What does it mean to license your invention for royalties?

If you are not familiar with the term “license”, think of it as a way of renting your invention as opposed to selling your invention.

A license agreement is when the inventor [licensor] agrees to let a third party [licensee] commercially use his or her invention for a period of time in exchange for some form of compensation, which is usually an ongoing payment called a royalty (described below).

One big advantage of licensing is the inventor does not have to invest in the manufacturing and marketing of the invention, which is the most costly part of the invention development process.  Typically, the company who licenses the invention will be the ones to manufacture and sell the product on the market.

When it comes time to actually enter into an agreement with a company, make sure you understand some of the key components of a license agreement.

Here are 10 common components of a license agreement that you should understand…

  1. Definitions.  License agreements typically define key terms that are used throughout the document to ensure that there is no ambiguity. 
    • LICENSOR – this is a term used to refer to an inventor, or the person/entity that is granting rights to the invention.
    • LICENSEE – this term refers to the company or party that is going to license your invention and pay money in royalties.
    • INTELLECTUAL PROPERTY RIGHTS – this term may refer to the patents, patent applications, trademarks, trademark applications, copyright registrations, etc.  Basically, it defines your ownership rights for your invention.
  2. Royalty.  The top question on most inventors’ minds is “How will I get paid?”  Since a majority of our agreements have based the inventor’s compensation on royalty payments (not outright purchase of inventor’s assets, patent(s), etc.), let’s reflect on what that means in terms of how you would ultimately get paid.  A royalty is the amount of money paid by Licensee to Licensor for the use of the inventor’s intellectual property.  There are different ways that a royalty can be calculated and this can be a hotly-negotiated issue.  Some variations are:
    • Most commonly in our experience, royalty is based on a percentage of sales by the Licensee and will fluctuate based on circumstances like patent status, development stage of the invention, profit margin for the Licensee, etc.
    • Instead of basing royalty on sales, sometimes it is based on manufacturing cost, or even on profit.
    • Instead of computing royalty on a percentage, Royalty can be based on a flat dollar amount per unit, for example, $X per unit sold.
  3. Advance Payment.  An advance payment is a highly desirable feature for a license agreement and something that we strive to include.  However, it is not uncommon for Licensees to resist the idea of offering an advance in light of the large investment that they are taking on by licensing.  Here are some of the expenses that the Licensee may face post-license:  design engineering, prototype development, tooling, samples, packaging design, inventory, warehousing, marketing/selling expenses, etc. It is important to have realistic expectations for what a company may be willing to pay up front.  Any advance payments would be defined clearly, along with timing for such payment, in the license agreement.
  4. Payment Schedule & Audit.  The license agreement will define the frequency at which royalties are paid (ex:  monthly, quarterly, annually), as well as any reporting that must accompany the payments.  As an example, our standard agreement requires royalty payments to be made on a quarterly schedule, and payments must be accompanied by a report showing the number of units sold, dates of sales, date of payment, and gross and net selling prices.  There should also be some language to define if, and how often, the Licensor is permitted to audit the accounting records of Licensee.
  5. Territory.  Are you giving the Licensee worldwide, exclusive rights to your product?  If they sell only in North America, then the territory that you grant might instead give only North America rights.  This must be defined in the License agreement.
  6. Term & Termination.  This can vary from one agreement to the next.  The “term” defines how long you are granting the license to the Licensee.  Some agreements define term with a specific end-date, which might be three years after the license was signed.  Other agreements, such as our standard agreement, provide a more open-ended term which will continue for as long as both Licensor and Licensee fulfill their obligations in the agreement.  Termination language should be included to give definition to both parties’ rights when the agreement is cancelled or expired.
  7. Improvements.  Let’s say that you license your invention, and then the Licensee transforms your product from something very “vanilla” into a much improved version of itself with various improvements.  It’s a good idea to define up-front who owns those improvements.  Our standard agreement states that any improvements developed by the Licensee (Company) will belong to the Licensor (Inventor).
  8. Deliverables.  Setting appropriate deliverables is the key to a happy license.  It would be a tragedy if you licensed your invention to a company who then just sat idly by, making no progress at all, and you had no legal rights to cancel the agreement.  Here are some examples of various methods to keep the Licensees responsible for and accountable to a defined schedule. 
    • Development deadlines – Define key development items along with projected completion dates and build those dates into the agreement to ensure continued progress towards getting your invention on the market. 
    • Minimum annual royalty payments – This refers to royalty levels that must be met each year of the agreement; if not met, then you have the right to cancel the agreement.
    • Sales activity – Once the product is fully developed and starts   generating royalties, some language to ensure that the Licensee maintains sales throughout the year is desirable. As an example, we have some language stating that if Licensee fails to sell “X” units in any continuous six-month period, then Licensor has right to cancel the agreement.
  9. Hardcore legal language.  We have many paragraphs in our license agreement that have been carefully crafted with the help of many attorneys.  These paragraphs include some of the most critical (and the most confusing) issues that you, as a potential Licensor, must address.  We strongly urge you to consult with an experienced licensing agent or an attorney to protect yourself and your invention.
    • Warranty Disclaimer and Limitation of Liability – This section should state that Licensor is not making any claims or warranties for things like merchantability, non-infringement, and fitness for any particular purpose.
    • Insurance – This section requires the Licensee to obtain product liability insurance to protect themselves from any claims or lawsuits (for example, if someone sues them because the product was defective and harmed them).  Along with carrying this insurance, the Licensee should also name you, the Licensor, as an additional insured party and provide a certificate of insurance to you for proof of insurance.
    • Indemnification – You want the Licensee to indemnify, or “hold you harmless”…in other words, you don’t want them to sue you for damages that might occur in their use of your invention.
  10. Housekeeping.  Obviously, there are general provisions in every legal agreement, such as defining the “parties” of the agreement, their contact information, the governing jurisdiction (should any conflicts arise, it means WHERE the conflict will be tried or arbitrated), and various other items that serve to answer all the “what if…” questions.  These questions can include the following-
    • What if I die, can the agreement be assigned to my spouse and kids?
    • What if the company licensing my invention goes bankrupt?
    • What if the company’s factory burns down and they can’t make the product anymore?