Licences are fully paid-up, royalty-free or royalty-bearing. A royalty-free licence is common in joint development projects and for service providers in the context of their provided services. Also, the right to give demonstrations or to hand out free (complimentary or testing) samples of a product is often free of charge.
Fully paid-up. If the licence is fully paid-up, it means that the licensee acquires the rights to use, as stipulated in the licence agreement, after a one-off (lump sum) payment. This licence fee structure is usually applied if the parties want to materialise the licence in one settlement, or more commonly, if the payment in periodical instalments is impracticable (e.g. in case of a broadly defined patent, if the licensee is active in a different industry and not amongst the usual customers of the licensor) or if the collection of licence fees is undesirably burdensome (e.g. in case of consumers or large numbers of users).
Royalty-bearing. Royalty-bearing licences take countless forms. A royalty implies the payment of a (recurring) licence fee, the amount of which is often dependent on the volume of “net sales” (turnover) of the product in which the IP is used or applied. It is important to define what the royalty amount covers. A common reference figure is a percentage of the net sales of the products on which the trademark is used or for which the manufacture of the licenced patent or know-how is used:
Net Sales definition. In patent or technology licences:
Net Sales means the aggregate amount of sales prices of the Products received by the Licensee and its affiliated companies, excluding:
(a) taxes and duties paid by the Licensee for the sale of any Products;
(b) insurance, packaging and transportation expenses of Products;
(c) deliveries of Products to Licensee’s affiliated companies to the extent that such deliveries are also included in such affiliated companies’ aggregated sales prices; and
(d) normal discounts, returns and rebates to Licensee’s customers.
In trademark licences, the above item (c) should be replaced by:
(c) deliveries of Products to Licensee’s affiliated companies for internal use by such affiliated companies only;
In both definitions, certain product-unrelated pricing elements, relating to delivery, logistics and insurance, are taken out of the net sales definition. The two definitions are different:
- In patent and technology licences it is important to capture (in case of a process-related patent) all processes where the licensee applies the patented invention or (in case of a product-resulting patent) all products sold by the licensee and its affiliates (even if there is no sub-licensing right). Any captive product sales (i.e. internally to affiliated companies) should be included at the Net Sales amounts received by that affiliated company from its customers (deducting the captive transfer price) but should be calculated at an arm’s length price.
- In trademark licences, internal sales are irrelevant and only the sales realised by the licensee and its affiliated companies vis-à-vis their customers is relevant. The brand does not operate as a particular unique selling point.
A percentage of net sales results in zero (nil) royalties if the licensee makes no sales efforts at all. Therefore, in many turnover-related licences, the licensor requires a minimum sales effort from the licensee by agreeing on a minimum royalty commitment: regardless of whether the licensee achieves the agreed minimum level of net sales, it must still pay for it (‘take or pay’).
NRE. In some industries, it is common to pay a part of the licence fees in an upfront lump sum amount. Such non-recoverable or non-recurring engineering fee is also known as “NRE”. This is useful if the licensor has to undertake development work in order to fit its product with the licensed IP into a given environment. The results of the development can be licensed to other parties as well. The possibility to relicense the IP justifies that the licensor assumes the costs of the investment, whilst the upfront payment is a way of financing the development work.
Royalty reporting. If any part of the licence fees is directly linked to (sales) amounts realised by the licensee, it is inevitable that the licensee reports on its sales. Accordingly, the licensor will require that the licensee maintains accurate bookkeeping and its records must enable the calculation of royalties by reference to the sales. In other words, the licensee must be able to account for the precise number of products in which the licensed IP was used (and the sales prices received for each product).
It is common to require quarterly reporting, although monthly reporting (in case of questionable debtors or high volumes of sales) and annual reporting (in case of low sales volumes or long lead times) also are agreed on. Royalty reports should be submitted within a few days after the end of the reporting period. Payment of the royalty should be made shortly thereafter (sometimes after the issuance of an invoice).
Royalty audits. If royalties are dependent on a variable, such as fluctuating sales amounts, it is appropriate to provide for an audit right: a right of the licensor (or its independent auditing firm) to verify the accuracy of the licensee’s royalty reports. In many industries, a royalty audit is considered to be a step-up to terminating the licence. Nonetheless, an audit clause usually addresses the maximum frequency of permitted audits (if previous audits revealed no irregularities), that an audit must be announced in advance, that it must take place during working hours, as well as a ‘penalty’ mechanism for settling misreported royalties. An example of a royalty audit clause is included in Model international trademark licence agreement (Section 6.6).