BUSINESS - IP LICENSING

Intellectual Property Licensing

What is Intellectual Property?

Intellectual Property (IP) comes in various forms, but is essentially the output of creative work. Someone puts in the effort and expense of producing, designing or creating an original concept or work and they then seek to protect their exclusivity in that work so that they can exploit it in whatever way they choose.

Arguably the more significant forms of IP are protected either by patent or copyright. Patent applies to original ideas or inventions, while copyright encompasses creative works such as photographs, books, articles, music, and software.

Patent protection is given through a form of registration obtained from various international bodies which examine and determine the exclusivity and originality of the idea or concept. Once it is deemed to meet appropriate conditions, these bodies provide a patent right which gives a recognised exclusivity to that idea to the applicant. Patenting is often complex, expensive and time-consuming, so it is important that organisations are able to monetise their ideas to justify the commitment. However, once the patent is granted it does make it easier (in theory) for patent holders to enforce their exclusivity through licensing and it is often a significant source of revenue for organisations.

Copyright is different in that it is asserted by the creator of the work and its validity is not tested until it is challenged for one reason or another in court. Many things are covered by copyright but widely copied illicitly, the best examples perhaps being music and video.

Software however is also very widely copied. Protecting ones copyright in software is often challenging, but software can be a lucrative area for licensing, which means protecting ones rights in the original work is very important.

In my thoughts on IP Licensing I use software as the kind of IP that most readily and comprehensively illustrates most, if not all, the issues one may face in IP licensing. However, many comments can apply equally to any other forms of IP.

Licensing

Licensing is different to selling as there is no transfer of title. The licensee acquires certain rights in the use of the IP, but title remains with the licensor. Although we often talk of 'selling' software, it is in fact licensed.

Licensing requires a clear description of what is licensed and what rights the licensee has in the use of the IP. It must also define the obligations of the licensor in supplying and supporting the IP, and how the licensor must protect the licensee from commercial threats originating with the IP, such as infringement of other IP rights. For the licensee it defines the payment (sometimes in kind) they are obliged to pay in return for the rights they have.

Business Model

Typically licences are non-exclusive, permitting the licensor to license the same IP to more than one licensee. Consequently, to recover the development costs the licensor can afford to charge each licensee less than the total development cost of the IP, the degree to which this is the case depends upon the number of potential licensees.

Once the licensor has licensed the IP sufficient times to recover the development costs, the on-going marginal costs for each new licensee can be small, and therefore making each new licence very profitable. Of course, if you cannot reach that critical number of licences the venture will be unprofitable. Typically we say that the most difficult position the licensor faces is when the first licence is agreed, which commits to the development, but will not recover the development costs.

In the event that the software is used in the manufacture of a product by the licensee (which is the typical example given here), the licensor may apply a royalty to each product manufactured or sold using the IP. Consequently, if the licensee is particularly successful with their product it can produce a significant return for the licensor.

The licensee may view the licence as a form of out-sourced R&D where the cost is shared with other licensees. They may also see the royalty as a part of the Bill of Materials of the product, and as such it may come under the same scrutiny as other component costs. They may however be sensitive to the fact that the licensed IP is the same as that being used by their competitors and as such limits their opportunity to differentiate. This can be overcome to some extent by allowing them to modify the IP, or by the way in which they use it. This is easier if the IP is a standard piece of technology which is not usually differentiated, such as a processor, which in turn becomes part of a differentiated product by virtue of the software being executed on it.

For the licensor there are issues to be considered in order to ensure success. It is common practice that licences to new technologies will be agreed prior to the completion of the development of the IP by the licensor. Interim releaeses are made to enable the licensee to begin their product development. This overlapping of development paths gives further advantage to the use of licensed IP. Licence fees are then often paid according to milestones in the product development programme being undertaken by the licensee, which means there is the added risk of their ability to achieve these milestones, even with the licensor's help. Of course, if the licensee ultimately fails to complete their product development there will be no royalties either. This can be seen as a double risk for the licensor, compounding their own technical and commercial risks with those of their customers.

Royalty rates often decrease as product volume increases, making the per unit return lower as more product is manufactured. Just as component costs reduce with maturity and volume, so will the royalties. However, because the risks associated with royalties are high, the licensor should never allow royalties go to zero, otherwise the up-side becomes constrained, and the overall justification, particularly as seen across several licensees, is impaired.

Types of Licence

Typically, licences are non-exclusive so that the licensor spreads their risk and return amongst a number of licensees. However, licences can be exclusive, although the costs and terms are likely to be very different in certain respects.

Licences may be constrained by geography. The licensor may permit the use of specific IP in only restricted locations around the world. They may do this because of the nature and extent of their patent protection, or they may feel certain countries are not sufficiently secure for their IP.

Licences are often limited to specific applications, which they may achieve naturally if the IP is application specific. Some for example, may wish to restrict the use of their IP in such applications as military.

Licences may be time limited, or term licences which automatically renew on payment of an annual licence fee.

Licences may specify that the licence may not be transferred or sub-licensed (see below), the IP cannot be modified or used to create derivatives. Concessions to these rights should be matched with improved licence fees as these things potentially cost the licensor in real terms or as lost opportunity.

Typically licences will be perpetual, worldwide, non-exclusive, non-transferable, non-sub licensable and giving the right to manufacture, sell and distribute products using the licensed IP.

Sub-licensing

Occasionally licences will permit sub-licensing, ie the licensee may in turn license the IP to a third party. Sometimes the business model requires this, but if it does then the right must be carefully defined to ensure that the licensee's sub-licensing of the IP will not impair the licensor's further business.

As an example, the licensee may create a device such as a semiconductor product which utilises certain software they license. Their model requires the distribution of the software with the semiconductor device and the original IP holder is not interested in such business. By carefully defining the rights given to the licensee such a model can be appropriate with the right approach to sub-licensing.

A more complex area though would be derivatives. See later comments on modifications.

Right to Modify

Giving the licensee the right to modify the IP licensed is potentially fraught with many challenges.

Firstly, the IP becomes difficult to support once the licensee has modified it. There are also issues surrounding the ownership of modifications in case such modifications are essential to the licensor's on-going business. However, modifications do then make it easier for the licensor to say that it cannot be supported unless such support is given for the original unmodified IP.

Modifications also complicate such issues as warranties and indemnities, but again, the presence of modifications may well provide the licensor with the opportunity to relax their undertakings in these areas.

If licensees are given an unrestricted right to modify they can, in theory at least, create derivatives, ie new versions or new generations of the products, otherwise 'derivatives'. This can be important as it can constrain the licensor's on-going business, limiting the value of further generations of the IP. If this is a potential problem it is possible to prohibit the creation of derivatives.

Specification

An essential part of the licence is the specification of the IP. This is the basis of the warranties, ie the licensor will warrant that it meets the specification. Consequently, it is essential to ensure this specification is complete and correct. Although it may be subject to change, it will be the basis upon which the licensee agrees to the licence.

In particular it is important to specify clearly the support services provided. These can be expensive to provide but of huge value to the licensee to get the licensor to do as much of the work as possible.

Support

In most licences the licensor will provide certain services to support the IP and the licensee's use of it. It may be defined in terms of man days of support, updates through bug-fixing, additional features, updates, etc, but there is always potential for confusion between such services and undertakings and the operation of warranties by which the licensee may expect the licensor to fix and maintain the software as and when it does not comply with the specification.

Often support services or maintenance may be incorporated in the licence. It may be free to begin with and thereafter charged, and it may provide more than just bug-fixes to the IP. It may for example, provide a service to update and maintain the IP or to provide on-site support to help the licensee if required, or to receive updates to the software which may add small levels of additional functionality.

Warranties and Indemnities

Warranties and indemnities are often linked, although they are not necessarily directly associated.

A warranty is an undertaking given by the licensor that the IP will fulfil certain conditions and in the event that the IP fails to meet such conditions, the licensee can expect the licensor to correct it. Usually the warranties relate to two things; functionality and third party IP infringement.

The licensor through the warranty undertakes that the IP will comply with the given specification. The licensee may make other claims if they think the IP is not really fit for purpose as such, but generally it is the specification that controls what happens, and so it is essential it is correct.

The licensor may warrant also that the IP will not infringe any other IP. This is in many ways a far more complex undertaking which comes to depend upon the nature of the IP and the potential for infringement. The warranty may be structured in a variety of ways to limit the potential liability this undertaking may create. For example, contributory infringement may be excluded, ie only circumstances where the licensed IP alone infringes and not in the event that it is the combination of the licensed IP with other IP that may infringe. Infringement in the event that the IP has been modified may be excluded too.

An indemnity exists to make good any losses the licensee incurs by virtue of the use of the IP, and more specifically in the breach of the warranties. In the event that the IP is found to infringe any third party IP and the licensee incurs a loss as a result, they may claim compensation to make good their loss from the licensor under the terms of the indemnity.

Indemnities are potentially hazardous for licensors. The difference between the scale of the business for the licensee, who is making a product in which the licensed IP is merely a component, and the liability the licensee has, can be many orders of magnitude greater than for the licensor. This happens because the liability is determined in relation to the licensee's business, so in situations where the IP is found to infringe, as an example, the compensation due to the third party IP holder will be as a percentage of the licensee's product and not the licensor's business.

Consequently, it is essential that these liabilities are limited when considering the scope of the indemnities. Firstly, there would be a cap on the total value of any indemnity. Such a cap may be expressed as a percentage of the licence fee in some way. Secondly, the licensor must ensure control of any third party dispute as any judgment by the court as to the liability of the IP would then extend to all licensees of the same IP. Thirdly, indemnities must be carefully caveated to ensure the liability only exists in specific and well-defined situations.

As a matter of course, consequential loss must be excluded, ie any loss of profit or revenue incurred by the licensee must be at their risk alone, whatever the cause. Again, the different scales of the businesses would be very challenging otherwise and exposing the licensor to very high risk.

Protecting IP

Protecting IP has become a major challenge for many companies. Preventing it from being copied without proper licences and stopping the theft of IP for illicit use in unauthorised and unlicensed products has significantly added to the risk of the IP licensing business, or indeed any business which has valuable collateral in IP.

Various methods can be used to protect software. For example, not giving access to source code is an effective way of avoiding it being misused, although this can add significantly to the cost and complexity of supporting the software as each change requires a complete new release. However, once licensees have the source code it becomes very difficult to control what they do with it and to prevent it being stolen or sold to others.

Confidentiality agreements may well provide some protection. A licence should either incorporate a confidentiality agreement or have one associated with it and this can be used to enforce the security of the IP. In fact, confidentiality may well be a preferred option to patenting for some as ideas are in the public domain once they are patented. Especially for highly embedded IP it can be impossible to detect and prove the presence of unlicensed IP if you need to defend a patent.

Other technical methods such as signatures within code can be used to enable the detection after the event of illicit copies of software, even in end products where the code has been compiled and linked.

Open Source Software

Today Open Source Software (OSS) is in common use and many products are built around such software. OSS is developed by members of the software engineering community to be freely available to all and to be used in non-commercial applications, ie no one should be making money from it.

In fact OSS is made available under a wide variety of licences, ranging from the simplest form requiring only the reproduction of copyright notices, to the most comprehensive licences designed specifically for OSS, such as the Gnu Public Licence (GPL) and its various derivatives.

Under the GPL, and other similar licences, the user of the OSS must offer back to the community of users any modifications and improvements they make. This can be onerous and it can require the user to publish the source code to their various products, often going well beyond the original OSS itself, owing to the way in which modifications are defined in licences such as the GPL.

Licensing software requires some vigilance regarding the use of OSS within the licensor's software IP products. Software engineers need to be disciplined in its use and they need to declare its use so that it can be identified in the licence. The OSS licence terms must be complied with and the licensee must be made aware of their obligations in using it.

Specialist software tools, for example Black Duck, can be used to verify and determine the use of OSS within a licensor's software. This software analyses the source code of the licensor's product and pattern matches it to known OSS. The tool is expensive, complex to use and is never likely to be 100% reliable.

Generally the rule is avoid using anything under the GPL unless it is essential or you (or your licensees) will be relaxed about publishing your product source code.

General Terms

Licences contain many general terms, some of which can prove to be very important under certain circumstances.

In certain countries, withholding tax is a tax that is applied to the licensee on their payments to the licensor. Under reciprocal tax treaties, the tax withheld can be recovered by the licensor from their home tax authority, but it can only be recovered as a tax credit against tax being paid, so if the licensor is not yet profitable for example, they bear the cost of the tax themselves. Also it is very important to get the right documentation in place to verify the tax has been paid and to satisfy the tax authorities here that the tax should be recoverable.

Expenses are potentially costly depending upon the geographical location of clients and the level of support they need. If you offer the support the licensee will use it, especially if there is no cost involved as it always better to get you to pay for the work than for them to do it. Be sure to have a balanced policy regarding expenses to avoid having to swallow heavy costs which only reduce margins.

Sometimes licensees will expect a form of acceptance to demonstrate a level of functionality to authorise payments. The work required to do acceptance is often significant and, as such, expensive. It is also a diversion for the licensee as they would probably prefer to be using the IP to create their own products rather than implementing tests just to verify it is working to an agreed level. Any form of acceptance must be very well defined and the licensee must be required to make an important input to the process and it should only be used, especially due to its cost, for major milestones.

Law and Jurisdiction is often a matter of debate, especially with international clients. Realistically the licensor's home should dictate both law and jurisdiction. Compromise here can be very costly in the event of any dispute, especially if the location is geographically distant and a different law dictates the need for local lawyers. One also has to consider that interpretation under a different law may reflect a very different meaning in some terms and without input from lawyers qualified in those laws, it may be difficult to understand the implications.

It is also important to recognise that not all jurisdictions will be prepared to hear cases under any laws.

Reverting to arbitration is often preferred, but this can be equally difficult as it does not necessarily dictate a resolution. The outcome of arbitration may yet require enforcement.

Operating

Once the licence is completed the contract must be operated and here it is important to comply as closely as possible to the terms agreed, especially if some required some hard negotiation to achieve them. Careful implementation of the contract and a full understanding of what it means is essential to ensure the commercial success of it. The programme manager, client manager and the key technical leads must ensure they are familiar with the terms. It is for example, very easy to over deliver, especially with such things as support, and in times when the conduct of the contract execution is not ideal.

Conclusions

IP Licensing as a business is very dependent upon many things. The product in question has to be appropriate to licensing; standard, undifferentiated and complex, so it is not easy for the customer to do for himself. The risks are not to be underestimated either as the development of the IP being licensed often takes a considerable time before any income can be realised and when the income is heavily linked to the success of the licensee's developments, it is just an additional factor in the risk, one which is not in the licensor's sole control.