OPTEON Topic 10 Fundamentals of Licensing Agreements

OPTEON Topic 10 Fundamentals of Licensing Agreements
WIPO-KIPO-KIPA IP Panorama Business School Investment Summit 7 October 2008 Geneva OPTEON Philip Mendes Level 3, 33 Queen St Brisbane QLD, Australia Ph Fax

Outline Presentation in 3 parts License Terms Performance Obligations
Structure of the Financial Terms of a License

What is a license ? Comparison with renting a building
Owner restriction Owner’s right User’s name User’s obligation User’s right Rented Building Cannot use building To collect rent Tennant Pay rent To exclusive use Licensed IP Cannot use IP To collect royalties Licensee Pay royalties To exploit exclusively

Legal -binding contract
What is a license ? Legal -binding contract An asset Contains terms Create rights (eg royalties) Imposes Obligations (to exploit, to complete R&D, to market Creates liabilities Warranties and indemnities Can be sold Can be used as security for a loan Can be given by will

Scope: Exclusivity Exclusivity: Exclusive Sole Non Exclusive
One Exploiter – the licensee Two Exploiters – owner and the licensee Numerous Exploiters – owner and numerous ‘ees

Scope: Exclusivity Which would be most likely be sort by a licensee ?
What rights does patent confer ? – exclusivity of use What rights is patent user likely to expect ? Most common type of license agreement ? Exclusive license Exclusive license: Where the licensee needs to have the same exclusive rights that a patentee has Particularly Biotech ICT

Scope: Exclusivity Sole License
Where rights to exploit are shared between the owner and a single licensee Owner can exploit Owner grants a single license only, there are no other licensees Eg, license of library for screening Non exclusive license Many licensees All competing with each other Competition reduces price Licensor maximises return by increased volume Eg floppy disk

Scope: Fields of Application
Some technologies lend themselves to different uses. These are called fields. field of science particular application industry by industry Some licensees have expertise / marketing networks in some fields but not all. Would you license in all fields where the licensee has the ability to service only one, but not others ? License particular field to match the licensee’s exploitation capability

Biotechnology Fields may be Human therapeutic and prophylactic applications Diagnostic applications Veterinary applications Plant applications Would you license a human therapeutic product to a diagnostics company ? A disease resistant Tg plant to a pharmaceutical company ? Maybe - these days, after mergers, some companies have merged their capability

. . New formulation for scratch resistant plastic Possible fields: Bottles for consumer products – injection moulding industry Car trim – motor vehicle industry Fashion: Handbags Kitchen appliances – kettles etc Mobile phones etc Would we license person in fashion industry rights in relation to mobile phones ? Would we license motor vehicle trim manufacturer rights in relation to kitchen appliances?

Pick our licensee with the expertise / capability / marketing networks, and license in appropriate fields Field of Application Appropriate Licensee Bottles Car parts and trim Handbags Kitchen appliances Mobile phones Injection Moulding Industry Motor Vehicle Industry Fashion Industry Appliances industry Electronics industry

Licensing multiple licensees in multiple feels of application All are exclusive licensees Not non – exclusive licensees Multiple licenses does not necessarily mean non exclusive Each license in each field of application is exclusive Each licensee expects the exclusivity to warrant its investment to take to market Same exclusivity that patent confers Non exclusive licenses occur when licensees do not have exclusivity and compete with each other Here, each licensee in its field of application, is an exclusive licensee

Scope: Territory Would we license North America to a European company that had no distribution networks in US ? If we did : there would not be any sales in the US there wouldn’t be any royalties for US Why would we license a company to exploit anywhere other than where it had the capability to market and sell to best advantage ? We wouldn’t.

Scope: Territory License whole world to:
a multinational that can service the whole world License North America to: A company that can service North America (whether in North America or elsewhere) License any Territory to a licensee that can exploit in that territory Key is capability to exploit in the market No point granting a license to a licensee with no capability to service the Territory licensed.

Scope: Territory Would we grant a world wide license to company in our own country ? No, if it did not have the capability to exploit in the global market If its capability was limited to our own country, that is where the license would be restricted to Yes, if It can service a worldwide market place It has alliance partners and networks with others that can service the remainder of the world In that case the license would have performance obligations in relations to sub-licensing to those alliance partners and those networks

Scope: Extent of rights
Extent of rights granted depends on the type of license A licensee to market globally: Worldwide exclusive license Invariably the case for biotechnology IP May be the case for an ICT technology A manufacturer to manufacture products and supply them to licensor for sale by the licensor: Manufacturing license only No rights to market, promote or sell

Scope: Extent of rights
Possible scope of rights: To manufacture To market and promote and sell If license is limited to manufacture, licensee can manufacture, but not sell If license is to market promote and sell, then manufacturing not permitted – licensor manufactures, and appoints distributors (more likely to be called a distribution agreement than a license agreement) If license is to manufacture, market promote and sell, then licensee effectively stands in a patent owner’s shoes

Scope: Summary Licensed rights can be scoped in numerous ways :
Exclusive / Sole / Non Exclusive Field of application Territory Extent of rights When different rights are combined, the number of possible exclusive licenses is theoretically limitless Practically: research organisations license worldwide exclusive rights in all fields of application

Term of license What should the term be ?
Depends on the nature of the license: Biotechnology patents: Typically until the expiration of the last to expire patent (with patent term extensions) Licensee needs the exclusive rights conferred by the patent License to a start up company, in any field Typically until the expiration of the last to expire patent ICT: May be expressed as a number of years only

Term of license Know how:
Effectively a license of confidential information Has value, but only while the confidential information is outside the public domain Once it enters the public domain, Looses its value Any person can exploit the confidential information without a royalty obligation Term in a know how license therefore expressed as being until the know how enters the public domain Theoretically this may be many years European Union 10 year limit on term of know how licenses

What is licensed: Patent / know how
Typically what is licensed is the combination of Patents Applications, PCTs, divisionals, continuations in part, grants, re-issues, etc etc Know how that is, all “intellectual property” in its widest sense, ie all knowledge includes confidential information includes knowledge encompassed in rejected patent claims which may still have value Usually in the licensor’s interest to provide everything to the licensee to equip it to the maximum extent to commercialise the IP

What is licensed – Improvements
Should Improvements be licensed ? Improvement is an improvement, modification, enhancement of the Licensed IP Licensee has a legitimate expectation of improvements Making the improvements available to the licensee improves its ability to commercialise, and to compete Not making the Improvement available may encumber the licensee, may make it less competitive Licensor has a legitimate reason to provide the improvements as well A better equipped licensee that has greater capability, and greater competitive edge will do better, in that way maximising the licensor’s return

Should an improvement automatically be caught by the license, with the licensor getting no additional financial return ? Or, should the licensor be able to get an additional financial return ? Improvements add to the quantity of the IP Logical that as the quantity of IP is increased, so does its value Value = X Value = X + Y Value = X+Y+Z

Consider the development / risk / value curve: Possible License Point A IP Value: X Possible License Point B IP Value: X+Y Possible License Point C IP Value: X+Y+Z Value Risk Development Concept Proof of concept Prototype Trial

The further along the development path a licensor travels (making improvements), the greater its remuneration should be Logically: An improvements increases the quantity of IP licensed And increases the value of IP licensed A license at Point A has a value of X eg, a royalty of 3% A license at Point B has a value of X + Y, eg a royalty of 5% A license at Point B has a value of X + Y + Z, eg, a royalty of 8% Logically therefore, an improvement should result in a higher royalty Our frame of mind should therefore be that an improvement should entitle a licensor to greater remuneration

But to be pragmatic: Most improvements are small incremental increases in knowledge They fine tune the IP They do not justify additional remuneration to a licensor What is the boundary ? Up to which improvements are captured by the license for no additional royalties From which, if they are to be captured by the licensor the licensor has a legitimate expectation of further royalties ?

For example: if the licensor discover an additional use in another field Is that a thrown in improvement Or does it deserve additional royalties ? Could that new application if it had been identified earlier Have resulted in a field license, leaving the licensor free to license separately another licensee with that additional field ? Or, if licensed to the same licensee, would it have justified a higher royalty payment ? In these circumstances is it fair that the licensee gets this additional IP thrown in for no further payment ?

A boundary is needed Possible boundary: If the practice of the improvement would infringe the licensed patent, then it is thrown in for nothing. Not a desirable boundary: a new application may necessarily infringe the Licensed IP platform Another possible boundary: That the Improvements has sufficient novelty to be granted its own patent The better test Still has a problem: the question whether it is an improvement may not be resolved until a patent is granted

Another limitation on Improvements: That the improvement is created by the same research team that created the original licensed IP Why? Cannot capture the improvements across all the activities of a large licensor, eg,a university University may not know, and cannot manage its obligations to identify improvements by other staff Therefore not unfair to limit the Improvement to that Which is created by the same research team Only while they are employed by the licensor

Consent to Sub-licensing
Typical term: Licensee may grant sub-licenses with the prior written consent of the licensor which is not to be unreasonably withheld Motivation Assess suitability of a sub-licensee Assess capability Assess identify of sub-licensee Is it a member of corporate group that would embarrass the licensor tobacco group environmentally irresponsible directors questionable These issues of concern to a university / public sector licensor (ministerial approval / embarrassment)

Consent to Sub-Licensing
Motivation (cont): Assess terms of license Royalties may be based on Sub-License income Consideration for sub-license may be non-monetary Cross License Other contract Therefore no royalty flowing back to licensor All proper motivations for a licensor to seek to control sub-licensing Besides, consent is not to be unreasonably withheld Constraints on that legal mechanism such that it is incumbent on a licensor to grant consent if a licensee has the capability

Consent to Sub-Licensing
But holding out for this may kill the deal Pharma / large biotech / multinational is not likely to agree to any restriction on its ability to grant sub-licenses Given its level of investment US$50m to US$800m, it will typically not be prepared to rely on consent Even if not to be unreasonably withheld Even if incumbent on licensor to give it Open Position: If licensee gets taken over by a tobacco company or an Exon, it does not want to loose its license, and write off its US$50 to $800m Holding out for this will kill a deal Licensors may have to be prepared to be relaxed in this

Consent to Assignment Same issues
Licensor is entitled to satisfy itself about the proposed assignee Does the assignee have the same capability Is the licensor concerned about the identity of the proposed assignee Normally, consent to assignment Expressed as not to be unreasonably withheld Again, makes it incumbent on a licensor to grant consent if a licensee has the capability Expressed as not required where the assignment arises out of a corporate re-organisation

Patent prosecution Who should make decisions about patent prosecution:
What patent attorneys to engage Scope of claims Negotiations with patent offices What countries to apply for patents Licensor is the owner, and may feel that it should Licensee that is a pharmaceutical company, multinational will insist on managing patents They have more at stake Not likely that licensee will make decisions to minimise its royalty obligations

Patent Costs Regarded as a commercialisation expense
Therefore licensee should pay this expense Licensees may resist paying for patent expenses May argue that patent expenses are an owner’s expense and should be paid for by the licensor May argue that is prepared to pay patent expenses, but only as an advance on royalties, so that future royalties are credited Needs to be resisted Patent expenses are a commercialisation expense and should be paid for by the licensee without clawback

Patent Costs What if the license is a field License
Should licensee pay all costs ? Should Licensee make decision on extent of claims ? Decisions: Licensor should make decisions given its broader interests in all fields Patent costs: Licensee argues Licensor should pay patent costs as Licensor will benefit in other fields But what if first field license is the only license – no other licensein other fields ? Licensee pays If future second license, Licensee is refunded 50% If future third license, licensee refunded further proportion, etc

Patent Infringements Who should have responsibility for pursuing infringers ? Licensor may feel that it should Licensee will want to pursue infringers Protect its commercial interests It’s a commercialisation expense It’s a commercialisation strategy – infringers will need a license Licensee has greater commercial risk: profits are greater than revenues Sometimes infringement proceedings give rise to patent revocation application by infringer – and licensee will want to control those proceedings Licensor will want Licensee to pursue infringers Can cost US$2m to “the sky is the limit” Research organisation Licensor unlikely to be able to fund

Patent Infringements Three Tiers Parties acting jointly
If they agree, they prosecute jointly, pay the costs jointly, benefit from damages jointly Likely that licensee will want to pursue infringers solely Solely making decisions in pursuing the infringer Solely paying the expense of doing so Licensee that is exclusive will have the standing to do so If Licensee does not pursue infringer, licensor may do so

General obligations on licensee
Reporting Progress in further research and development Progress in seeking regulatory approvals Progress in trials (including clinical trials) Marketing strategies Sales forecasts Improvements made Use of patent numbers Compliance with laws No misleading or deceptive conduct No use of Licensor’s name without consent

Confidential Information
Typical for license to contain all the terms commonly found in a Confidentiality agreement Usually mutual, as licensee also discloses confidential information to the licensor Restriction to disclosure to third parties Cannot disclose without consent Can disclose without consent where the purpose of disclosure is commercialisation Can disclose to employees etc Restriction on use Cannot use IP except for the purpose of commercialisation Usual exceptions. Public domain Disclosure from third party etc

Release Licensee releases licensor from any liability in connection with commercialisation ie, Licensee cannot sue Licensor if “it does not work” Licensor cannot assess this, nor make warranties about it at the time of the grant of the license, when more R&D still has to be done These are matters for the Licensee’s own commercial assessment Licensor Licensee

Limitation of Liability
Release does not always work Legal principles may limit their operation Therefore a limitation of liability Financial limit on what Licensee can sue Licensor for May be expressed as A stated amount A limit equal to the aggregate of all monies paid under the license Exceptions not subject to a limitation of liability: Breach of confidentiality Breach of warranties

Indemnity Indemnity against product liability claims
Release is “Licensee cannot sue Licensor” Indemnity is “Licensee will pay damages if someone sues Licensor” Indemnity usual in relation to product liability claims Hard to envisage a Licensor being liable when it is not the manufacturer / seller In the US, some law that suggests that an owner of a patent may have a liability Licensor Someone else Licensor

Product liability insurance
Not enough to rely on an indemnity from a licensee Licensor needs to ensure that licensee has the capacity to meet product liability claims Usual covenant that Licensee takes out and maintains product liability insurance Reputable insurance company Minimum amount of insurance cover Some licensees self insure: pharmaceutical companies / multinationals US established product liability claims fund Therefore little point in requiring a large pharma to self insure Biotech company must insure.

Warranties What are warranties ?
Warranties are statements made by a licensor Akin to a guarantee A licensee warrants something to be true, that is, the licensor guarantees something to be true If the statement is untrue, the licensee can: Sue for damages Terminate the agreement and sue for damages Therefore important that warranties that are made, are made accurately Important consequences follow from the breach of a warranty As a rule, a licensor will want to make the minimal warranties sought

Warranties: Warranties about ownership of IP
Not uncommon for a licensor to warrant that the licensor owns the IP being licensed, (or has a license to it) Should such a warranty be unqualified ? Consider: Patent application filed License granted in PCT stage Licensor warrants that it owns the IP in that patent application Later, it is discovered that another person has an earlier priority date That other person owns the IP in that patent application, not the licensor An absolute warranty about ownership would therefore be beached Such a warranty about ownership: should not be unqualified should be expressed to be made to the best of the licensor’s actual knowledge

Warranties: Warranties about infringement
Not uncommon for warranties to be sought that a IP does not infringe another person’s IP rights Should such a warranty be unqualified ? Use of an improvement patent held by the licensor infringes an earlier patent Or, exploitation of licensor’s patent encumbered by another person’s blocking patent Neither situation may be known to the licensor Licensor cannot undertake a complete search to be able to ensure accuracy Patent applications may be filed with an earlier priority date, but may not be published for years afterwards Such a warranty: should not be unqualified should be expressed to be made to the best of the licensor’s actual knowledge

Warranties: Warranties about unencumbered rights
Not uncommon for a licensor to be expected to warrant that: No notice has been received of any claim asserting infringement No notice has been received opposing the grant of a patent, or challenging its validity No license has previously been granted No option to license or right of first refusal has been granted If any of the above are incorrect, warranties are made subject to disclosures Should such a warranty be unqualified ? All these are matters within the control of a licensor Licensor should be able to make the warranties sought without any qualifications

Warranties: Warranties about patents
Common warranties about patents: That named persons are the only inventors No inventor has been omitted from being named in the patent application That no person is named as an inventor who is not an inventor That named inventors are employees of the licensor and made the invention in the course of employment All patent maintenance, continuation and renewal fees have been paid Patents licensed have not been revoked Patent applications have been made properly No failure to take a required step in the patent application process Should such a warranty be unqualified ? All these are matters within the control of a licensor Licensor should be able to make the warranties sought without any qualifications

Expiration and termination
Expiration is where the term of a license ends Term of x years Licensed rights end on the expiration of x years Any further exercise of rights would infringe the IP Term until the expiration of a patent Licensed rights end upon the expiration of the patent Termination occurs unilaterally, one party terminating in response to a termination event taking place The termination event may also give rise to a right to damages.

Termination Non sudden termination, with an opportunity to remedy a breach 14 days in breach Notice to remedy requiring remedy within 30 days If still in breach – can terminate Types of breaches that may give rise to that mechanism Failure to pay a royalty Failure to provide a report Failure to take out product liability insurance Failure to meet a performance obligation

Termination Sudden termination, without any opportunity to remedy the breach For Event of Default Where the breach is serious: Granting a sub-license without consent Assigning without consent Commercialising outside the Field Commercialising outside the Territory For Insolvency, winding up, bankruptcy, etc

Consequences of termination
Cease using licensed rights Return all confidential information Sometimes, continue sale of products in stock until exhausted, or an agreed period, such as 6 months Destroy biological materials licensed Clauses that survive, and continue to operate notwithstanding termination Confidentiality Insurance Release from claims Indemnity against third party product liability claims

Performance Obligation
OPTEON Philip Mendes Level 3, 33 Queen St Brisbane QLD, Australia Ph Fax

What are performance obligations
Obligations that oblige a licensee to exploit a technology to a minimum extent Licensor seeks to maximise its financial return on its technology ensure that the licensee does not underperform, fail to perform “shelve the IP” Performance obligations oblige a licensee to perform to a minimum extent With termination of the license / damages as the result if the licensee fails to do so

Are performance obligations necessary?
Postulate: License granted of technology that is not fully developed Licensor licenses to partner with a licensee that has the capability to complete R&D, and to take to market Engineering product at prototype stage IT Product: patents & theoretical code but no application code Biotech product in late pre-clinical stage, with years of clinical development still to go Licensee has finite resources Resources sufficient for top 3 projects – this one ranks fourth Licensee makes a prudent commercial decision to defer R&D The technology remains idle, perhaps forever Licensor obtains no financial returns

Postulate: At the time of the license the licensee has best of intentions to commercialise to the maximum extent Afterwards Licensee develops its own competing product Licenses in a superior competing product Licenses in an inferior but less expensive competing product Licensor’s technology remains idle, perhaps forever Licensor obtains no financial returns

In each case Technology is idle Licensor obtains no financial returns Technology is trapped with the non performing licensee Licensor needs a mechanism to achieve: Termination of license Reversion of rights back to the licensor Licensor free to go out and find another licensee that can perform and maximise the financial returns back to the Licensor

“Best endeavours” obligations
Licensee to Licensor: “I’ll agree to use my best endeavours to commercialise” May once have been a sufficient obligation “Best endeavours” obligations were once onerous obligations: Required “leave no stone unturned”: “Best endeavours means what it says - it does not mean second best endeavours” But best endeavors obligations have been watered down It requires what “could reasonably be expected... having regard to the circumstances” commercial and financial considerations can be taken into account to weigh up the reasonableness of the obligation These commercial considerations may operate to relieve a Licensee from the obligation to perform

Better approach to performance obligations
A better approach to performance obligations is to negotiate precise performance provisions to provide for the consequences of non compliance Two phases to consider performance obligations: First Sale End of Term Deal Signed Pre market entry R&D phase Post market entry Product phase

Performance obligations - R&D phase
Licensor wants to know that the Licensee Will continue R & D (if applicable) Will complete R & D (if applicable) Will expeditiously start and travel the regulatory pathway (if applicable) Not “shelve” the IP Commercialisation Milestones Milestones that a Licensee must achieve along the R&D and regulatory pathway Not achieve milestone – license is ultimately terminated

Commercialisation Milestones: engineering example: If more research is needed to bring product to a market ready state, the completion of that research Produce a prototype Conduct a trial Complete construction of pilot plant Complete construction of production plant Obtain any regulatory approval Employ a person with particular expertise Grant a sub license to a partner in key market First sale anywhere in the world

Commercialisation Milestones: Biotech example: If following completion of research, more research is needed to bring products to a market ready state, the completion of that research Completion of animal studies Completion of collection of data for lodging IND in USA Commencement of Phase 1 Clinical Studies Commencement of Phase 2 Clinical Studies Commencement of Phase 3 Clinical Studies Filing of NDA with FDA in USA Approval of NDA with FDA in USA First sale anywhere in the world

If these pre market entry milestones are not achieved There may never be market entry and sales Licensor may never receive royalties There needs to be mechanisms for Termination Reversion of rights to licensor So that Licensor can find another licensee Licensor can earn financial returns from a Licensee capable of achieving these pre market entry commercialisation milestones Ultimately, failure to achieve these milestones must lead to termination and reversion There may be models that allow flexibility, but ultimately with termination

Performance obligations – Product phase
Performance obligations do not cease after market entry After first sale, Licensor wants to ensure that there is the maximum possible penetration of the market Achieved by minimum sales If minimum sales not achieved: License may convert to non exclusive Allowing licensor to find another non-exclusive licensee License may be terminated Rights revert to licensor Again, allowing the licensor to find another licensee

Territory Period Target, in units USA & Canada Year 1 1.0m Year 2 1.25m Each following year 1.5m European Union 1.75m 2.0m China & South East Asia 0.75m

Might consider: Broad geographical markets, region by region Smaller geographical markets, country by country Flat minimum sales in each period Ramped up sales as marketing is ramped up, followed by flat minimum sales Minimum targets holiday in initial period after market entry, followed by ramping up, and then flat sales Reassessment of minimum sales if a competing product enters the marketplace

Financial Terms in a License
Structure of Financial Terms in a License OPTEON Philip Mendes Principal Level 3, 33 Queen St Brisbane QLD, Australia Ph Fax

1. Royalty on sales by a licensee
X% of sales price Gross sales price; or Net sales price Most common type of royalty provision Royalty is remuneration for quantity of use Greater the quantity of use, the greater the royalty The more sales, the greater the royalty But there can be more to a licensor than just a royalty on sales Clever ways for licensors to increase their remuneration Clever ways for licensees to reduce their royalty overhead

2. Royalty upon sub-license income received by licensee
Licensee grants sub-license Sub-licensee will pay to Licensee Royalties on the sub- licensee’s own sales Milestone payments, etc All that income is sub-license income Licensee pays a royalty of Y% to Licensor on all that income . Licensor Licensee Sub-Licensee

Royalty upon last Licensee’s Sales
Royalty on sale price for which the last licensee sells product Royalty rate remains fixed, e.g. 2% of sale price of last sale – that is all licensor will receive Licensor might be better off receiving Y% of Sub-license income – might be greater than this 2% - as Licensee will sub-license after value adding and will secure a substantially higher royalty . Licensor Licensee Sub-Licensee Buyer

Royalty as a currency Royalties sometimes expressed as a currency amount, rather than a percentage Eg, on software products, a royalty of $X per unit Eg, computer game May be an attractive model when the product is expected to have a short product life of say 2 years Why attractive ? Licensor is assured the same royalty regardless of downward price fluctuations, which in a product with a short product life may be expected.

Royalty as a currency Dangers
Should not be used where the product has a medium to long product life cycle In this case, can expect upward price fluctuations If fixed currency royalty, value of the royalty reduces over time with inflation Percentage royalty on invoice price preferred If financial analysis of royalties have been based and negotiated on currency amounts, convert the currency amount to a percentage on anticipated invoice price

Royalty on sales in countries where patent granted
Expressed as: “Valid Patent Claim” Sales in country where but for license product would infringe a granted patent That is, licensor onlys receive a royalty where sales are made in countries where the sale of a product is protected by a granted patent Traps: No royalties on sales made while patent pending (e.g., delays in examination, opposition proceedings etc) No royalties on sales in countries where patent is not sought, nor granted – ie, if patent in US only, you only get royalties on sales in US

Royalty on sales in countries where no patent is granted
This royalty often resisted by licensee – “why should I pay a royalty for sales in countries where there is no patent and I have no power to prevent competitors ? Royalty might still fairly be payable: Patent may be taken out in 20 – 25 countries and that may represent 90% - 95% of the global market – so why shouldn’t royalty be paid on sales in remaining countries ? Licensee will select the countries where patent will be sought Result pay full / part royalty, reducing by 50% if a competing product enters the marketplace, if it would have infringed the patent

7. Royalty Splitting – know how
Split royalties so that they are referable to different parts of the IP that is licensed Instead of seeking a royalty of 5%: Royalty of 3% for use of patent Royalty of 2% for use of know how Purpose: If patent is invalidated, license on foot, with a royalty for the know how component getting a royalty in countries where there are no patents

8. Royalty stacking Can arise in two ways
1. Product to be sold needs license in of complementary technology, e.g., a delivery system for a drug another active ingredient for a drug a complementary product where both sold together e.g., a vaccine cocktail Sale price of product sold reflects complementary technology as well 2. Freedom to operate – license in patent that is infringed Cannot reduce royalty by whole amount of royalty paid to another person Alternative: in each case, reduce royalty by X% of royalty paid out, up to max of y% reduction on any royalty payment

9. Ramped Up Royalties As a product is more successful, and costs reduce, royalty increases Licensor forgoes royalties in early stages, in return for higher royalties later Licensor indirectly contributes to initial manufacturing and marketing costs Cumulative gross sales in USD$ Royalty % Up to 100m 4 100m to 250m 5 250m to 500m 6 500m to 1b 8 1b and over 10

Research Tools: Reach Through Royalties
Research tools are tools that enable a product to be developed A valuable piece of IP How do you measure its value to properly remunerate the Licensor that owns the research tool ? Examples: License of a Mouse Model Mouse Model validates a drug target Therapeutic drug developed that acts on that target License of an assay Assay identifies and qualifies a compound that may be developed into a drug Reach through royalty is a royalty based on the sales of the drug that is developed with the research tool (mouse, assay, etc) Royalty is not on the technology itself, but instead is a royalty on the sales of the product that is enabled by the technology In that way measuring the quantity of use of the Licensor’s technology

11. Measuring quantity of use
Royalties are intended to remunerate a Licensor for the use of its technology Greater the quantity of use, the greater the licensor’s remuneration should be How do you measure quantity of use (and therefore remuneration through royalties) where the technology Is enabling Does not itself produce a product For example: Software that provides a capability A process technology Consider some other measurement of the quantity of use of the technology For example Software program – royalties on reagents Product produced with less cost as a result of a new catalyst

12. Royalties on value added
A license may enable a licensee to sell products But a license may also give the licensee a capability to sell other unrelated products License may allow a licensee to sell diagnostic reagents But additionally, may equip licensee to sell a diagnostic machine to test the reagents Licensee is profiting from Sales of licensed reagents Sales of diagnostic testing machine License equips licensee to make additional revenues and profits from the diagnostic testing machine May be legitimate to value the license not just by reference to profits anticipated from reagents But additionally from profits anticipated from diagnostic testing machine

13. “Most favoured” royalty
Most favoured clause is very common in the case of a non exclusive license Agree on royalty of 10% If licensor later grants a license in the same country to a competing licensee for a lower royalty, that lower royalty will apply in lieu of the 10% royalty Sought by non exclusive licensee to enable it to be able to compete

15. Lump Sum License Fees Once Only License Fee
Or, license fee payable by installments May be the only consideration for the license May be one of a package of other financial terms Important to try to secure in every license to offset past patent expenses, expenses of doing the deal (travel, legals etc) some part of R & D costs

16. Milestone Payments Payments made at identifiable points along the development / regulatory pathway Biotech Milestones Grant of patent USD $2m Filing New Drug Application FDA UDS $5m Commencement Phase II Clinical Trial UDS $10m Commencement Phase III Clinical Trial UDS $15m Product registration FDA UDS $30m

16. Milestone Payments Payments made at identifiable points along the development / regulatory pathway Engineering Milestones Completion of Prototype USD $2m Completion of Pilot Plant UDS $5m Completion of Trial UDS $10m Completion of Production Plant UDS $15m Grant of a regulatory approval UDS $30m

16. Milestone Payments Payments made at identifiable points along the marketing pathway Marketing Milestones Market launch USD $1m Granting sub-license in key market (US) UDS $2m Worldwide sales reaching $X UDS $10m US sales reaching $Y Worldwide sales reaching $Z UDS $20m

17. Minimum Annual Royalty Alternative to performance obligations
Performance obligations are obligations that a licensee must meet to continue to be licensed Avoids shelving (non use) of IP Licensor gets no financial return and wants to be able to license someone else Avoids inadequate performance (e.g., no commercialisation in a major market, such as US) Licensor gets inadequate financial return and wants to be able to license someone else

Commercialisation Milestones: engineering example: If more research is needed to bring product to a market ready state, the completion of that research Produce a prototype Conduct a trial Complete construction of pilot plant Complete construction of production plant Obtain any regulatory approval Employ a person with particular expertise Grant a sub license to a partner in key market First sale anywhere in the world

Commercialisation Milestones: Biotech example: If following completion of research, more research is needed to bring products to a market ready state, the completion of that research Completion of animal studies Completion of collection of data for lodging IND in USA Commencement of Phase 1 Clinical Studies Commencement of Phase 2 Clinical Studies Commencement of Phase 3 Clinical Studies Filing of NDA with FDA in USA Approval of NDA with FDA in USA First sale anywhere in the world

17. Minimum Annual Royalty Examples of performance obligations
Usually require minimum sales revenue / units sold Expressed as worldwide / or markets If failure in a market Exclusivity converts to non exclusivity Or termination In the market concerned, without affecting other markets Multinational licensee - none of that is acceptable Will be prepared to make minimum annual payments Territory Period Target, in units USA Year 1 1,000,000 Year 2 1,250,000 Each following year 1,500,000 Countries in EU 1,750,000 2,000,000

A pharma / multinational will not ordinarily accept performance obligations of these type in an early stage deal A biotech company will not be able to secure those types of performance obligations from a pharma, and so will also not accept them from a licensor Alternative is Minimum Annual Royalties A minimum amount of royalties to be paid Licensee must pay the higher of Actual royalties, or Minimum annual stipulated amount Ramp up the amount year by year If Licensee elects not to pay, termination

18. Pay royalties on what ? Pay on net profits ?
Would this work ? “The Licensee will pay a royalty of X% on the net profits from the sale of Products” How are net profits to be calculated ? Net profits are subject to manipulation Allows overheads to be taken into the calculation, in that way reducing royalties A 5% royalty on net profits may in fact be a 1% true royalty

18. Pay royalties on what ? Pay on invoice price
Royalties always paid on invoice price That is, royalties are referable to the gross arm’s length sale price of products Some agreed expenses are deductible taxes, duties, VAT, GST etc on sale credit for products returns trade and quantity discounts Deduct packaging, freight and insurance Only if separately invoiced Or lump sum deduction, maximum of 3-5%

19. Pay royalties on what ? Bundling
What is bundling ? Where the product is sold in a package or bundle with other products Package includes Licensor’s product upon which a royalty is payable Other products upon which no royalty is paid, or a royalty is paid to another licensor For example: two software products sold in a bundle Or, end user license for a process, and technical assistance services The total price of the package may be discounted Can’t tag royalty to invoice price because invoice price includes other products Tag royalty to the prevailing market price when Product sold unbundled

20. Pay royalties on what ? Combination products
Bundling issues – combination products But what if there is no prevailing market price for the Product because it is not sold separately For example, a vaccine that is always sold as a cocktail, that is, multiple vaccines in one injectable – always a combination product Invoice price may never relate solely to the licensed product Some approaches: Prevailing market price in another country where it is sold separately (if any) Royalty on the invoice price of the cocktail (but over time the cocktail may have different components) As negotiated in the future as prevailing circumstances change (with expert determination if no negotiated outcome)

21. Pay royalties on what ? Sales to related parties – transfer pricing
Licensee may sell products to a subsidiary or related party Non an arm’s length transaction Invoice price presumes that there is a market price – set by prevailing market conditions A sale to a subsidiary or related party may not be for a market price There may be an intention to manipulate the invoice price artificially to manipulate a royalty Or, there may be legitimate reasons for sales to a related party, eg sales from manufacturing subsidiary in one country to a marketing subsidiary in another country There may be a motivation to take advantage of lower tax rates in another country, so transfer prices may have the objective of choosing a lower tax jurisdiction

21. Pay royalties on what ? Sales to related parties – transfer pricing
Approaches Royalties based on invoice price to first arm’s length party (ignoring on sales within a company group) Royalty on prevailing market price Can only work when the licensee sells some products on an arm’s length basis No grant of sub-license rights to a related party without consent (and deal with the issue as a part of dealing with the request for consent)

22. Inspection of accounts and audit
Typical to include rights in a license that Licensee must keep good accounting records of items upon which royalties and other payments are based Keep records to a standard International Financial Reporting Standards (IFRS) - the accounting standards set by the International Accounting Standards Board Or, an equivalent in a country (In Australia, GAAP) Particularly important when a licensee has no legal obligation to maintain books to a certain standard (eg non publicly listed companies) Keep records for a minimum of X period Avoid time limit on inspecting accounts (eg, only last X number of years records) Licensor (or appointed auditor) may inspect those accounts (on giving eg 7 days notice) take copies or extracts

22. Inspection of accounts and audit
Costs of inspection and audit Borne by Licensor Unless an underpayment of amounts due to licensor is discovered that exceeds an agreed amount (eg 5%), in which case, the cost of the audit are payable by the licensee Inspection of Sub-licensee’s accounts Licensee must report to Licensor Any inspection or audit of a sub-licensee’s accounts Results of that inspection, including copies of reports Licensor can exercise Licensee’s rights to inspect Sub-Licensee’s accounts May be considered for appropriate transactions

25. Withholding tax A tax effectively payable by a non resident
Paid by a resident licensee effectively on behalf of a non resident Licensor 5% to 30% Licensee in USA owes royalties of $100,000 Withholding tax of 10% Licensee will pay $90,000 to licensor Licensee will remit $10,000 to IRS In this way, effectively a tax on a non resident licensor entitled to royalties Withholding tax also often paid on interest income and dividends

25. Withholding tax If a license is silent about withholding tax, the licensee must remit the royalties without deduction Licensee effectively becomes the taxpayer Licensee in USA owes royalties of $100,000 Withholding tax of 10% Licensee will pay $100,000 to licensor Licensee will remit $10,000 to IRS Licensee has effectively paid the tax The effective royalty rate is now 10% greater.

25. Withholding tax Where there is a double tax treaty between the Licensor’s country, and the country where the sale of a product takes place, the Licensor gets a tax rebate for the withholding tax paid In this way, double tax is avoided Licensee in USA owes royalties of $100,000 Withholding tax of 10% Licensee will pay $90,000 to licensor Licensee will remit $10,000 to IRS Licensor will provide evidence of payment of $10,000 to IRS Licensee pays tax on $100,000, and gets tax credit for $10,000, the amount withheld

Conclusion There’s more to a royalty than just filling in a blank on a license template !

OPTEON Topic 10 Fundamentals of Licensing Agreements

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OPTEON Topic 10 Fundamentals of Licensing Agreements

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