If you’re new to this series, you may want to begin by reading Part 1, Part 2, and Part 3. The purpose of this series is to help entrepreneurs consider licensing strategy from a university’s perspective, so that you can be more successful in planning the future of your business. I have organized my thoughts into the following categories: Getting Skin in the Game, Taking (and Disposing Of) Equity, Royalties vs. Upfront Fees, Options and Contingent Licenses, Keeping the Innovators Involved, and Owning Future Inventions.
Royalties vs. Upfront Fees
Like other aspects of license negotiation, the choice between an up-front license fee and deferred royalty payments represents a decision about risk. The start-up has three basic goals: 1) lock up rights to the IP quickly, 2) for low out-of-pocket cost, and 3) in a way that won’t put heavy constraints on future operations. For the university, the basic question is how to price the IP to maximize achievement of the university’s goals, which usually include some combination of revenue and economic development.
Universities may prefer to set a high upfront licensing fee because it means they have immediate cash-in-hand. High up-front fees may also discourage first-time entrepreneurs and favor those start-ups that have experienced leaders who can raise enough money to pay up front, and therefore the ability to pay becomes a proxy for measuring the probability of future success. High initial fees are the hallmark of a licensing operation with a low tolerance for risk.
For most entrepreneurs, it seems easier to agree to pay royalties due at a later date than to pay an up-front fee at the time a license deal is signed. The up-front fee is a nice achievement for universities, but over the longer term royalties represent a continuing revenue stream that may grow if a product becomes successful. For these reasons, universities with moderate-to-high risk tolerance in their licensing programs may offer to license based on royalties alone or some combination of upfront fees and royalties.
At first glance, downstream or deferred royalties can be attractive to both parties under the right circumstances. However, royalty agreements that depend on unit sales numbers or gross revenue milestones introduce additional complexity to the license negotiation, and pose additional questions that must be answered to avoid contract disputes later in the relationship:
• Who will keep track of product sales and royalty payments? Who will ensure the counts are correct? If there are third-party auditors, who will pay for the audit?
• How much is a reasonable royalty? Is the royalty set in terms of real dollars, or a percentage? (A percentage of what: gross or net?) Should this number change over time?
• Should payments start immediately, or after the first 100 sales? 10,000 sales? $100,000 in gross revenue? $50,000 net income? Six months’ time? Or perhaps some other more-complicated calculation, like after the start-up’s EBITDA reaches some threshold value where the start-up is stable?
• Should the start-up make payments monthly? Quarterly? Annually?
• What happens if a royalty payment isn’t made on schedule?
Remember that a university that takes an all-royalty license is accepting a big risk: if the start-up is unsuccessful, the university may never get paid at all. Universities are likely to apply a risk premium to royalty calculations, so every dollar in up-front fees the entrepreneur avoids will likely cost more than a dollar to pay back in the future.
It’s natural for entrepreneurs to want to reduce or eliminate upfront fees as much as possible, but the decision to push payments into the future may carry hidden costs. Avoid excessive administrative burdens tied to complicated royalty schemes. If you decide to base royalty payments on milestones, take care to choose milestones that can be easily (and inexpensively) verified by all parties. Make royalty payment calculations as simple as possible for all parties to understand.
Steve Glista is Of Counsel to Slinde Nelson, and his practice is focused on helping clients understand the risks — and rewards — that come with doing business, specifically on the internet. He also currently represents defendants and John Doe targets in a series of online file sharing lawsuits.