You may recall a popular piece from September 2012, Licensing Your Intellectual Property for Fun and Profit. The point of the article was to describe the potentially lucrative, yet often overlooked business model of licensing technology to an independent company rather than building a company around the technology yourself.
This post is the first of three that will cover the “licensing vs. operating decision” in greater depth.
Here, in part one, we will give an overview of the two business models that owners of IP have to commercialize their technologies. Next week in part two, we will argue in favor of the traditional (or, operating) model and against the licensing model. Finally, in part three, we will argue in favor of the licensing model and against the operating model.
Once you are familiar with each business model and the issues involved, you will be well on your way to monetizing your innovations.
The Operating Model
The operating model is often referred to as the standard or traditional business model. In this model, an inventor, who could be an individual or a company, develops a unique innovation and then protects the innovation by filing a patent, copyright, or trademark. In instances such as a formula or a software solution, no protection is necessary simply because the innovation is considered a trade secret.
Once the protection is in place, the owner of the IP will assign the innovation or the technology to an operating entity (corporation or LLC) which the owner and perhaps some investors will jointly own. We will refer to this operating entity as Acme Manufacturing Company.
So, now that Acme controls the technology, it will be responsible for turning the innovation into a commercial product and in so doing, will manufacture the product, market the product, and distribute and sell the product. There is nothing new here, right? This happens every day. It is important to note that Acme will incur all of the costs associated with bringing the product to market and in return, it will receive all of the profits (or losses).
The Licensing Model
Before I describe how the licensing model works there are two very important issues to remember:
- Licensing can only happen when technology or other intellectual property is protected through a patent, copyright, trademark, or trade secret.
- Licensing can only happen when one party has “something” of value that another party wishes to have AND that “something” provides the second party with the best-known solution to its needs.
In the licensing model, an inventor develops an innovation and then protects that innovation (through a patent, copyright, trademark, or trade secret), and thus creates intellectual property. The inventor-owner of the intellectual property then licenses the innovation or technology to a second party who takes responsibility for commercializing the innovation. In other words, rather than the inventor being responsible for manufacturing, marketing, sales, and distribution, someone else has purchased the right to do those things and will earn the profits (or losses) that will result from the successful or unsuccessful operation of the business. The inventor will receive her compensation (called a royalty) whether or not the licensee is successful.
The vehicle through which the use of the IP is transferred from the inventor to the user/licensee is called a licensing agreement and it is the basis for the licensing business model. The five most important terms of every licensing agreement are always the same. They are:
- Exclusivity. Licensing agreements will describe whether the agreement provides for the exclusive or non-exclusive use of the IP.
- Purpose. The agreement will determine how the IP may be used. For example, it is possible that the inventor will license the innovation to one licensee for consumer purposes and to another licensee for commercial purposes.
- Geography. Licensing agreements will detail where the licensee may market and sell the product derived from the IP. The licensing agreement may provide for worldwide authority or perhaps just authority to market and sell in one part of the U.S.
- Term. All licensing agreements have a term. That is, all agreements have a start date and an end date. At the conclusion of the agreement, the agreement may be extended or the licensor may enter into an entirely new agreement with a new licensee.
- Compensation. The licensing agreement spells out the royalty – the compensation for transferring the use of the IP. Royalties usually take the form of a specified dollar amount for each sale (say, $0.05, $5, or $500) or a percentage of the selling price for each sale (say, 3.75%). Royalties are usually paid monthly or quarterly. Sometimes the licensor will receive an upfront payment as well.
Many licensing agreements will require the licensor to be responsible for offering periodic updates, like in the case of a software license.
To illustrate common licensing terms, the summary terms and conditions of a licensing agreement may be as follows:
Acme agrees to license a new technology to a medical device company for its exclusive manufacture and sale to healthcare providers in the United States for a period of 20 years. As compensation, Acme will receive an initial payment of $15 million and a royalty of 2.5% of the wholesale price of each device to be paid on a quarterly basis.
So, now that you are familiar with each, which is the better business model: operating or licensing?
Which model will make you more money? Which model is riskier? In which model do you have more control?
The answers depend on a number of factors, all of which will be examined in the coming weeks. Stay tuned.
This article is for general informational purposes only and does not constitute legal advice. You should consult a qualified attorney before making important decisions concerning intellectual property.