Performance Clauses In a Licensing Agreement

How to Make Sure a Company Takes Good Care of Your Invention

You've got a company interested in possibly licensing your invention! That doesn't happen often and you should feel great about reaching this stage. Negotiating a licensing deal began when you chose the company that's now interested. Understanding the company's motivations and how it operates are now critical in successfully reaching a deal. Performance requirements are necessary to ensure that the licensee continues to care about your invention when the enthusiasm of the moment wears off.
But If you set requirements too high or try to impose requirements that don't give the company freedom to operate, you can kill the deal.

A great royalty rate means nothing unless the invention is actually developed, made and and sold as a quality product.

If you've targeted the #2 or #3 company in the market, you've made a wise choice. They'll be enthusiastic about stealing market share from #1 and are unlikely to sit on your invention. If you've chosen #1 they might be interested solely for defensive reasons: even if your invention offers a huge improvement in performance, it will not be seen as a way to grow market share, but instead as a way to prevent others from diminishing the market share they already have - in other words, the #1 company might be fine with sitting on it. That said, if the invention offers big cost savings, then #1 will have a fine incentive.

But even if a company has incentive to perform with your invention, you'll sleep better if you have performance requirements in the licensing agreement. Performance can be broken down into two areas. The first is that the company will actively develop and sell the product. The second is that they will maintain product quality.

A common way to do this is with an annual minimum ("Minimum"). The Minimum can be a quantity of products produced or sold or it can be a dollar amount. We prefer a dollar amount because it's simple.

In many of the contracts we do the Minimum typically begins in the 2nd year of the agreement This gives a company time to start making money with the product before having to pay royalties on it. It's much easier for a company to agree to pay on actual sales. Hopefully by end of year 2 the company has sold enough product and has already met the Minimum. But if they haven't, when the Q4 royalty is due, they are required to pay additional funds to meet the Minimum (we like to have royalties paid each quarter on the previous quarter's sales).

The point of the Minimum is to insure the company doesn't sit on the product. It's not to guarantee income to the inventor.

What happens if the Minimum isn't paid is another negotiating point. We sometimes have two Minimums. One Minimum enables the licensee to keep EXCLUSIVE rights (that's a high number) and the other enables the licensee to keep ANY rights (termination of rights can be complicated, involving the sell-off of remaining inventory, customer lists and more - it's a topic for another day).

How to determine a Minimum? I usually ask the company to propose it based on what they think they'll do with the product. This puts the company on the spot ("I'm gonna have you hang yourself" I say with a smile). If they shoot too low they know you might walk (and maybe you will). At the same time it makes you look reasonable. Being reasonable helps you get other things in an agreement.

Typically we like to set (and accept) a Minimum that's 25% of what we roughly, conservatively, GUESS the royalties might be (there's no way to know). This provides plenty of incentive for the company to perform without being punitive when changes take place in the market.There are other ways to guarantee minimum sales performance.

There are ways beyond specific dollars or order quantities that can work too. For a given company it might make more sense to require placement at 50% of bricks and mortar Wal-Marts, or a number pf presentations on QVC by a specific date. Creative performance requirements can work better for both sides.

A Minimum serves to insure that a company is active. But you'll also want to insure that the product quality is maintained. Typically we do that with a clause that says something like, "Licensee warrants that Products will be manufactured, distributed and sold with attention to quality, service and sales equal to that of Licensee's other products." It's a legally messy and imprecise clause and only useful if the Licensee is doing a horrible job - but it helps me sleep better at night.

Mike Marks