On the Duration of a License and the Importance of Negotiation

May 2011Articles
Duration of License

One of the central elements of any license agreement is the duration of its term. Since each side to a negotiation seeks to minimize its risk, the greater the uncertainty that is involved in a license, the more difficult the negotiation of its term likely will be. Depending upon whether the property is a new introduction or an established evergreen, the parties may disagree whether the term should be brief or lengthy, fixed or subject to extension or reduction, and if the latter on what basis.

Too Short? Too Long?

Unless each party’s expectations for success approximate reality, one or the other of them likely will regret the deal it has struck. If the deal requires a minimum royalty guarantee for each year of a license, the licensee will want the opportunity to shorten the term if the property becomes a disappointment in the marketplace. If it’s a big winner, however, the licensee doubtless will want to extend its rights. The licensor may have the opposite interest in either scenario. If a property takes off, the licensor may wish an early opportunity to auction the licensee’s rights to the highest bidder, but if it is not successful, the licensor will not be interested in shortening the term if that means reducing the guaranty.

Alternative Approaches

As a hypothetical, let’s assume that the licensor won’t move from $100,000 per year in minimum royalty guarantee for the desired rights or from three years for the term of license.

The “Success” Scenario:

Both parties know that the licensee is willing to undertake significant initial risk because it has faith in the property. Assuming that the licensor is inclined to be reasonable, it should be willing to give the licensee the opportunity to extend the license if it proves successful.

First / Last?

The licensor might offer a first right of negotiation to extend beyond the initial period, but a circumspect licensee will recognize this would put it into a position of having to negotiate against its own success. That is, if its products have sold well, another potential licensee is likely to offer a premium in order to step into our licensee’s shoes and partake of the fruits of its efforts without having taken the risk. Even if the licensor suggests incorporating a matching right into the license, the premium offered by the third party might be beyond our licensee’s means and cost our licensee the opportunity to enjoy its own success.

Pre-set Threshold

Normally, it would be preferable to the licensee to establish conditions at the outset upon which the agreement could be renewed. The parties might agree up front to set a specific minimum guarantee for an extension period, or alternatively to define a formula by which the minimum can be objectively determined, should the licensee elect to extend. (For example, the renewal-period minimum guarantee could be based on an agreed multiple of the actual royalties earned during the initial term.) However defined, if the licensee were willing to pay the minimum for extension, it would have the option to do so.

Multiple of Initial Term Royalty

From the licensor’s perspective, these approaches might be palatable in concept but might require safeguards against making renewal too easy for the licensee. For example, if the renewal is based entirely on guaranteeing that the licensee will exceed in the renewal period some multiple of the total royalties earned during the initial term, the licensee could qualify very cheaply if it has been relatively unsuccessful but nevertheless wishes to extend.

Aggravating the licensor’s regret in that situation would be greater success of the property in product categories other than those of our hypothetical licensee, implying underachievement by the licensee. Therefore, the wise licensor will seek to condition any such option to extend on some threshold performance achievement – for example, the option could be conditioned upon the licensee’s exceeding the minimum guarantee during the initial term by some multiple (rather than simply a multiple of actual royalties generated during the initial term) in order to qualify for the right to exercise the option.

The “Disappointment” Scenario:

If the property fails, everyone will be reading the license agreement hastily. The licensor will want to assure itself that it will receive at least the minimum guarantee for the initial term. The licensee will be searching for an inexpensive opportunity to depart from the relationship. Particularly, if a license involves an unproven property (or an established property, but applied in unproven product categories), some form of exit strategy should be near the top of the licensee’s list of objectives during the initial negotiations.
Referring to our example of a three-year term and $100,000 minimum, one exit concept could be a right of the licensee to cancel the third year by giving notice of early termination and paying a buy-out fee in an amount somewhat less than the third-year’s minimum guaranty (e.g. $25-$50,000). If the licensor is willing to consider this alternative, it likely will insist upon a substantial lead-time for the exercise of the buy-out, in order to have an opportunity to replace this licensee with one who is more enthusiastic about the property. If the licensee negotiates for and exercises such a buy-out option, it will have reason to congratulate itself for its diligence, if not for its initial evaluation of the property.

Regardless of the mechanism chosen for extension or early termination, the efforts of each party to risk-adjust the deal during initial negotiation in order to make it mutually palatable is certainly warranted.