The article below appeared in the January 2007 issue of Technology Transfer Tactics.

Having a clear policy that supports a strong negotiating position toward sublicensing is the first step in dealing effectively with this sometimes contentious issue.

Most universities allow sublicensing only for exclusive licenses, except under narrow and specific circumstances. For example, The Rockefeller University in New York City might allow sublicensing in a nonexclusive license only “when we are providing something like a sequence that we’ve not exclusively licensed to others, and if the company uses that sequence to develop a product and then wishes to sublicense their product,” explains Kathleen Denis, PhD, associate vice president in the university’s Office of Technology Transfer. Such an arrangement would grant limited rights for a value-added technology, “but not our naked intellectual property,” Denis says.

Drexel University in Philadelphia takes one of three tacks in negotiating sublicenses, according to Robert B. McGrath, PhD, executive director and associate vice provost for entrepreneurship and technology commercialization in the Office of Research. These include:

• a flat sublicensing rate for the length of the license;
• a high up-front rate sublicensing rate — sometimes as high as 40%-50% — that steps down over three or four years as the sublicensee develops and adds value to the technology, remaining at the lower floor rate for the duration of the license; and
• a flat but relatively high sublicensing rate of 30%-40% specifically for licensees whose business model is designed to attract sublicensees rather than to sell the technology itself.

In the third scenario, “we pursue a higher rate throughout the license because we tend to provide more support to sublicensees for testing, sponsored research, and other purposes,” McGrath explains. While the first licensing model lends itself to life and physical science technologies, usually with exclusive rights, the third is more appropriate for platform technologies that can spin off multiple products and support multiple sublicensees in various fields.

“In these cases, all parties acknowledge up front that the company is designed exclusively to stir up interest in the technology and encourage larger companies to take a sublicense,” McGrath says. “The licensee invests time and energy to bring sublicenses to the table, but it doesn’t contribute dollars to develop the technology.”

Beware license assignment

One of the first priorities in constructing sublicensing terms and conditions is to distinguish clearly between sublicensing and assignment — a task that is increasingly complicated in view of changing corporate structures.

Due to enforcement issues (see sidebar below) and the potential for complex legal maneuverings by licensees, assignment of a license should simply be prohibited, advises Paul Devinsky, partner in the Washington, DC, law office of McDermott Will & Emery LLP. That advice is sometimes difficult for TTOs to enforce, however. In her license negotiations, Denis tries to prevent sublicensees from automatic assignment but may permit assignment under specific circumstances.

“We have very early-stage technology, and we never quite know what direction it’s going to go,” she says. “Five years down the road, if it’s clear that a technology is only going to be used as an animal diagnostic or therapeutic, the licensee may want to assign it to an affiliate or sublicensee who actually does that work. We’ve done several of those types of agreements, but only after sufficient discussion and permission.

“Still, it’s a huge advantage to have a chance to have a dialogue with the company at the point of assignment,” Denis adds. “Often, the license agreement needs modifications for the new licensee. If you don’t have the ability to have that conversation, sometimes you’re stuck with a bad mismatch of abilities and terms in the license agreement. But it’s a contentious issue, especially in venture-backed companies that want the ability to do whatever they can to make money as soon as they can.”

Assignment of sublicenses is a more standard practice, provided the deals aren’t done strictly to allow the new entity to send the university’s IP further downstream in another transaction.

“We ordinarily permit assignment of a sublicense by the sublicensee in the context of mergers and acquisitions of the entire business to which it pertains, except in the event that the proposed M&A partner is a direct competitor of the patent owner, which wouldn’t typically occur with university licensing,” Devinsky says. “Basically, the only caveat on the assignment of the sublicense is that it can only be assigned as part of the business to which the license pertains. Otherwise, the sublicensee is sublicensing.”

While Columbia University in New York City sometimes authorizes assignments, “the devil’s in the details,” says Scot Hamilton, JD, senior director of operations for the university’s Science and Technology Ventures. When a licensee seeks to assign substantially all rights related to the agreement, “does that mean all rights in the field of pharmaceuticals if it’s a pharmaceutical, or all products derived from the technology?” he asks. “You have to craft these agreements carefully so someone doesn’t effectively create a merger solely for the technology as opposed to creating a merger of two companies.”

Drexel contemplates the prospect of assignment in its license agreements and in equity arrangements with start-ups. The university views any entity seeking to sublicense all rights to a technology as essentially seeking assignment and requires authorization to approve such a deal, McGrath says. Negotiating these arrangements is contentious, especially with start-ups, “but we’re concerned about making sure the technology gets into the hands of a company that’s both committed and able to develop it,” he says.

Seek notification or approval

TTOs differ on whether to ask for notification or approval of sublicensing rights. Most companies are reluctant to grant universities the open-ended right to approve sublicenses, Hamilton says. However, many universities — including Columbia — are just as reluctant to seek that right, preferring instead to require notification and ensure original license agreements stipulate that sublicenses comply with the original license terms.

“We don’t believe we have the bandwidth to approve these agreements on a one-by-one basis, so we ask for notification,” Denis agrees. “If we ask for approval, we need somebody with the expertise to read [proposed sublicenses] in a timely manner. And if we miss something, we have no recourse because we approved it.” Nevertheless, Denis asks for a complete, nonredacted copy of the sublicense. “We also add language in the license agreement that the sublicensee will be bound by all of the terms and conditions in the original license agreement,” she adds.

Drexel takes a similar approach, seeking notification at a minimum, “though some licensees are happy to give us approval rights,” McGrath says. “We like to know who we’re dealing with, but the licensee is free to negotiate the deal that it wants, so long as it’s consistent with the terms of our license.”

In some cases, TTOs may handle sublicensing directly but rely almost exclusively on standard, pro-forma agreements, Devinsky adds. However, only a limited number of technologies, such as consumer electronics, lend themselves to a one-size-fits-all agreement, he cautions.

“You can have a pro forma sublicense document attached as an exhibit to your licenses so the parties have agreed in advance to the terms and conditions of the sublicense,” Devinsky says. “Even then, periodically you have to review royalty rates as what was once a high-margin product becomes a low-margin product.”

When a technology is early in the product lifecycle, margins typically are high and licensees or sublicensees can afford to pay substantial royalties and still realize a decent profit margin, Devinsky points out. As the product is commoditized and margins shrink, however, if sublicensees are forced to pay what they initially agreed to pay, they could be in a money-losing position. “Licensors have to recognize such realities if they want to keep the technology commercial,” he says.

Certain biotechnologies may be mature enough to use a pro forma approach.

“If the scope of the patent claims is such that you can determine the resulting commercial product and evaluate the profit margin, there’s no reason why you can’t go with a pro-forma type of agreement,” Devinsky says. “But such situations are rare. In most technologies, patents are still being issued with claims of varying scope that could apply to many different industries and product lines. In these cases, it’s almost impossible to do anything that is both comprehensive and pro forma.”

Pass-throughs preferable to floors

Not surprisingly, one area of sublicensing that attracts significant attention is the topic of royalties. The percentage of income universities can expect to derive from a given sublicense is largely dependent on the scope of the patent, sources say. Although, in general, TTOs should seek the highest percentage of sublicense income they can reasonably expect to derive, “if it’s a narrow patent and relatively easy to design around, chances are you’re not going to see much in the way of sublicense income,” Devinsky says. “If it’s a broad patent and your direct licensee is practicing one tiny segment of it but insists on some form of exclusivity, you should look for a much larger percentage.”

Many TTOs insist on pass-through royalties from sublicensees as their primary negotiating stance.

“If there’s a 5% royalty in a license, everyone pays a 5% royalty,” Denis says. “We specify a certain percentage of net sales, and it doesn’t matter who sells — an affiliate, a sublicensee, or the actual licensee. Everyone pays the same percentage.” Nevertheless, Rockefeller has granted some carve-outs in the application of certain technologies to narrow fields of use, such as animal test kits, that generate small margins.

No matter which of Drexel’s three sublicensing structures is used, “I push hard to have the royalties we negotiate pass through,” McGrath notes. “We seek to negotiate a fair and reasonable deal for the technology when we do the license, knowing the licensee will add value to that technology down the road. There should be more than enough room between the royalty we negotiate and the royalty they negotiate with the sublicensee for them to enjoy the benefits of that sublicense. In the meantime, we receive a fair royalty up front.”

When licensees reject pass-through royalties, universities are forced to fall back to their sublicense provisions, perhaps with a royalty floor. Any floors must be spelled out in the original license, but they can backfire if they are not set reasonably, Devinsky warns.

“Royalty floors are a funny animal,” he says. “You use them to try to ensure a maximum royalty stream back up to the university, but if you use them improperly they can squash the royalty stream.” He suggests imposing a minimum annual royalty on a sublicensee only in the context of some sort of exclusivity and, perhaps, only after a certain incubation time, such as three or four years. “Otherwise, they tend to have exactly the opposite effect that you intend,” he says. “Instead of weeding out nonperforming sublicensees, you squash some very promising start-ups.”

“Most of the companies that refuse pass-through royalties are open to a royalty floor because it gives them the flexibility to negotiate the deal they want — structuring it for more cash or equity investment, for instance,” McGrath says. “At the same time, it doesn’t totally cut us off from enjoying the benefits of the sale.”

But, in these cases, it’s also essential to pay close attention to the application of their sublicensing provisions.

“I’ve seen cases where proceeds from a sublicense are treated as net sales, and then the royalty rate would apply,” McGrath says. “Normally, we would have a floor of a sublicense at 10%, but I’ve seen cases where it was defined that only a 2% royalty would apply to the floor rate. It’s critical to make sure that sublicense language is well-defined so you don’t get into a situation where you receive a percentage of a percentage.”

In another example, Columbia typically negotiates the greater of pass-through royalties or a percentage of revenue for any sublicense agreements, since it’s often difficult to anticipate the ultimate value of an early-stage technology.

“We try to have our cake and eat it, too,” Hamilton says. “Sometimes we negotiate a pass-through on the royalty but a percentage on any other income, like up-front payments or milestones.”

Require reporting of sublicense income

Reporting and payment of sublicense income is another area that requires due diligence on the part of the licensor. Irregularities in reporting sublicensing income occur “more than your intuition would lead you to believe,” Devinsky says, so licenses should allow for regular audits of sublicensing income. (See sidebar below.)

“We usually put in a provision where the licensor will pay the cost of the audit unless it shows an underpayment of 5% or more, in which case the licensee will be responsible for the cost of the audit and will pay the amount of the deficiency plus a penalty, which is usually prime plus 4%,” Devinsky says.

“We also sometimes require that the royalty report is signed by the chief financial officer,” he adds. “The idea is that people in executive positions don’t sign something just because it’s slapped in front of them, and people who gather the numbers for a report they know their CFO will sign are usually more careful about the accounting.”

Columbia asks licensees to pass on royalty reports from sublicensees, “and the parent agreement obligates sublicensees to report the same kind of data that the parent licensee is obligated to report,” Hamilton says.

“If we find irregularities in the sublicensing data, the licensee would have the right to audit their sublicensee or allow for us to conduct the audit at our expense,” he adds. “Typically, we lay this responsibility on the licensee, and they usually take action to resolve it. But I would imagine, as university tech transfer hits middle age, that we will see more cases where products are being sold by sublicensees, and we’ll want to have more direct contact with them.” In fact, the university recently hired its first director of post-contract compliance to assist with enforcement of license and other contractual provisions.

Additional auditing provisions may be needed when licensees or sublicensees are located outside the U.S.

“You have to pay attention to the local law, which adds another level of complexity and another imponderable,” Devinsky says. “If the entity is located in Switzerland, for example, you may be limited as to what you can discover in terms of a contested audit of royalty records.”

Structure have-made rights carefully

When a sublicensee is a subsidiary of the licensee, the TTO should resolve any transfer pricing issues to ensure that royalty obligations are not affected. Have-made rights also need to be carefully controlled.

“Of all of the exclusive rights that may be licensed, have-made rights have been the most problematic,” Devinsky says. For example, a sublicensee, if granted a have-made right, may give a foundry the right to make a widget under its sublicense. If the sublicensee then places an order for 10,000 widgets but the foundry produces 100,000, technically the foundry hasn’t committed an act of infringement because it was licensed to make them, Devinsky points out. However, the other 90,000 widgets typically find their way into the marketplace, and the licensor doesn’t receive a royalty for them.

“We generally include strictly limited have-made clauses and separate them from the general patent license grant so we can control how that specific right is exercised,” Devinsky says. For example, he typically requires that a have-made right be associated with a particular trademark and product design, with an order that requires the sublicensee to consume 100% of the products that are produced, and with licensor approval of the purchase order by the sublicensee that imposes limits on the foundry.

“Sometimes we just refuse to grant have-made rights,” Devinsky adds. “If you’re licensing a semiconductor patent and your licensee or sublicensee already has ample capability to manufacture semiconductor chips, why should you give the license the right to engage another manufacturer who may be outside your control?” A licensee or sublicensee might understandably request the ability to outsource the manufacturing at a cheaper rate to enhance its profit margin, “but if there’s a significant risk that a revenue stream from valuable technology is going to be diluted, we sometimes refuse,” Devinsky says.

Cross-licensing can dilute royalties

Cross-licensing is another issue to carefully address during negotiations. When a licensee offers a sublicense for a given technology and receives a cross-license as partial consideration, the monetized royalty rate for the technology is reduced, Devinsky says.

“If the licensee receives a cross-license from its sublicensee, there should be some mechanism for the licensor to revalue upwards the royalty stream moving up to its direct licensee,” he suggests. “If the licensor is entitled to some pro-rata piece — 20% or 30% of the sublicense’s revenue stream, for instance — the dollar value of that piece will be lower because of the cross-license. You need to be able to account for that.”

Depending on the technology, TTOs also should ensure that the basic licensing agreement prevents licensees from signing so many sublicenses that they cannibalize the technology.

“Some patents lend themselves well to field-of-use licensing,” Devinsky says. “If you have a novel steering wheel, for instance, you can license it separately for use on cars, boats, planes, ATVs, golf carts — product lines that are essentially independent of each other. You can also limit sublicenses geographically — by region, by state, by market — and you can do both, depending on the scope of the technology and what the patent covers.

“But if you have too many sublicensees and they’re not limited by field of use, geography, or any other mechanism, pretty soon you’re in a Starbucks situation, with one on every corner, taking away each other’s sales,” he adds. “Typically, that’s not a good strategy to maximize your return.”

Editor’s note: Contact Denis at 212-327-8266 or denisk@rockefeller.edu, Devinsky at 202-756-8369 or pdevinsky@mwe.com, Hamilton at 212-854-6552 or scot.hamilton@columbia.edu, and McGrath at 215-895-0303 or robert.mcgrath@drexel.edu.

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Sidebar to main article

Revisit sublicenses in light of MedImmune decision

Just like all other licenses, sublicensing arrangements must now be viewed in the context of last year’s U.S. Supreme Court decision in MedImmune v. Genentech, which held that a patent licensee need not breach a license agreement in order to seek a declaratory judgment of patent invalidity, unenforceability, or noninfringement. Though that decision broadly applies to licensing, some TTOs and their counsel are tweaking their licensing agreements to deter not only licensees, but also sublicensees from challenging the underlying patent(s).

In the context of MedImmune, “although the clause has not yet been tested, one thing we now try to include in all of our licenses is a clause to the effect that any direct or indirect challenge to the validity of the licensed IP may, at the discretion of the licensor’s option, result in termination of the agreement,” Devinsky says.

“In addition, in the event of a direct or indirect challenge to validity by a licensee, we suggest inclusion of a back-up royalty table, which is essentially double the normal agreed royalty rate. In other words, the message to the licensee is: ‘If you force me to defend the validity of my patent, maybe I’ll terminate you and maybe I won’t, but you’re going to pay for my defense, because I’m going to charge you double royalties during the period of the contest.’” The enforceability of such clauses has not yet been tested in court, Devinsky emphasizes.

Contact Devinsky at 202-756-8369 or pdevinsky@mwe.com.

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Sidebar to main article

Require detailed royalty reports, audit power in sublicensing deals

Validating an accurate flow of revenue from sublicensees back to the original licensor is one of the thorniest issues of sublicensing, sources tell Technology Transfer Tactics. Increasingly, TTOs are placing language in licensing contracts that permits or even obligates them to audit not only direct licensees, but sublicensees as well.

And with good reason. A 2007 report by Invotex Group, an accounting and IP management firm based in Baltimore, indicated that, in 2006, 80% of all licenses had underreported royalties, and 40% underreported their royalties in excess of 25%. Unreported sublicenses accounted for 17% of the total unreported royalty dollars uncovered by Invotex’s audits. In fact, errors in sublicenses occur often enough “that I investigate sublicenses in every audit,” says Debora R. Stewart, PCA, the company’s manager director.

One of the biggest issues with sublicenses is that licensors “generally are kept in the dark,” Stewart adds. To protect themselves, licensors should include language in their original licensing agreements requiring the licensee to provide them with copies of sublicense agreements as well as copies of royalty reports. Agreements should also give licensors the authority to audit each sublicensee’s records, she says.

“Auditing a company that receives a sublicensee royalty statement is useless,” Stewart says. “You would know whether you’re getting your piece of what the licensee received, but you don’t know if that piece is accurate. Licensors should require royalty reports from sublicensees to have at least the same detail that they require from the original licensee.”

Based on her auditing experience, Stewart also advocates the use of pass-through royalty rates from sublicensees, enabling the original licensor to receive the same percentage of proceeds as the direct licensee, and she advises licensors to make licensing language clear on this point. In addition, Stewart cautions against allowing licensees to grant any kind of discount to sublicensees. “These don’t make economic sense,” she says.

But a greater concern is that licensors pay too little attention to the definition of sublicensees in their original licensing agreements. Especially in pharmaceuticals, many licensors enter into what they call distributor licenses, marketing agreements, and other types of third-party arrangements, Stewart explains. In her view, these are essentially sublicenses, yet the third parties often pay the original licensor only a fraction of the royalty that would be owed under a sublicensing agreement.

“The definition of sublicensee — or any partner involved with the technology — needs to be broader to capture all of the economic benefit the technology generates,” she emphasizes.

As part of their standard business practices, well-managed tech transfer programs should regularly audit every licensee and sublicensee, typically on a three-year schedule, she advises.

“When people know you’re watching, they take a little more care in preparing their royalty reports,” Stewart says. “That being said, you can have an audit program but still look for red flags, such as errors on royalty reports.” Sometimes, even publicly reported information on the industry or a sublicensee will provide a licensor with sales or profit figures on a licensed technology.

“It sounds too easy, but many times I conduct an audit and see from public statements that a licensee is misreporting its royalty rates,” Stewart says.

Audits cost money, but over time an audit program recoups more dollars than it costs, according to Stewart. Audits that detect underreported royalties at least pay for themselves and sometimes recover millions of dollars.

In general, licensees and sublicensees are not purposely stealing from licensors, Stewart emphasizes. Instead, audits typically uncover mistakes due to underreported sales, disallowed deductions, unreported sublicenses, differences in license interpretation, unreported benchmarks, transfer prices – even simple math errors.

“The world is pretty busy,” she says. “Reporting royalties is one minor part of a company’s business, and often it’s an afterthought.”

Editor’s note: Contact Stewart at 410-824-0141 or dstewart@invotexgroup.com.