Step 4: Prepare To Negotiate A Licensing Agreement
The right time to prepare for negotiation is prior to contacting a prospective licensee. You never know how far an initial conversation may go. If you hit the right person on the right day you might end up with a deal quite quickly. This will only be possible if you're prepared.
Being prepared means you should have clarity on two things:
1. The potential value of your invention to the licensee:
How much profit is the licensee likely to earn from the invention? How much investment will it require? How fast will the investment be returned? How will the invention affect other items in the licensee's product line? Will the invention lead to other new products and additional sources of profit?
2. A deal value that would make you happy: A dollar amount for a buyout or a sum of money that is paid monthly/quarterly/annually.
For a deal to take place, the licensee's value must be equal to or greater than the value you need to be happy. As discussed in Chapter 4, you should answer some questions about value prior to developing your invention in earnest. However, most inventors gloss over the subject and develop inventions because they believe in it and had confirmation from close family members and friends. Now, if you want a deal to come together, the subject of value is unavoidable and must be addressed seriously.
When it comes to a new product, no one really knows what it will be worth. Marketing and distribution along with social and economic factors are as important as the product itself. All anyone can do is make a reasonable guess based on available information from similar products.
Buyout vs. Royalty
There are two basic forms of licensing deal, buyout and royalty.
1. Buyout: in a buyout deal the licensee makes a single payment to the inventor and owns rights to the invention ever after.
2. Royalty: in a royalty deal the licensee makes ongoing payments to the inventor related to the commercial success of the invention. The licensing contract generally specifies annual minimums and other things to insure performance by the licensee. If the licensee fails to perform as specified by the contract it loses some or all of its rights to the invention.
Buyout
Buyout deals are much simpler and are preferable to both sides if a fair price can be established and agreed to. The problem is establishing a fair price in a world of uncertainty. Regardless of how promising an invention seems in the development stage, commercial success is far from guaranteed. Miscalculations, competitive pressures and world events are impossible to know in advance. A buyout value must take these possibilities into consideration. Thus, the value a licensee thinks an invention might have, assuming everything goes well, must be reduced by the risk factor that things will go wrong.
The list of things that might go wrong is endless and horrifying: a product liability suit could kill the invention in its first year; knockoffs might appear and dominate the market; another inventor might claim that your invention infringes his patent and so on. For this reason a licensee's risk factor is necessarily high. For an invention that might generate $100 million in sales over ten years (if everything goes right) a licensee might reasonably offer a buyout value of $250,000.
After a buyout, the inventor has cash in hand and need not worry about whether the invention is ever introduced, if it is successful, or if that success will last. Any factors that affects the invention's impact in the market is no longer a concern of the inventor.
The longer the life cycle of the invention the bigger the discrepancy between a buyout deal and a royalty deal. For an item with an anticipated one to two year life cycle a buyout value might be 25% to 50% that of a projected royalty. For a product with a projected 10 to 20 year life cycle a buyout value might be 5% to 10% that of a projected royalty.
Royalty
While a buyout puts all of the risk on the licensee, a royalty deal shifts a great deal of that risk to the inventor. Everything the inventor does not need to worry about in a buyout deal becomes a concern in a royalty deal. In a royalty deal the inventor becomes a partner in the licensee's business, participates in the success or failure of that business, and in the success or failure of the customers of that business. For example, if a key customer goes bankrupt, the licensee may go bankrupt too, causing the inventor's stream of royalty income to dry up.
On the other hand, in a royalty deal money is paid to the inventor as either a percentage of sales or as a fixed amount per unit; the more successful the licensee is in selling the invention, the more money the inventor makes. Generally there is no cap on royalties. Thus, if the invention is a blockbuster (impossible to forecast), the inventor stands to make money in excess of everyone's reasonable expectations.
Royalty comes from profits. Every dime the inventor earns as royalty is one dime less profit for the licensee. Consider an average product that is sold by a licensee for $10. If the licensee typically earns $3 in profit on an average product, it will be quite interested in a new product that offers the chance to earn $4. If the inventor earns a royalty of 5% of the $10 selling price ($0.50/unit), the licensee will see a profit of $3.50 and probably still be interested. However, if the inventor takes a royalty of 10% ($1/unit), then the new product will generate just $3 in profit for the licensee and will look just like any other product … except that the new product entails investment and risk. In this case the licensee will probably walk away from the deal.
A successful deal comes together when everyone involved can make better than normal profits.
Value to a Licensee
Prior to talking to a prospective licensee you should learn as much a possible about the market. Do not be intimidated by a Fortune 500 name. With regard to your invention and its product category you have the ability to know more than anyone on the planet. Do not let a prospect tell you how big the potential market is – find out for yourself. Remember, no one really knows. Everyone is just guessing using whatever tools they have. Prospective licensees will be deeply interested in your estimates of market size and potential if you've done some reasonable homework.
Chapter 4 discusses ways to estimate the value of your invention and guesstimate market size. If you have not done so already, take some time to reread that chapter, do some research and create guesstimates for your invention and market category.
The best way to prepare for licensing negotiations is to prepare to go into business yourself. If you are genuinely prepared to make and sell your invention then you will not be afraid of rejection from a prospective licensee. At the same time, if you take an honest look at all of the factors involved in commercializing a new product and running a business, you might find the idea of licensing is so appealing that you do not want to risk a rejection; you might settle for a somewhat lesser royalty to insure getting a licensing deal.
Value to You
Many times in this book, I urged you to consider things from someone else's perspective. Now it's time to turn inward. Be truly honest with yourself. How much money do you need to earn from this invention to be satisfied? In answering this question you should consider the alternatives of different licensees or doing it yourself. Remember that the world will keep on turning without your invention – if you get greedy your invention will never be commercialized and you'll earn nothing.
Come up with two numbers: a buyout number and an annual royalty number. Do a gut check. If you sold the product on your own how much do you h o n e s t l y think you would actually put in your pocket each year.
One of the biggest mistakes people make in business is to worry about how much money the other guy is making. What the other guy makes is not your concern, except to the extent that it helps you sell your idea. Worry about yourself. Determine minimum numbers you can live with. When it comes time for final negotiations your goal will be simply to improve upon those minimum numbers. This will be discussed in detail later on.
For now, as you get ready to make your initial presentation, it is only important to have some rough numbers in mind. Be ready for an offer you can accept. If you feel that your numbers will never be met then you should avoid even presenting your invention. Regardless of Confidentiality Agreements, the number two reason inventors get knocked off is because they back out of a deal after provoking serious interest from a prospective licensee (the number one reason is that they have a successful TV product).
Preparing for Negotiations with Black & Decker
Prior to making its initial presentation to B&D WorkTools seriously considered making and selling the CounterPoint staple gun on its own. The company figured that within 2-3 years it would be able to earn annual profits of $1 million on sales of 200,000 staple guns plus staples. This represented 5% of the estimated annual US market. Worktools guessed that B&D, with its established name and distribution network, would be able to sell 10X as much, a total of 2 million units. Thus if the company could earn an average of $0.50/unit on a royalty basis it would be able to earn the same $1 million per year with less risk and effort. The WorkTools partners believed in the long term potential of the CounterPoint and, with one eye to making it themselves, determined a buyout number of $5 million. Of course there was no way B&D was going to pay $5 million up front. When B&D asked how much it would cost to buy out the rights to the tool. I answered as follows, "We figure that within 5 years this product in B&D's hands should achieve 50% market share, generate upwards of $50 million in annual sales and over $10 million in profits. Further we believe that this product will add a halo of innovation to B&D as a corporation, generating tremendous publicity and effect a rise in the price of B&D stock on the NYSE of at least $0.25 per share. Since there are 80 million shares outstanding we believe that upon introduction of our invention B&D will see a gain of at least $40 million in value. With all of that in mind we would be willing to accept a buyout of $10 million…" I had a big smile on my face that signaled I knew this was ridiculous. I continued with a smile, "…but that's negotiable. In all seriousness we know that B&D isn't prepared to write us a huge check so we'll be pleased to discuss a royalty." And that's what we did.
For the initial meeting with B&D we had the following:
· Working prototype with a highly evolved mechanical design;
· Invention prospectus including strategic analysis of the staple gun market, survey data and a sample ad;
· A secret internal understanding that we would accept a royalty deal that would pay out at $1 million/year if B&D achieved 50% market share.
The subject of royalty and buyout was not seriously discussed until subsequent meetings. The working prototype was absolutely critical. The written information helped the B&D staple gun team sell the project internally.
Creating the Presentation
An invention is more than just a design and a prototype; it is something that delivers benefits to users, manufacturers, marketers and retailers. Those benefits should be detailed in the form of an invention prospectus that is left behind after your initial meeting. The prospectus should answer the likely questions a licensee might have regarding your invention.
The prospectus is comprised of primary material that describes your invention and the market opportunity and support material that answers likely questions.
INVENTION PROSPECTUS
I. PRIMARY MATERIAL
· Photo or illustration of the invention
· Summary of the market for the invention
o Total market size
o Description of competitive products and current market shares
o Anticipated distribution channels
o Results of end-user surveys
· Comparison to competitive and alternative products (It is UNACCEPTABLE to say, "Nothing competes with my invention". Airplanes compete with trains, cars, trucks and ships in the field of transportation. Your invention does not exist in a vacuum. If it did there would be no customers.). Describe how your invention is superior. Think about it from the perspectives of end user, retailer, manufacturer and marketer. If you've identified prior art patents it is appropriate to include cover pages of those patents.
II. SUPPORT MATERIAL
· Sample magazine ad or TV commercial for the invention. The purpose of this is to show how powerfully and easily the benefits of the invention can be communicated. Strong concepts matter more than production quality.
· Cover pages of issued patents and trademarks for the invention. Also include cover pages of any relevant prior art patents for directly competitive products.
· Price quotes from manufacturers
· Photo or illustration of proposed packaging
· CD/video demonstrations . This is a more engineering-oriented presentation that shows how the invention works.
· Highly relevant current articles regarding the market and similar products.
· Bios of the inventor, partners and advisors. Cover each person in a short paragraph. Include a photo.
· Bio of the inventor's company. If you formed a company for your invention, briefly state when was it found, how it is organized (LLC, corporation, partnership). Mention any highlights.
· Statement of confidentiality. I use the following language on the title page and at the bottom of every page inside the prospectus: "Confidential and proprietary information of WorkTools, Inc., Copyright 2002, all rights reserved. For more information contact Mike Marks at Tel: 123-5456-7891, email mikemarks@worktools.com"
· Contact information . Provide complete contact information: office and mobile telephone numbers, fax, email, post office and express delivery addresses, web site.
Be as brief as possible. The primary material might be 5 pages in all. The support material could be another 20 pages. If it is too long no one will ever read it. Do not include raw data from surveys and the like. Do not include full text from patents – use only cover pages. Do not include canned market analysis or invention evaluations from a third party.
The prospectus should give the licensee all of the information it needs to make a decision about your invention. This is why it is critical to disclose upfront all of the available information you can find about competitive/alternative products. You should be able to convincingly answer why your invention will triumph over those products. If the licensee does not already know about the competition it will learn about it prior to making a deal with you. The prospectus is your chance to educate the licensee about the competition on your terms.
Creating a prospectus may sound intimidating, but it is not. Take it one step at a time and do the best job you can. Do the job yourself or have a partner or advisor help you –honest information matters far more than slick presentation. If you make the effort yourself you'll truly be the world expert on your invention. Your ability to sell your invention will grow exponentially.
Beware of Invention Submission Organizations
Contracting an invention canning factory such as one of the self-proclaimed invention gurus on the Internet or, even worse, an invention submission organization, is likely to be a complete waste of money and might even hurt you more than help you. Canning factories typically charge fees in the range of $10,000 to research prior art, perform a market analysis, and submit the invention to potential licensees. The factories generally, more or less, perform all of the services they are paid for. And that is the problem… doing the job right is not factory work and should cost far more than $10,000.
The invention canning factories follow the same routine for every invention. All of the work they produce looks the same and is essentially devoid of meaning. I personally review hundreds of invention submissions each year. I pay close attention to detailed submissions made by inventors themselves and have tremendous respect for submissions made in hand writing. When I receive a canned Invention Evaluation and Market Analysis, I feel a moment of empathetic pain for the inventor's wasted dollars, spend 10 seconds trying to figure out what the invention is, and 99/100 times throw the submission immediately in the trash.
Paying an experienced professional to research, prepare and present an invention prospectus is a custom job and should cost in the range of $50,000 to $100,000. I am not saying that is a wise investment. It is simply that doing the job right requires a focused mind and a meaningful investment of time. The job you do yourself will be less slick but probably much more effective than if you handed it off to a professional. The knowledge you gain will give you confidence that cannot be bought at any price. And confidence in your invention will drive you to succeed.
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