les Nouvelles August 2021 Article of the Month:
Licensing Structures And Compliance In An Evolving IP Landscape
Los Angeles, CA
Ocean Tomo’s Investment Group
Saratoga IP Advisors
Las Vegas, Nevada
I. Licensing Structures
As we discussed during the roundtable in the 2020 LES Annual Conference,1 there are various types of licensing structures available to licensors, each having its own unique set of pros and cons. However, over the past two decades, licensing has seen a gradual transition from the traditional running royalty-based agreements to various, more predictable financial solutions, including fixed annuity fee structures and one-time lump-sum payments. This business transition was accelerated by the adoption of the accounting rule ASC 606, which defines when and how royalties should be recognized. While this transition is by no means complete, the increased commonality of predicable financial solutions mentioned above has made licensing negotiations more nuanced, introducing variables previously not considered. Depending on the type of deal structure agreed upon, these new variables should be considered and explored in preparation for deal making, as well as at the negotiating table—be it real or virtual.
From a fixed annuity fee arrangement or one-time lump-sum perspective, the aforementioned variables influence how an intellectual property owner can boost their short-to intermediate-term earnings. Whether licensing income is attributed to a “profit and loss” business or merely rolls up from a cost center into a parent entity, the never-ending drumbeat of quarterly earnings calls and other near-term financial pressures drives behaviors at the decision-makers’ desks. Licensing revenue is high-margin income that can boost earnings or lessen losses, thereby enabling a decision-maker to navigate competing interests and “financial potholes.” Decision makers are under routine pressure to boost profits, either for a particular quarter or over an intermediate year or few years, for a host of reasons. This pressure can easily force a decision maker to push licensing negotiations from a running royalty stream to a lump-sum payment or defined annuity stream over a fixed period of time.
On the other hand, an intellectual property owner (IPO) unencumbered by quarterly financial pressures and driven to maximize licensing income may have the ability to take a more flexible, running royalty approach—assuming this falls within a licensee’s own strategy. This path may be driven by the overall objectives of the licensor and licensee. For instance, some patent owners run their licensing programs as a tool for secure grant-backs to ensure freedom to operate from prospective licensees. This, of course, would not preclude an IPO from also trying to extract the maximum licensing income from their portfolio. Depending upon the prospective licensee, a structured financial solution using a lump-sum or fixed annuity payment(s) may not be optimal for certain IPOs. In this situation, IPO-licensors may very well prefer a running royalty stream.
One potential downside to a lump-sum or structured annuity payment schedule is that the licensor hypothetically could leave money on the table in exchange for the financial certainty of a guaranteed payment—of course, the contrary may also be true. If a licensor underestimates the upside business potential of the licensee, the licensee may benefit from agreeing to a lump-sum payment. Setting up a running royalty stream tied to the success of the licensee may maximize the overall financial potential of the IPO’s assets. Naturally, if the licensee fails to achieve the lofty goals envisioned at the time of the agreement with the licensor, a running royalty strategy will likely lead to disappointing revenue generation for the licensor. Further, if the IPO’s assets are invalidated before the U.S. Patent and Trademark Office or in a court of law, there is a risk of termination and a cessation of further running royalty payments from the licensee.
At the outset of a licensing negotiation, the preferred path of fixed payment(s) or running royalties amongst both parties may or may not be clear, even if there is increasing evidence that licensees are moving to resolve infringement issues with a fixed solution. Setting up a running royalty regime that is enforceable also requires a compliance program, including audit provisions and human resource investments by both licensor and licensee. Compliance programs are intended to ensure financial returns match the contractual obligations and monies owed. The licensor’s upside in conducting royalty audits in a previously unaudited environment is the potential of uncovering overdue and/or unpaid royalties. The key prompt to launching an audit by a licensor is a sufficiently high enough likelihood that the financial value of royalties unpaid outweighs the audit expense. Audits can also increase compliance as they may be costly for licensees and have a prophylactic effect by signaling the marketplace that non-compliance will not be tolerated. It is also common for licensing agreements to include clauses that impose interest for late royalty payments, surcharges or penalties, and provisions that shift liability for the audit fees if there is a material underpayment - for example, an underpayment of greater than five percent.
Another accounting consideration is the importance of accurately tracking royalty payments. This includes booking payments properly and validating that they are for the appropriate amount and are paid timely. This is an area where a fully-fleshed-out compliance program, including royalty audits, may very well come into play. Matching payments to the appropriate licensing agreement is a critical first step in both contract management, as well as forecasting revenue.
In addition to the aforementioned issues, a licensor may have to deal with exogenous factors that may come into play, such as general legal, antitrust and practical execution problems. The strength of the relationship between licensor and licensee can be crucial to the success of the business solution agreed upon. Unless the licensee is a competitive threat to a licensor’s business, one of a licensing program’s key goals is to extract value from the intellectual property portfolio, not putting licensees out of business. Of course, some licensors view negotiations as a win-lose strategy, which may well be short-sighted.
However, licensees may not desire to engage in an ongoing, running royalty contractual agreement. This reluctance can be attributed to human resource, cash flow, or accounting infrastructure constraints. Again, the licensor’s relationship with the licensee will very likely be a key ingredient in determining the appropriate structure between the parties. Academic institutions, given their typical nonprofit status, are more likely to take a flexible approach concerning licensing payment structures because they are immune to quarterly earnings calls that can have an outsized impact on public companies. Of course, there is also increasing pressure on academic institutions to generate alternate sources of income—pre-COVID-19 and surely post-COVID-19 pandemic. In addition, academic and other nonprofit institutions often have a stated goal of facilitating the transfer of new technology to society at large to enhance brand and reputation.
In a public company, lump-sum or fixed-annuity fee arrangements may be preferred by the licensor and the licensee. The fixed value proposition and avoiding the nuisance prospect of an audit may have a strong appeal for both parties. From the licensor’s perspective, revenue recognition under ASC 606 may help navigate earnings pressure. If there is an anticipated revenue deficit during a particular quarter(s), a lump-sum or fixed annuity fee may be vital to the licensor’s financial health, shareholders’ perceptions, and stock price. Of course, the practice of relying on one-time lump-sum payments may undermine the long-term viability of a licensing “profit and loss” business. Also, in a start-up environment, lump-sum payment arrangements may not be financially feasible absent alternative valuable consideration, such as shareholder equity. Therefore, license deal structures are dictated to a material degree by the nature of the licensee’s business model.
Factors influencing the approach to licensing terms may be driven by the concerns or business model of the licensee. The unique nature of both the technology and business model for each deal’s structure may, in theory, make each agreement a one-off transaction. Both licensor and licensee have to rely on the framework of their competing interests to arrive at a mutually agreeable solution. In the end, a compromise solution should be the goal. However, given the current state of licensing, litigation may be a necessary tool to achieve “the compromise solution.”
Entities preferring lump-sum or fixed-annuity fee arrangements are driven to do so because they simplify forecasting income and balance sheets. These types of agreements may also allow a more refined allocation of resources—human capital and cash—to support a strategic vision(s). The modeling of an annuity-driven deal includes variables such as appropriate royalty rate(s), addressable income(s) of the desired product(s), a CAGR (Compound Annual Growth Rate), a discount rate for a net present value calculation and the length of the licensing term.
Some complex licensing agreements, typically the case with non-practicing entities, may also include waterfall structures. Some such structures include a “first mover’s benefit,” which may afford the first licensee some consideration from the waterfall as a willing collaborator with the licensor. In such circumstances, the key issues include expenses. For example, caps on expenses for operations and litigation, rights afforded, payout and/or abatement triggers are potential real-world considerations.
For deal structures involving parties that each own relevant intellectual property, a common issue is reciprocity. If the agreement involves a cross-license, the IP of both the licensor and licensee may have to be considered, and even evaluated to determine the net value in terms of cash payments or other forms of consideration from one party to the other. This could entail some legal and financial assessment to make this value determination between the parties. If one of the parties is investing in research to make material improvements to a technology, for instance, it may benefit the other party to gain access to new patents and applications from this research. This may afford a reduction in one party’s financial obligation to a total outbound net value owed to the other party in a cross-license agreement.
Another common concern in running royalty stream-based agreements, separate and apart from audit rights, is the prospect of a licensee missing a payment(s). There is a plethora of options to handle this, including a cure window followed by immediate termination of all granted rights. The licensing agreement may also expressly include a clause that the licensee will be deemed a wanton and willful infringer in the event payments are not paid within the cure window. Clauses can also be inserted regarding an interest penalty, dispute resolution forum, and legal fees borne by the licensee. In so doing, the dispute becomes a matter of contract law, as opposed to patent infringement.
Unless the parties are direct competitors, most licensors are typically not motivated to drive the licensee out of business. This is acutely the case if the licensor’s model is purely financially driven, and the payments to be made in whatever structure are part of their strategic vision. In the case of a missed payment, one approach is to allow for the forbearance of payments in the licensing agreement, rather than putting the licensee in breach of contract. This scenario has become increasingly prevalent due to the COVID-19 impact on sales, revenue, and cash flow, especially for contracts containing term annuity payments. This issue, among others, should be strategically considered by each party separately and then again addressed during negotiations. One of several potential goals of outbound licensing is to recapture the research dollars invested in developing a technology. Of course, in a war between rivals, the objective is wholly different than a licensor simply looking for a return on investment from a licensee.
Since the US Supreme Court decision in Alice v. CLS Bank2 in 2014, an increasingly common tactic among licensees is to rebut patent infringement assertions as invalid under 35 U.S.C. § 101. A licensor, in response, should be armed with post-Alice U.S. case law in which these same or similar arguments were made at trial, failed, and were confirmed on appeal. Ultimately, a license is effectively an insurance policy against a lawsuit. Few patents are completely unassailable, and similarly, few prospective licensees are without any risk of litigation expense. Ideally, the licensing bargain is on reasonable terms based on each party’s risk tolerances and motivations.
Another critical component in structuring a licensing agreement is revenue. Each company takes its own path with respect to their evaluation of each of these issues. Regarding revenue recognition, futures relate to a license grant to patent applications filed after a licensing agreement is executed. From a GAAP (Generally Accepted Accounting Principles) or IFRS (International Financial Reporting Standards) accounting perspective, futures change when—in what year, for example—licensing revenue may be recognized.
II. Essential Ingredients in Cross-Licensing Agreements
To negotiate an effective cross-license that achieves the ambition of both parties, various considerations must be thought through prior to even engaging in negotiations. For example, is there a benefit for each party treating inbound and outbound license agreements completely separately? By separating inbound and outbound negotiations, time to closing both agreements may be disproportionately extended. It may be intuitive that an agreement on an outbound license from the first party to a second party will directly influence the inbound terms the first party receives from the second party. This approach can also be more complicated as it necessitates two rounds of completely separate negotiations.
Furthermore, complications may arise if the first party has large addressable sales impacted by the second party’s patents, even if the first party has a larger portfolio. It may then follow that if the second party has significantly smaller addressable sales to the first party’s large portfolio, an asymmetry will be created. This imbalance between the parties is independent of the value of the portfolio in aggregate or any specific individual patent(s). To further this scenario, imagine the second party is a small start-up developing revolutionary innovation for managing noise suppression in high frequency communications and owns five granted patents and three applications covering their collective inventions. In a negotiation with a large conglomerate with, for example, a portfolio of 2,000 granted patents and 1,000 pending applications relevant to high-frequency communications, the small start-up approach to licensing negotiations may be highly complex. Considerations in an individual patent’s value include addressable income and apportionment if the small start-up’s five patents, for example, strike directly at significant sales of the conglomerate’s products. In that case, the licensing arrangement will likely drive towards an asymmetrical negotiation regardless of the conglomerate’s portfolio— i.e., the comparative disproportionately impacted revenues may likely mute out much of the first party’s sizeable portfolio. Therefore, even with addressable revenue of the start-up that is associated with specific patents in the conglomerate’s portfolio, the engagement may still be asymmetrical in favor of the start-up. Here, the start-up, with only a handful of patents, may be the equivalent of the proverbial David with a giant rock to sling at the conglomerate Goliath.
It is incumbent upon licensing professionals to take a rational look at the relative value that each portfolio brings to the other party. This can obviously be an intricate and time-consuming exercise. Financial pressures may well drive C-suite management to underestimate the scale of diligence required to extract the patent portfolio’s maximum value. Generally speaking, the proper way to handle this type of situation is for annual, quarterly and weekly commitments and buy-in to negotiation strategies.
III. Changing Legal Landscape
The changing legal landscape across the globe has also impacted how licensing professionals approach negotiations, as well as where they may choose to pursue patent protection. One of the essential questions in any licensing program is staking out and gaining buy-in from the C-suite regarding the short, intermediate, and long-term mission, and what strategies would be supported to implement that mission. If generating income is the sole short- to long-term ambition of the IPO with support for an annual operational and litigation budget, the licensor can engage with licensees from a position of strength in running its program. Naturally, it would be advisable that the implementation of the IPO’s mission and strategy take into consideration changes in the worldwide landscape in terms of enforcement, injunctive relief, and potential damages awarded. For example, US Supreme Court cases like eBay v. MercExchange3 and TC Heartland v. Kraft,4 The Fourth Amendment to the Chinese Patent Law, and the formation of The Unified Patent Court already have or will have a material influence on how licensing negotiations are conducted and executed.
For example, jurisdictions such as Germany, China, and Brazil each have distinct forums for IPOs to pursue claims against an infringer. Brazil has a legal system that enables ex parte actions, including the potential of a temporary restraining order (TRO), which operates more quickly than other jurisdictions. Of course, the difference in market sizes between Brazil, Germany, China, etc., as well as the predictability of outcome, should be part of the consideration in implementing the mission and strategy. The ability to secure injunctive relief in countries other than the U.S. may help the licensor drive the licensee to a global settlement including the U.S., where damages are considered most favorable.
As noted above, damages from infringement outside the U.S. are secondary to using a local court system. These countries afford injunctive relief, which is the primary basis for looking to them in a litigation context. China affords injunctive relief and, while still lagging the U.S. with respect to damages, is directionally moving forward with The Fourth Amendment. Brazil, China, and Germany, among other countries, also are strategic options because they afford the IPO injunctive relief.
The US Supreme Court’s ruling in TC Heartland v. Kraft is yet another consideration for IPOs and licensing professionals because where a patent plaintiff can properly file suit against an infringing company is a diminished certainty. The historical standard of “minimum contacts” with the jurisdiction prior to TC Heartland is generally no longer the proper standard. Consequently, the location of an infringer’s state of incorporation may be the most assured venue for a lawsuit. As of this writing, the most common venues for infringement cases brought by patent plaintiffs are the Western District of Texas and the Eastern District of Texas. If neither of these jurisdictions are available because the infringer does not conduct any business, including stores, in the aforementioned districts, other districts of Texas, Delaware, and the Northern District of California are common venues. It is important to note that the Northern District of California has reputationally been more accommodating to accused infringers within the district, at least as perceived by those enforcing patents from owners outside the district. This factor should weigh heavily in the IPO’s mind when deciding how the choice of litigation venue in the U.S. will impact potential settlement discussions.
Another important consideration in enforcement is the cost/benefit of filing additional actions in ex-U.S. jurisdictions. Fortunately, it is markedly less expensive to proceed with actions in Germany, China, or Brazil than in the U.S. The time to trial and the availability of injunctive relief in countries outside the U.S. enable potential positive inflection point(s) in a licensing campaign before the litigation expense in the U.S. becomes substantial. A TRO in Brazil in concert with an injunction in Germany can heavily favor a global settlement with an infringer before trial in the U.S.
When building a portfolio, some IP owners are disadvantaged by not having in-house counsel with portfolio building, licensing, negotiation, and litigation expertise to help formulate and properly implement the mission and strategies. This is not atypical in the start-up community. Disinformation regarding the advantages and disadvantages of filing patent applications and impactful jurisdictions for enforcement, among other considerations, can create a challenging environment for making the optimal decision to match the IPO’s vision. Similarly, investors that fund start-ups need experienced advisors. In cases like these it is often important for the IPO to engage patent lawyers and/or experienced licensing professionals to help them design and implement their strategy. Building a portfolio with a global footprint is a strategic decision to be made by management, with the advice and counsel of seasoned IP professionals with versatile experience. Consideration should be given to how a portfolio might be leveraged with competitors, as well as selectively using easily detected assets that are most likely to be infringed. Management’s decision on IP strategy will send a signal to shareholders that their investment is not only being protected by enforceable intellectual property, but also indicates how their capital may generate a return if licensing is part of the mission.
Depending on the type of patents at issue, license grants in some negotiations may be limited to the U.S. only, therefore limiting exposed revenue potential and income to the licensing program. For instance, European entities may be unwilling to engage in a license for patents that are enforceable in the U.S., but are not in Europe because of differing claim scope or local laws. This may influence negotiations over a global settlement to simply U.S. only, at least, at the onset of discussions. This is but one example where licensing dynamics can change entity by entity, patent by patent, and country by country.
The complexity of navigating these competing business and legal considerations often means that the resulting negotiations depend on the outlook of both parties. This point is not constrained to merely licensing as it also arises in mergers and acquisitions. Deal psychology can be pivotal in all types of negotiations, including licensing. There is a huge difference in outcome for a particular deal if one or both of the parties have a win-win culture as opposed to a win-lose philosophy. Some companies are inclined to balance the risk of a being sued for infringement and the prospect of invalidating the asserted patent(s) in one jurisdiction, against the larger goal and expense of gaining freedom to operate by obtaining a worldwide license.
Negotiating licensing agreements in the face of a rapidly changing IP law landscape with present-day economic realities has made for an increasingly complex and ever-changing topic. Different parties try to resolve these issues in a variety of ways. Still, fundamental business differences impact the decision whether to use a running royalty, lump-sum or fixed annuity fee structure. Licensing executives must be mindful of the strategic goals of all parties involved in negotiations. Being reasonable in approaching a licensing arrangement, and creating a deal structure that supports all parties’ business objectives, should enable value creation for all parties. ■
Available at Social Science Research Network (SSRN): https://ssrn.com/abstract=3771448
- This article is based on a presentation by the authors during the 2020 LES USA/Canada Annual Meeting.
- Alice Corp. v. CLS Bank International, 573 U.S. 208 (2014).
- eBay Inc. v. MercExchange, LLC, 547 U.S. 388 (2006). This case materially reduced the likelihood of injunctive relief for a patent owner upon a finding of infringement.
- TC Heartland LLC v. Kraft Foods Group Brands LLC, 137 S. Ct. 1514 (2017). This case defined the term “resides” under 28 U.S.C. § 1400(b) as the state of incorporation under the statute, 28 U.S.C. § 1400(b). TC Heartland, however, does not address the first paragraph of the statute, 28 U.S.C. § 1400(a), which has been relied on to some measure of success by patent plaintiffs—and has caused some potential infringers to rethink their presence in, for example, the Eastern District of Texas, entirely. The impact of the TC Heartland case to the Eastern District of Texas has been noticeable. At least one large conglomerate has retrenched all reasonable presence in the district under 28 U.S.C. § 1400(a) and (b). The Eastern District of Texas is still one of the most common venues for filing these cases because of 28 U.S.C. § 1400(a).