If you’re aiming for a licensing agreement with a company, this is the last lap. You’ve got a company interested and you want to negotiate a deal that nets you the best royalty rate possible. But even though things are looking good, there’s still a lot of scope for making mistakes that can leave you with no deal, or a much poorer one than you deserve. This Project runs you through the whole process of doing business with a half-interested, then a very interested, company. With luck, you may emerge from it with a licensing agreement good enough to make your marathon of pain and frustration seem highly worthwhile.
What companies look for in a new product idea
Understanding how companies have to look at new ideas is an important part of the battle to win them over. Their ideal is an idea that will give them a mountainous profit for no risk. They know they’re unlikely to get it, but that’s the direction they’ll be coming from. Not in a month of Sundays will they look at your idea and say: ‘Hey, this is so good we must do it, no matter what it costs us!’ Before taking any risk involving a hefty commitment of funds or time, a company must be satisfied that everything about your idea stacks up.
Key factors they’ll look at include:
See also Project 4, as much of it will be relevant here too.
If you have a prototype, expect an interested company to want to keep it for a period of detailed assessment. This is where you can come unstuck, especially if you only have one prototype. You don’t want it locked inside one company for months on end, especially if you’ve filed a patent application.
It’s difficult to meet both your own and a company’s needs with a single prototype, but the following guidelines may help you to stay in control of what is after all your property.
Assuming the company has assessed your idea or product and wants it, the next big test is hammering out a licensing agreement that enables the company to exploit your IP in return for some form of payment to you. From your point of view this is the most important part of the whole relationship.
Most licensing negotiations are a long ride - think months, often lots of them - and a bumpy one even when both parties quite like each other. That means high potential for conflict, perhaps especially when you’re dealing with a big company used to getting its own way. Your negotiating strategy needs therefore to begin with some thoughts on how you’re going to avoid, or deal with, conflict.
You and the company may have known each other for some time, but in that time the relationship may have changed in subtle ways that only now break surface. Look out for the following signs that warn of conflict ahead (or here right now):
According to research, skilled negotiators tend to display the following characteristics which can help reduce conflict and misunderstanding. Acquire them if you can.
In general, to be a good negotiator on your own behalf you need four key abilities:
If your product has international potential we recommend that you involve your patent attorney, solicitor, team members or other professional advisers in all discussions, as you’ll be out of your depth attempting on your own to negotiate licences covering several countries. If prospects are so good, hang the expense. This is a case where the cost of not having heavyweight support could be enormous.
If negotiations take place entirely overseas it may be tempting to use professional services based in that country, but beware. It’s difficult to check quality or performance and in many countries, especially the USA, it can be virtually impossible for a non-national to sue for malpractice or incompetence. Many UK patent firms have offices in or professional links with other countries, so you’re likely to be safer leaving the sourcing of non-UK legal expertise to your current patent attorney.
Irrespective of your product’s potential, if you so seriously doubt your negotiating ability that you don’t want to be directly involved in any discussions at all, you can assign front-line duties to someone else with appropriate competence. A patent attorney is once again probably best, as much of the discussion will centre on IP. Your patent attorney will in any case be involved in drafting the full agreement, so there is sense and some economy in having him or her at the table from the start. Anyone else - perhaps a team member if you’ve seen this problem coming from a long way off - will need at the very least some knowledge of IP law, the judgement to decide what is and isn’t in your best interests, and an ability to get on well with the company side. People who fit that bill won’t be thick on the ground.
Where does your royalty come from?
A few basic facts of life first:
Knowing that 25 per cent of gross profit is your probable maximum doesn’t on its own get you very far. Most companies won’t want to give you 25 per cent of gross profit, or anything like it. They’ll want to give you the most miserably small percentage they can get away with. Nothing, if at all possible. You therefore need to be able to convince them that you deserve more than they want to offer.
The battleground will be the value of your product. You need to decide how commercially valuable you think your product is, and bid for a royalty percentage that reflects that value. The company will go through the same process and almost inevitably arrive at a much lower valuation. You then argue and haggle until both sides either accept a compromise value or agree to part company. At bottom it’s not that much different from selling a house or car, except that it usually takes much longer and you end up not with an agreed price but an agreed percentage.
So how do you work out a value for your product? You start by understanding that it’s not (yet) a number that you’re after, but a ranking somewhere on a scale from very high to very low value. From then on, there are two rough and ready ways of assessing value: A reality check or a gross profit per unit and market size.
Many inventors overvalue their products (or more accurately, don’t attempt to value them at all) and ask for an unrealistically high royalty. This can get negotiations off to a bad start from which they may not fully recover. A reality check like this can help you to bid more credibly, and thus more successfully. It may even make you realise you’ve undervalued your product. Simply adjust your royalty expectation up or down as you answer these questions. It’s all very approximate but it may help you to gauge whether the percentage the company offers is derisory or merely at the low end of realistic.
A good indicator of value is an estimate of the product’s gross profit per unit and probable market size. You’ve already got a figure for gross profit per unit, so all you need to know is the size of the probable annual market for your product. The company’s sales forecast should tell you this but it may be overly conservative, partly out of sensible caution and partly to stop you getting ideas above your station. If you have reason to doubt the company’s forecast, do your own research into market size.
The bigger the potential gross profit per unit, the higher the value of the product. For example: Mousetrap X can be made for a penny and sold for a pound, while Mousetrap Y costs 50 pence to make but can’t sell for more than a pound. By this measure, Mousetrap X is far more profitable and thus more valuable and thus more deserving of a better-than- average share of gross profit as a royalty.
But that’s only half the picture. We need to take market size into account as well. For example, a product that promises to sell in huge numbers for several years has a higher value than a product with the same gross profit per unit but only a limited life in a small market. If our Mousetrap X has years of high- volume sales ahead of it, it’s a clear overall winner in the value stakes. But if the market for mousetraps is shrinking fast as fewer homes have problems with mice, its value will be diminished despite the healthy gross profit. And if Mousetrap X is a flimsy, throwaway product while Mousetrap Y is robust and reusable, Mousetrap Y might in the long term be a better seller.
Overall value therefore depends on averaging out several value-related factors. Depending on circumstances, exactly the same mousetrap could easily have anything from a very high to a very low value for royalty purposes. For example:
If you want to combine your reality check, gross profit per unit and market size values it might help to draw up a scale from 1 (very low value) to 10 (very high value). Give your product a score out of 10 for each factor:
We hope you’ve understood everything so far, because here’s where we have to make a switch from gross profit to net sales price.
Up to now we’ve talked only about gross profit because that’s the most accurate measure of your royalty expectation. However, it’s standard business practice to negotiate and express royalties as a percentage of the product’s net sales price - that is, the ‘factory gate’ price minus all taxes. Net sales price is a better yardstick for businesses than gross profit because it reflects the difficulty of making an actual profit.
Shifting from gross profit to net sales price is no worse than converting from imperial to metric measures: the terminology changes but the thing you’re measuring doesn’t. Or you can look at the difference like this:
Most royalties probably fall into the 2-7 per cent range of net sales price. The lower end is for products which sell in large quantities (typically hundreds of thousands), while the upper end is for products which sell at more modest levels (typically tens of thousands). A royalty of 4-7 per cent of net sales price for an ‘average’ product is good going, while some specialised products such as industrial software or medical equipment should exceed 10 per cent without too much trouble. Don’t however be outraged if offered a fraction of one per cent for a product likely to sell in endless millions. Do the sums and rejoice.
Don’t expect your royalty percentage to be forever. A typical product life cycle consists of three phases: modest but rising early sales, good peak-period sales, then falling sales as competitors catch up or the technology becomes obsolete. Whenever sales and profit change significantly, expect the company to want to renegotiate your royalty. This is quite reasonable, so a worthwhile negotiating tactic is to accept or even suggest a sliding scale of royalties based on the total royalty income involved. For example: seven per cent up to £20,000 per year of total royalty income, reducing to five per cent between £20-50,000 and to three per cent when your total royalty income exceeds £50,000 per year. This shows that you acknowledge the company’s falling profit margin as sales rise, and demonstrates your professionalism and willingness to be flexible in everyone’s best interests.
Don’t however let yourself be too easily persuaded to accept a lower royalty. In some situations gross profit may actually rise as sales decline. Production equipment may be fully paid for and thus cost next to nothing to run, and components may become cheaper by the same process or as market demand for them drops. To avoid becoming an easy touch, keep yourself fully up to date about the state of the company, its suppliers and purchasers, and that market or industry generally.
This is where you and the company sit down and thrash out the basics of an agreement, trying to find as much common ground as possible. The aim is to:
The following list gives you some idea of the component clauses that need to be talked through, then written up as a heads of agreement document. Its range is typical but by no means complete. Ask a patent attorney or solicitor to advise you on additional aspects specific to your idea which may need to be brought into the talks.
Expect all these clauses to be present in some form or other in your agreement, and make sure that anything else you can think of is covered too. Don’t expect the company to bat for anyone except itself, so try to work out the exact effect each and every clause will have on you. Do this by constantly asking ‘what if?’ questions, both at the negotiating table and elsewhere. Ignore any pressure to hurry up or accept clauses on the nod, and don’t be afraid to call a halt for hours, days or even weeks if you need time to think or consult someone. If any answer is unsatisfactory or you don’t understand it, insist on renegotiation until that point is clear and acceptable. Bear in mind though that ‘acceptable’ won’t always mean ‘in your favour’. Don’t forget what we said earlier about the purpose of negotiation being not to win but to reach agreement.
It may help to have your own heads of agreement drafted out in full before the meeting. Don’t disclose it, as you stand to lose too much face if the company rejects it clause by clause, as they will certainly try to do. Its better use is as a checklist to help you gauge how on- or off-track you are if the going starts to get confusing.
Let’s grapple for a moment with the issue of advance payments. Many inventors think they have a God-given right to a large up-front sweetener, but back on planet Earth the situation is more complex. Virtually no company will readily agree to an advance payment so a lot depends on how big an issue you want to make of it. If you push it too hard it could be a deal breaker, but in some circumstances the risk may be worth taking.
From the company’s point of view it’s one thing to discuss a fair sharing of future profits, quite another to hand out a hefty pre-sales sum when the inevitable accountant’s question: ‘What exactly is this money buying?’ may be very difficult to answer. A small company may genuinely be unable to afford it, especially if they’re already going to be stretched to finance your product. Therefore, one argument is that in the interests of conflict-free negotiations you should forget about a lump sum and focus on maximising your royalty percentage. That way, whatever money you eventually get comes technically from the product, not the company. The risk is that the product doesn’t sell, but that’s the company’s risk too.
A counter argument is that the company needs to show genuine commitment to selling the product rather than just acquiring a licence, and a fair way to do that is to pay you a golden hello. There may be force in this argument if:
If and when you’re happy with the heads of agreement, the next and final stage is to convert them into a full legal agreement.
This will inevitably be a complex and near- incomprehensible document, often scores of pages long, which neither you nor the company’s negotiators will be competent to draft. This is a job for legal specialists, though they’ll consult you on points of detail. The company will use its own advisers, so you must use your own patent attorney and/or solicitor to make sure that the final document is consistent with the heads of agreement and doesn’t conceal some elephant trap dug by the company since drawing up the heads.
For your part, don’t look on the full agreement as an opportunity to undo the deal. Best policy is simply to say to your solicitor: ‘Here’s the outline agreement. I’m happy with its terms and figures, so please draft a full agreement based on it’. Unless your solicitor or patent attorney finds evidence that something is badly wrong or unworkable, or spots a way of improving the deal for everyone, resist any temptation to try to alter what’s been agreed. Maybe you were steam- rollered here and there, but the deed must now be considered done and any attempt to wind the clock back is more likely to wreck the deal than improve it. In any case, most professionals charge by the hour, so any intervention that takes time to sort out may cost you a lot of money for not much gain and lose you valuable goodwill.
The following checklist is partly an action planner and partly a reminder of what matters. If you’re tempted to think ‘I don’t need to do all this stuff’, it may help to point out that we’ve modeled the checklist on questions professionals are very likely to ask if you want their advice, support or money. We therefore have to be stern and say that if you aim to be a respected and successful inventor, you can’t afford to duck any of it.