In a past Inventor’s Digest article I wrote about the ten non-negotiable demands that every inventor has the right to insist upon when entering into a licensing agreement. Each demand that I discussed is perfectly reasonable, and the omission of any would be reason not to execute the agreement. Non-negotiable demands include receiving a non-refundable advance against royalties, an agreement that royalties must always be based on sales (not profits), having the right to inspect the licensee’s sales books and being named on the licensee’s product liability insurance policy.
However, as I pointed out in that article, a licensing negotiation does not mean that the inventor dictates terms of surrender to a hapless licensee. No good will come of that. The licensee has legitimate rights, and a licensing agreement works best when both sides leave the table satisfied with the result. If you can come up with one good new product idea, you can come up with another, so if accommodating your licensing partner in ways that don’t punish you unjustly will help establish a pleasant working relationship, it’s an investment well made. Just as there are ten absolute demands, there is another set of ten that you must be prepared to negotiate.
1. How Large is the Advance?
How high is up? How long is a length of string? Up is as high as people agree it is, and the string is as long as it is supposed to be. You and the licensee might agree that there should be an advance, but you won’t initially agree on how much. If you each wrote a number on a piece of paper, there’s not one chance in a thousand that both of you will have written the same sum. Knowing this, you should never ask the licensee what he’s prepared to offer as an advance. That would be like owning a clothing store and asking the customer what he’d be willing to pay for the new suit he’s trying on. You’re the seller; it’s your job to put a figure on the table. I can’t tell you what that figure should be because there are too many variables, but I can tell you what it should represent.
There are two purposes for the advance. The first is to establish the seriousness of the licensee. It’s what we used to call “earnest money.” The advance should be large enough to convince you that the licensee is serious, yet not so large as to cause him to have second thoughts about the deal. The other reason for the advance, since it is non-refundable, is to compensate you for your time if, say, six months down the road the licensee changes his mind and decides not to produce your product. As a purely arbitrary rule of thumb, I try to calculate what a year’s royalty might be and ask for an advance that represents about 25 percent of that amount. That seems to work in my own negotiations and the sum that is finally agreed upon is usually not far from that amount.
2. What Percentage Should the Royalty be?
The reason these points are negotiable is that there are no hard-and-fast rules. If what you’ve licensed is a high-volume, low profit type of product, you might be happy to get 3 percent. If it’s a slow moving but high profit item, you might be entitled to 10 percent. None of the products I’ve ever been involved with have strayed beyond either of these extremes, and most wind up in the 5 percent area.
I developed a wonderful negotiating strategy that you’re free to use. Let’s say I ask for 6 percent and the licensee complains that competition will be able to undersell him because of the high royalty. I tell him that if and when competition comes along, if he’s not competitive, I’ll cut the royalty. I even know from experience that if and when competition does come along, it is usually based on features rather than price – and even if it is price, this clause is long forgotten as time passes and the product has evolved into something entirely different. But my suggestion sounds good when offered at the negotiating table and shows a sense of willingness to cooperate.
3. When Do You Get Your Royalty Payments?
My contracts always state that I’m to be paid monthly. Company salesmen get their commissions monthly, so why shouldn’t I get paid the same way? Some small companies might agree, but larger ones never will. There’s too much bookkeeping involved and most will insist on quarterly payments. It’s a reasonable request and I always agree. The only reason I don’t change my contract to read “quarterly” is to offer the licensee a small victory.
4. How Long Does the Licensee Have to Bring Your Product to Market?
I apply the same principle as with the royalty payment schedule. My contracts call for the licensee to have the product on the market in six months. They always balk and I always change it. Six months is usually not enough time, particularly with a seasonal product, and I’m prepared to allow as much time as seems necessary. Nine months is usually a reasonable time for the kind of products I’m involved with. The only reason my agreement still says six months is to provide further proof of my flexibility and willingness to oblige. Your invention might be more complex, involving a year or more in production, so you have to give the licensee the amount of time that’s reasonable and fair, but not so much time that he has no incentive to move ahead at a brisk pace.
The longer the delay, the less chance your idea will become a reality.
5. What Territory Are You Awarding?
My contract routinely award licensing rights to the United States, Canada, and Mexico, which is fine for some companies but not for others. A company with worldwide operations is going to want to sell your product all over the place. That should be alright with you — why not? However, many smaller companies may sell abroad without a really strong international presence. My suggestion is to structure two separate agreements with performance guarantees built into the international one. That way, down the road, you can remove the international rights for non-performance, without interrupting their domestic activities where, hopefully, they’re going great guns. If they’re not doing a job for you overseas, they won’t care if you take it away.
6. What Performance Guarantees Should You Ask For?
If you’re licensing a product that is not patented, you can’t ask for any guarantees. Once your product is on the market, it’s fair game for any company that wants to knock it off. Since you can’t re-license it elsewhere, you’re stuck with the guy you gave it to in the first place. However, if your product is strongly patented, you can move it around and are entitled to ask for minimum royalty guarantees. How much should it be? Who knows? It’s an arbitrary figure based on what would be a reasonable amount in sales. The licensee should be able to make an estimate based on experience in the business, and you should be able to judge his estimates based on sales of similar or competing products.
7. How Long Are You Entitled to Receive Royalties?
I take the position that as long as a company is selling my product, or variations thereof, I should get royalties. Fair is fair. Some companies disagree. They figure that, since they are taking all the risk, and they’ll be putting money into constantly changing, improving and adding to the product, at some point in time enough’s enough. Actually, years ago my accountant found a loophole in the law that gave me great tax advantages by using a finite time and calling it a sale rather than a license, but that loophole has since been closed. There may be others, so if a great deal of money is potentially involved, you may want to discuss this with a tax attorney or your accountant.
8. Who Pays the Legal Fees to Complete Patent Work?
Let’s assume your product is not patented, but that it could be, or that you have filed a Provisional Patent Application. It’s not unreasonable to negotiate with the company to pay for the application for a conventional utility patent. The patent would be issued in your name and you would assign marketing rights to the company. You have a good chance of doing this with large companies who have patent attorneys on retainer and less of a chance with small companies where the legal fees are a burden – but it’s worth putting on the table for discussion.
9. Who Pays Legal Fees in the Event of Infringement?
If you’ve licensed a patented product, another company might ignore the patent and simply knock it off. Or, if your product is not patented, you may have innocently infringed on an existing patent. Who pays the legal fees to defend the patent or defend against the infringement issue? Presumably, as the licensor, that’s your responsibility, but I urge you to never, never sign a contract that obligates you to take legal action. It will cost you a ton of money if you lose the case, and will probably also cost you a great deal of money if you win. Duck the issue entirely if you can, but if it does come up, you have to simply tell the licensee that the two of you will deal with the issue if and when it arises. You cannot and should not obligate yourself to take legal action to defend a 5 percent royalty. If you do, I can almost guarantee you’ll regret it.
10. What About Remaining Inventory?
There’s an old business axiom that you can never count your profits until the entire inventory is out of the warehouse. Products tend to have a natural life span, and when it’s over, the manufacturer is invariably stuck with merchandise he can’t sell. If he has to dispose of this merchandise at a cut price, do you still get your regular royalty rate? Frankly, it would be mean-spirited of you to insist on receiving the regular percentage, and I believe it will come back to haunt you. My suggestion is to use this simple formula: If the licensee has to sell the remaining merchandise at a 25 percent discount, you should also take a 25 percent discount in the royalty percentage. If he sells at a 50 percent discount, then you should also take a 50 percent discount. And so on. There probably won’t be a great deal of money involved, and the licensee will remember your fairness when the next deal comes along.
The overriding intent of a licensing agreement, aside from the obvious desire to get what’s reasonably deserved, should be to have a friendly, equitable deal that makes the licensee as satisfied as you are. Listen to the other side’s legitimate needs, and be prepared to compromise when it’s not too painful to do so. You’re going to invent something else for this guy, and something else again after that. Your reasonableness at this first negotiation will set the tone of your on-going relationship; you’ll be rewarded for it many times over as time goes by.
Professionals like to deal with other professionals. The less you allow emotion to dictate, and the more businesslike your attitude in addressing these issues, the more assured of success you’ll be.