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6) Licensing Agreements: Do's and Don'ts - Devco gets 5% Royalty

Dreadful Drafter reads his President's notes concerning royalty "Devco gets 5% royalty" and decides that instead of a fixed royalty, Devco is to receive a royalty based on revenues. He writes "In consideration of Interco having the right to distribute the Licensed Software, Interco shall pay to Devco a royalty equal to 5% of net sales."

6.1 "Sales" versus "Revenues"

Dreadful Drafter has used the word "sales" . Likely Devco's sophisticated software will be "licensed" rather than "sold". Software developers often refer to grants of fully paid perpetual licenses in the vernacular as "sales", but this word is not an appropriate legal word. Devco and perhaps Interco, will want to retain rights to the Licensed Software; a "sale" could deprive them of these rights. "Sales" may be appropriate in licenses of tangible property. Probably Dreadful Drafter too carefully followed a license agreement designed for tangible property; such a precedent could be very misleading in a license of software.

****TACTIC: BEWARE OF VERNACULAR; IT MAY CHANGE THE LEGAL CONTEXT.

6.2 Source of Revenues

Dreadful Drafter tries again and this time uses "5% of gross revenue from licenses". He has included only fees for licenses of the Licensed Software granted by Interco to end users. He has not contemplated:

(a) Interco using the Licensed Software itself and getting revenue from its own use;

(b) Interco using the Licensed Software in a joint venture where others gain the benefits of its use;

(c) consideration for sublicenses granted by Interco to distributors who will market to end users including:

(i) initial payments for the right to distribute;

(ii) revenues earned from royalties generated by these distributors.

(d) Interco providing copies to its staff to be used for marketing purposes; and

(e) Interco providing copies to third parties for the purpose of review and testing.

****TACTIC: DEFINE "REVENUES".

6.3 Non-Cash Consideration

Dreadful Drafter has not considered non-cash consideration being paid for the grant of license rights, for examples, by shares in a closely held corporation or by a grant-back to Interco of the right to distribute the sub-licensee's software. How will Interco value non-cash consideration which it might receive from a sub-distributor at the time of granting the rights to that sub-distributor?

****TACTIC: CONSIDER THE EFFECT OF NON-CASH CONSIDERATION BEING INCLUDED IN THE ROYALTY BASE.

6.4 Exceptions from Revenues

Dreadful Drafter did not specify what would be excepted from revenues. Will Interco be able to deduct amounts resulting from:

(a) sales taxes;

(b) packaging;

(c) reproduction of user manuals;

(d) transportation;

(e) return allowances; and

(f) commissions.

****TACTIC: INCLUDE THE EXCEPTIONS.

6.5 Triggering Event

The event that triggers the royalty right is not stated in Dreadful Drafter's clause. It could accrue:

(a) when the Licensed Software is copied from the master disk perhaps on to a compact disc or a floppy disk for delivery to a customer;

(b) when the Licensed Software leaves Interco's premises;

(c) when Interco invoices the licensee;

(d) when a customer no longer has any right to reject the Licensed Software; or

(e) when Interco receives payment.

Devco will want to have the triggering event as early as possible in the distribution process, such as the shipping of the product. Interco will want to use payment as the triggering event to preserve its cash flow.

With software licenses, "receipt" of the consideration is often chosen as the triggering event. Although Devco shares the risk of bad receivables with Interco, this may not be an unreasonable risk since the cost of each copy of software is minimal and this risk may allow wider dissemination of the Licensed Software.

****TACTIC: ROGER!: TRIGGER THE ROYalty

6.6 Bundling

Interco may want to market the Licensed Software as a unit with another product it markets (i.e., "bundle" the two products). If there is a single price or license fee, can it be broken down easily to determine Devco's share?

The Licensed Software could be bundled with Interco's hardware or with other software marketed by Interco. The profit margin in the hardware may be very different from the profit margin in the software. The royalty rate might vary depending on the nature of the products bundled.

****TACTIC: BREAK THE BUNDLE.

6.7 License Fee vs. Support Fee

Interco could decide to make more profit for itself by increasing the amount it receives for support and other services it provides, keeping all such revenues for itself, and correspondingly reduce the license fee for the Licensed Software.

Dreadful Drafter might require Interco to deal with the Licensed Software in good faith and prevent it from obtaining an unfair advantage.

****TACTIC: AVOID PREDATORY PRICING.

6.8 Interco's Affiliates

Dreadful Drafter should contemplate Interco placing a subsidiary between itself and the end user to reduce the royalty payable to Devco. The license agreement might require Interco to deal as if at arm's length with its affiliates. If this is not likely to provide adequate comfort, the License Agreement might prohibit dealing with an affiliate. A solution that is practicable will have to be tailored for each situation.

****TACTIC: PREVENT AFFILIATES FROM SCOOPING PROFITS.

6.9 Tax Treatment

Royalties payable from a United States based company to a Canadian based company are generally subject to a withholding tax levied by the United States. However, under Article XII, Section 3 of the Canada-U.S. 1980 Tax Convention, no withholding taxes are levied on "copyright royalties and other like payments in respect of the production or reproduction of any literary...work". Under the Copyright Acts of both Canada and the United States, a computer program is defined to be a "literary work". Thus if the royalty was paid on account of Interco's copying of the Licensed Software, rather than on account of Interco's distribution of the Licensed Software, the withholding tax perhaps could be avoided. (The Canada-U.K. tax treatment has a similar provision).

Note, however, that a guaranteed minimum payment might disqualify the payment from being treated as a "royalty" since the payment is not entirely attributable to the production or reproduction of the literary work. Following this logic, this disqualification might not apply if the failure to attain minimum performance requirements resulted in loss of license or exclusivity rather than payment of money.

The imposition of a withholding tax may be of great significance to Devco if it is not yet paying sufficient Canadian taxes to offset the taxes withheld by the U.S. authorities.

****TACTIC: TAX PLAN: AVOID CONTRIBUTING TO GOVERNMENT EXCESSES.

6.10 Invalidity of Intellectual Property Rights

For the sake of illustration, let us assume that the value of Devco's software comes from the trade secrets embodied in that software. These trade secrets would be revealed to Interco on the delivery of the source code to it. Let us assume that after Interco integrates the software into its product, Devco's trade secrets become publicly available through a third party's inadvertence. It would seem that a licensee in Canada or the United States might be obligated to continue to pay the royalties for continued use of the trade secrets even though others can readily gain access to them. In the United Kingdom, the obligation to pay the royalty might cease on the essential trade secrets becoming publicly available. (25)

If, however, Devco had obtained a patent in the United States and the license grant was the right to make copies of the Licensed Software under that patent, under U.S. law Interco's obligation to pay royalties would cease upon the patent being established as invalid. I understand the same outcome would apply in the United Kingdom. However, in Canada it is suggested that the licensee would be obligated to continue to pay even though the patent has been established to be invalid unless there is an express clause stating that the royalty should cease to be payable.

Thus, in any agreement, Dreadful Draft should:

(a) prohibit/permit the licensee to challenge the licensor's intellectual property rights (the related rights vary from country to country and may depend upon the type of intellectual property);

(b) state whether the royalty remains payable after the intellectual property rights ceases to be effective;

(c) state whether the royalty is suspended during the challenge period (consider restraint of trade implications);

(d) state whether the royalty remains payable but must be paid into escrow; and

(e) state whether the granted rights are lost if payments are withheld and licensee loses its challenge of the licensor's intellectual property rights.

****TACTIC: CROWN JEWELS TO COSTUME JEWELRY: WHITHER THE ROYALTY?

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		Created: 2003-02-13 Updated: 2004-03-18	Top of Page	Important Notices