Understanding licensing agreements is very important for the business in the year 2021 and afterwards.
The term “license” has two meanings—one in common terms (a driver’s license, for example), and one in business and commerce. A license in its most general sense is “a permit from an authority to own or use something.”
In business, licenses are typically given by a company that wants to give rights to another company in return for payment. Usually, these rights are to make or sell or use something your business owns.
Understanding Licensing Agreements
Two kinds of assets can be licensed:
- Technology, like computer apps or using a patent to produce products, or
- Intellectual property (trademarks and copyrights)
1. Licensing Technology
For a company that has a great product but no ability to manufacture it, licensing is a great way to get that product to market. Entrepreneur says that, of the possible ways to market a product, licensing “offers the most potential return on investment and has the greatest chance for success.“
You can license the right to produce a product from a patent you own or give someone the right to use one of your trade secrets, like a process your business has developed.
Some examples:
- A company has a patented product that it doesn’t want to make and sell so it sells a license to someone else to make that product.
- A company that has a “trade secret” process sells the right to use or market that process to another company.
2. Licensing Intellectual Property
Licensing often involves intellectual property, like trademarks, copyrights, or patents. Digital assets like apps and trademarks are often licensed.
Some examples:
- Sports teams sell trademark licenses to companies who create products with the team’s trademark on them.
- A movie company sells licenses to companies who create products based on trademarked characters in the movie.
Copyright licenses involve the right to reproduce and sell the copyrighted asset, including derivative works (works based on the original work). The right to perform the work publicly might be licensed. For example,
Patent licenses involve the right to make, sell, use, distribute, and export the patented product.
Trademark licenses involve the right to use the trademark on specific items and in specific ways.
Trade secret licenses involve the right to use the trade secret in specific ways, at specific locations, and in specific processes.
Here’s another example: Salvatore has a line of t-shirts with a distinctive look that he has trademarked. He sells a license to make the t-shirts to Carol, who pays him an advance and royalties based on how many t-shirts she sells.
The Difference Between Franchising and Licensing
A franchise is a specific type of license.
A franchise license issued to someone to operate a business using a common brand name, a common operating support system and involving the payment of initial and/or ongoing fees.
If someone has a franchise, there may be a licensing agreement in place, and there may be several types of licenses within the franchise. For example, a McDonald’s franchise might include licenses to use the McDonald’s logo on products and packaging, and another license to make its patented processes or product ingredients.
How a License Agreement Works
A license agreement is a business contract between two parties. The licensor (the seller of the license) owns the asset being licensed and the licensee (the buyer) pays for the right to use the license. An example is a resellers agreement. The licensee customarily pays an intitial licensing fee and thereafter pays royalties to the owner in exchange for the right to sell the product, use the technology and the proprietary business systems.
Royalties can be paid in several ways, both based on sales of the property (copyrights, for example):
- Continuing to hold the copyright and being paid on a percentage of revenue from sales, or
- Selling the copyright and receiving a continuous stream of revenue.
Factors Involved in a Licensing Agreement
The license usually involves several factors:
Exclusivity and Territory. The licensee is granted the exclusive right to make and sell the product in a specific territory. The licensor agrees not to allow anyone else to sell the product in that territory. This part of the agreement usually has a term attached to it.
Subsidiary licensing. The licensee may or may not be granted the right to allow someone else to make or sell its products. This depends on the specific terms of the licensing agreement.
Payments. As noted above, the licensee typically pays royalties to the licensor. There may be an initial advance against royalties, and then continuing royalties are based on sales. Royalties may be paid based on a percentage of sales or a flat rate. Consider which method is best for both parties (and don’t forget inflation and currency exchange rates).
Monitoring and Quality Assurance. To protect its product or business solution, the licensor requires specific tests and monitoring of sales. The tests might include an initial sample of the product to make sure the quality is acceptable. The licensor may require periodic checks of product quality. In addition, the licensor has the right to monitor sales, to check that products are not being too heavily discounted and that quality is kept high. Monitoring might also include
Sub-agreements. Within the license agreement, as with other types of contracts, there may be sub-agreements. For example, the licensor may require a non-disclosure agreement to keep the licensee from disclosing proprietary product features or processes to others. The licensee may require the licensor to sign a non-compete agreement, to keep the licensor from breaking the agreement by allowing someone else to sell the product within the licensee’s exclusive territory.
Tips for Creating a Licensing Agreement
There are certainly benefits to licensing your company’s assets, but be sure you consider these factors in creating a licensing agreement:
Establish ownership first. If you are selling or buying a license for a product, make sure the ownership of that product is clearly stated in the agreement. Also make sure that no one else is using the asset, (a trademark, for example) and get that the trademark registered or file the registration for a copyright. You don’t want to get into a licensing agreement and then find out that someone else questions ownership.
The licensing agreement should include language that addresses the issue of ownership disputes. For example, what if someone disputes the ownership of a trademark you have licensed? Or, what if someone plagiarizes the copyrighted work that’s under license? Both parties to the licensing agreement should agree on how to deal with these issues.
Pay attention to definitions. Make sure the product or process is described completely and clearly, so there’s no misunderstanding about what is being licensed.
Describe how royalties work. What gets paid and when? Does the ownership stay with the original owner during the license term? What happens if minimum sales are not met? Is there an advance on royalties?
Explain the process of monitoring and quality assurance. There should be an initial test sample of the product that must be approved before the products may be created. Periodic checks should be done on product quality. Product sales monitoring should be spelled out. Who determines product price? May products be discounted?
Check on government regulations. Depending on the type of product being sold and who it is being sold to, there may be restrictions on the licensee. For example, some products (like weapons) may not be allowed to be sold in certain countries or U.S.states.
Do your due diligence before the agreement. Both parties should thoroughly check out the other party. Check business credit and management resumes. Ask for financial statements. Visit the other company’s offices and manufacturing facilities. Leave no stone unturned.
Consider other “What-Ifs. As you work with an attorney to write the contract, it’s a good idea to consider now circumstances that might be a problem later. What if the licensor goes bankrupt? What if the licensee goes bankrupt? What if either party can’t fulfill its obligations? Can the licensor transfer its ownership to another party? What are the penalties for breaching (violating) the contract?
Understand taxes. The royalties paid by the licensee are counted as a business expense. The royalties must be counted as income to the licensor and reported on Form 1099-MISC. Check with your tax professional about the tax effects of royalties.
A Sample Licensing Agreement
Every licensing agreement is unique, and these agreements vary by type (copyright, trademark, patent, etc.). In general, you will find these sections in most licensing agreements:
Subject Matter. A detailed description of the product or service or trade secret being licensed. This part might include patent, copyright, or trademark number.
Definitions. Terms and details are defined.
Purpose. The parties are named, with identification, hereinafter called the “Licensor” and “Licensee” or brief names.
License. The license itself is described, with details about the limits of time (one year?), extent (U.S., worldwide?) of license, and assertion of exclusivity. Details about what the licensee can do with the license (make products using it, sell it, sub-license it, distribute and export, etc.).
Payment. Details of payment to the licensor, including whether there is a base or royalties, and the percentages. How and when payments are made. How sales are verified. Payments if there is a sub-licensee. Licensor’s right to an annual audit and periodic verification of sales.
Restrictions. What the licensee cannot do with the license. Maybe the licensee can’t sell it below a certain price or sub-license it or use in certain ways or on certain types of products.
Beginning and End of Agreement. Spell out when the agreement is effective and when it ends. Describe the possibility of renegotiation and continuation of the agreement at the end of the term. Include circumstances when the agreement might end before the end of the term. What happens to the ownership of the product at the end (usually it converts back to the owner)?
Non-disclosure agreement. Both parties agree not to disclose trade secrets.
Non-compete agreement. Licensor agrees not to allow anyone to compete with the license in the territory and time period designated in the agreement.
Jurisdiction. Where the case must be tried (usually a U.S. state).
Dispute settlement. How are disputes settled? Is arbitration a requirement?
Preparing the Agreement
This article is only a general overview of licensing agreements; it’s not intended to be complete and shouldn’t be used to prepare a legal document. Using a template you find on the internet is dangerous because it can’t address specific laws and your own situation.
Get an attorney who has expertise in licensing agreements. These agreements are complicated and specific to each situation. Many attorneys know how to construct a general contract, but they may not know the details of licensing agreements. An intellectual property attorney might be a good place to start.
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