a 10% running royalty and a three-year call option with a strike price of $5 million. Under such a scenario, the licensee would pay a 10% royalty but would have the option to purchase the patent outright for $5 million at any time over the next three years. While the financial payoffs of structuring an agreement in such a way are similar to those achieved by the inclusion of a maximum royalty provision, the execution of a call option would also convey the right of patent ownership to the licensee. As a result, the use of a call option would likely provide a greater incentive to the licensee to invest in and commercialize the technology in that the agreement would provide, at the option of the licensee, all of the benefits associated with ownership of the patent including, but not limited to, the ability to enter license agreements and collect royalties from third parties. Furthermore, because the option price is set at a predetermined level that is not influenced by the extent to which the technology is commercialized, investments made by the licensee would serve to significantly increase the value of its call option. From the licensor's perspective, although such a license structure does not guarantee a minimum payoff, as a result of the control conferred to the licensee and the duration of the option, the negotiated strike price would likely be set at a rate in excess of any guaranteed minimum royalty payments that the licensor might be able to negotiate. Moreover, any additional investment made by the licensee into the subject technology would serve to increase the likelihood of achieving the $5 million payment ceiling.

Put Option Provision

The inclusion of a put option provision on a running-royalty license agreement could provide the licensor with the right, but not obligation, to sell the licensed patent outright to the licensee for a predetermined strike price within a specified time period. A putable license would provide the licensor a means of monetizing uncertain future running royalty payments independent of the success of the technology commercialization. Like its callable counterpart, a putable license would simultaneously encourage licensee investment in the subject technology and discourage licensee design-around efforts. Put option provisions may also be attractive from the perspective of a licensee in that they would place downward pressure on negotiated running royalty rates.

To that point, assume a license agreement with a 10% running royalty and a three-year put option with a strike price of $5 million. While the benefits of structuring an agreement in such a way are similar to those achieved by the inclusion of a guaranteed minimum royalty provision, the use of a put-option also allows for the patent holder to 'wash his hands' of the technology by forcing a sale to the licensee. In such an event, the licensor would no longer be responsible for the management of the portfolio, payment of maintenance fees, or any other activity required to maintain the technology for the purpose of complying with the terms of the license agreement. Furthermore, because structuring the agreement in such a way would both guarantee the licensor a minimum payment and provide an opportunity to benefit from the upside in the event that the commercialization of the technology exceeds the parties' expectations, it would be expected that the licensee would have significant leverage to negotiate a lower royalty rate.

Conclusion

Because successful patent licensing transactions provide 'win-win' outcomes for both the licensor and the licensee, it is important to find deal structures that anticipate the ever-expanding goals and objectives of the negotiating parties. The application of derivative provisions, such as those commonly found in the financial markets, to patent license agreements may provide an attractive alternative to negotiating parties interested in altering the inherent tradeoffs of traditional licensing structures.

Kevin Arst and Michael Milani are managing directors in Ocean Tomo, LLC's Expert Services division. Their practices are focused on assisting clients and counsel with the determination of damages in IP infringement litigation. They are based out of the firm's San Francisco and Chicago offices respectively.