INFORMATION & TECHNOLOGY LAW

Right Sizing Intellectual
Property Licensing

July 2001

By Jon M. Garon*
For an Interface Tech News White Paper: A Legal Compendium for Technology Professionals.

Whether a company has grown as large as IBM or remains a one-person consulting firm, the key to profit flows from its ability to sell its products and services. An intellectual property license provides the licensee rights to use the licensed matter in the manner described in the license in exchange for payment. The license may include patents, copyrights, trade secrets or trademarks. The art of licensing intellectual property is distinct from the sales of traditional goods or services, requiring a unique set of legal and business approaches for the success of the licensor. These tools are particularly important for the Northern New England high tech community, because much of its success is focused on software, content, and consulting rather than traditional goods.

A content license may be nothing more than the sale of a copy of a software program to a consumer, or it may be as complex as any merger between publicly held companies. The fundamentals of good licensing apply to any size transaction. The licensor must focus on the transaction's goals rather than the mechanics. By focusing on generating revenue, maximizing exploitation of the intellectual property, minimizing risk, and building a common understanding between the parties, the licensing agreement will serve both parties.

Revenue & Pricing

The goal of every business agreement is to generate profit or revenue. Intellectual property licenses must be designed to maximize the profits to the licensor and value to the licensee. This obvious objective becomes less clear in practice, since the licensor cannot look to the cost of materials as the basis for pricing. A wooden table is typically priced based on the cost of the wood and the labor to construct it. Neither poet nor inventor can use this starting point.

Copyright and patent licenses are sometimes described as public goods because they can be sold numerous times without diminishing the source. When a gallon of gas is pumped, there is one less gallon to sell in the tank. When a song is played on the radio, it does not reduce the number of stations on which the song can be played. Put another way, the manufacturing cost bears little relation to the retail cost. The same CD can embody a $5.00 software game, a $18.00 musical album, or a $400 business software program. In addition, the licensee can reproduce the licensed work with relative ease, and the product does not have an inherent life span (although software, unlike music or books tends to have a short market life rather than the nearly infinite lifespan of entertainment content).

Software and other public goods do not follow general profit formulae of traditional goods. In the world of manufacturing, the process is relatively simple: maximize revenue by balancing the profit received on each unit by the number of units sold. Selling one hundred widgets for $1.00 generates the same gross revenue as ten widgets at $10.00. Because of manufacturing costs, the fewer units that can be sold at the highest price will result in the maximum profit. As the price goes up, the number of units sold goes down which counterbalances the price pressure caused by the manufacturing costs.

For software, when the manufacturing cost is treated as a constant, then pricing is based almost exclusively on the balance between the number of units sold and the price per unit. This balancing is sometime a difficult one. If the software is sold to corporations, the revenue stream will be different than if sold to consumers. Retail rules vary from wholesale rules. These are not legal distinctions, but rather purchasing expectations that are difficult to change overnight.

The home video market serves as a good example. When first created, videotapes were sold to rental stores for the purposes of public rental. The film studios missed the opportunity to license the videotapes on a per-rental basis, so they instead sold the tapes at $80-100 per unit, priced to reflect the rental potential for each tape. Only after this market had matured did the studios begin to "sell-through" directly to the public by reducing the sales price to $29.95 and shipping the tapes to WallMart in addition to Mom's Home Video.

Microsoft adopted this approach early in the software marketplace. Microsoft captured the operating system market by pricing itself hundreds of dollars below the better established CP/M operating software. The first generation IBM-PC could be operated using either system, but a clever (or lucky) pricing decision priced DOS at a fraction of the CP/M. Resellers did not particularly care which system they included, but cared quite a bit about the cost of the computer. CP/M was dropped in favor of DOS.

For consumer sales, software publishers must actively monitor the market to determine whether a new product has changed the accepted pricing structure. Discounts and upgrades add flexibility, but the publisher must maintain the ability to rapidly respond to changes in the marketplace, both contractually and practically. For example, if CadCo. produces a $1,000 per copy CAD program named PowerCAD and suddenly company B releases a competing product entitled Kiddie-CAD, a home CAD program that competes fully for $99.95, it will not be long before CadCo's product is in deep trouble. Kiddie-CAD may have cost as much or more than PowerCAD to develop. Over time, however, the marketing decision to price Kiddie-CAD cheap and popular could well outsell its competitor tenfold. On the other hand, if the true CAD marketplace is relatively small, then Kiddie-CAD would not make the profits known to PowerCAD. This will be of little solace to CadCo, if the less profitable Kiddie-CAD manages to drive it into bankruptcy. I addition, if Kiddie-CAD dominates the marketplace, it can afford to have a lower initial revenue on the theory that others will have a harder time competing profitably given the lower profits, while future versions of the product will create an ongoing revenue stream.

To avoid the mistakes of CP/M and the hypothetical errors of PowerCAD, software publishers should be reluctant to guarantee minimum prices to authors or licensees or to seek such guarantees from resellers. IBM is reported to have guaranteed the authors of CP/M a price minimum. By protecting the pricing structure CP/M lost the market. Similarly, any profit or gross participation may be better if based on revenue received rather than units sold. Otherwise, the participation cost will increase the per-unit expense and further limit flexibility. Finally, exclusive product licenses may be more valuable than pricing guarantees. By being the exclusive (or at least featured) software product associated with a computer or consumer product, the marketshare can be protected.

Scope of Rights Licensed for Consumer Software

One of the ongoing legislative debates turns on whether software is so different than goods that a different commercial code must be developed to address the specific concerns of software. I share the sentiment of most academics that the answer is no. The proposed Uniform Computer Information Transactions Act (UCITA) provides a new set of default contracting rules for software transactions, but most of the proposed changes can be achieved under the existing Uniform Commercial Code without the confusion and difficulty created by adopting UCITA. Nonetheless, those changes are important to identify.

The first question addressed by UCITA and often deemed significant is whether the transaction for software is a license to use the software or a sale of the product. For consumer transactions, this distinction is more illusory than real. The so-called consumer software license allows the consumer to use the software and to create a back-up copy, but not to modify the software, make additional copies, or to incorporate the software into another software package. Since copyright law provides these same protections for all copyrighted works - songs, software, or films - there is no meaningful difference between a sale protected by copyright or a license protected by contract. The primary difference is whether the purchaser can re-sell the particular copy. This right is protected by copyright but generally abrogated by most license agreements. In practice, however, no software publisher has attempted to enforce this licensing limitation on a consumer, so the advantage sought under UCITA is an empty, perhaps unenforceable right.

Even if software is treated as a good under commercial law, copyright law can be used to expand the publisher's protection from competition. Specifically, if the publisher harbors concerns about reverse engineering, the software should be encrypted. Whether the encryption proves impregnable no does not matter. Copyright law prohibits the decryption of encrypted software in all but the most limited of situations. As a result, the use of some encryption provides an additional measure of protection. The sales or license agreement should similarly prohibit reverse engineering and decryption so that no claim can be made that the publisher had waived the copyright protections.

In the commercial setting, the terms of the sales or license agreement must be negotiated specifically. Unless the sale of the software is for a single use by the commercial purchaser, additional terms must be added such as the number of users (or copies that can be made of the software), the ability of the purchaser or licensee to modify the software, the length of the license term if not an outright sale, the ability of the licensee to incorporate the software into its own products or services, and similar issues typically negotiated between a component manufacturer and the manufacturer of a completed product.

Scope of Rights in Commercial Licenses

For non-consumer transactions, the scope of the license may be the most important negotiated term of the transaction. The scope reflects the range of uses to which the licensed property can be put, as well as the limitations on such exploitation. Companies often make mistakes by demanding too much as well as too little for their intellectual property licenses.

An example of scope occurs in the structure of a site license. It is well established that a license for 1000 computers will cost significantly more than a single user license, but not 1000 time more, because the licensee expects economies of scale, and for most software, can operate without installing the software on every single computer when the cost become too high. By reducing the site license to an employment figure, the employment base becomes a surrogate for the scale of the company rather than a numerical count. The licensee is granted the right to use the software throughout a particular plant (or the entire system) with the license payment based on the employee pool. Because this price remains significantly below the cost of purchasing individual licenses for each employee actually using the software, it is an efficient alternative for both parties. In this model, the licensor foregoes some revenue, but gains certainty and avoids impractical auditing. The ease of use will also help retain the license over time.

The scope should also take the corporate changes into account. A site license that is based on the employment structure should include provisions that automatically adjust in the event of a merger, acquisition or substantial business change. A separate provision may require that the transfer of the license through corporate merger is subject to the licensor's approval, but such provisions are all or nothing. If the substantial change results in a change to the workforce, the contract can be structure so that the payments are recalculated. Of course, the licensee will want this clause to be reciprocal, so that if the workforce is greatly reduced, the license fees are reduced as well. Given the increasing volatility in the workforce, such a pricing structure may become a selling point for site licenses.

Scope takes on a somewhat different meaning for Internet sites and content sellers in the publishing or multi-media industry. In many situations, the revenue comes from advertising, so the content is often distributed freely in an effort to attract viewers. The true concern should be creation and enforcement of contractual obligations to keep the content tied to the advertising. If, for example, a feature column is distributed for free on the Internet, the column continues to be successful for the company so long as the advertisements remain associated with it. The difficulty with this approach stems from tracking and capturing the advertising revenue for readership away from the website.

A commercially motivated licensor should welcome the widest dissemination possible. Structurally, if the advertising (wherever found on line) can direct the viewer back through the licensor's website, then the revenue is captured. Alternatively, if the distribution is historically consistent, then the advertising rates should reflect the premium for the indirect associations. Tiger Woods is not paid primarily for each Nike commercial he films, but rather for serving as its spokesman. The press coverage of Woods wearing Nike branded clothes and products provides Nike far more than the paid advertising. A licensor's content serves as its spokesman, reaching out throughout the Internet and print world, spreading the URL of the publisher and the advertising of the associated products.

The website, HowStuffWorks.com provides a stellar example of this policy. The site promotes reprints of its wide-ranging content. For educators, the policy allows up to 500 paper reprints of each article, so long as "logos, ads, copyright notices, URLs, bylines, etc." appear the same as the printable version. Since the company is in the business of selling advertising, not content, the policy promotes its revenue stream. To relate the policy to income, the advertising contracts should track prints of the articles as part of its basis in calculating the basis of advertising revenue.

The spokesman model should also provide a basis for cross-licensing content to other commercial publishers. If the association with the licensee promotes the licensor's brand, then the co-branded license may be beneficial. If the licensee detracts or provides no value, then income becomes a more pragmatic reason for the license.

In other situations, the primary purchasers are libraries or other institutional buyers. This market is highly stable, but shrinking somewhat as the amount of content increases and the alternatives to print become more attractive. Publishing content on the Internet will generally not deter institutional buyers, but instead may increase the relevancy and recognition of materials by opening them to the much larger readership that does not access the professional library marketplace. As publishers for institutional audiences begin to lose marketshare, those that promote audience recognition though generous licensing policies will be the ones most likely to be able to promote growth and development of their content. Those that restrict licensing to protect content will invariably lose market share and relevancy.

Usage Restrictions

In another vein, the license must also reflect the usage intended by the licensor. In a consumer license for a single computer, the license will invariably restrict the licensee from any modification, and most are drafted to bar even transfers to new computers (although the latter is almost never enforced).

If the licensee is a commercial licensee, then modifications to the software may be necessary. Ownership of these modifications often becomes a point of significant contention. Economically, the right should be allocated to the company in the better position to exploit the modifications. If the licensee can re-sell the modifications, then it is in the licensor's best interest to allow for the modifications - in exchange for an appropriately priced licensee fee or a percentage of the licensed revenue. If the modifications can be sold separately, then the licensee gains a sales agent for its base software. Too often, companies ban modifications to maintain absolute control rather than to maximize long-term revenue. A ban on modification provides some protection from liability and marginal safety from copyright violations, but it also stifles revenue.

Open source software represents the other extreme, with every product based on the open source code to be reported back for use by other developers. This provides an excellent method of improving software, but severely lessens the income potential for most software developers. Ironically, a good marketing and packaging company can do quite well using open source software by creating value in the installation, support, and documentation. Participating in client's development of the licensor's software or content can create new opportunities and greatly reduce development costs or time to market.

A variation on the licensing model provides that the licensee is free to modify the material, but that the variations belong to the licensor. The licensee receives only the right to free use of the modifications developed. Although much less likely to produce great innovation on the part of the licensee, this approach reflects an alternative balance between licensee and licensor that allows both to exploit the content. The balance can be negotiated to fit the relationship appropriately.

Intellectual Property Protection

The most significant danger in allowing modification comes from the creation of a competitor. The litigation between Microsoft and Sun over modifications to the Java programming language illustrates when partnerships go bad. In contrast, Intel's new Itanium chip (formerly code named Merced) was developed in a partnership with Hewitt Packard. The Wall Street Journal reports that during the negotiation phase of the relationship, all documents related to the technical specifications were locked in a cabinet that took keys held by each company to open. If the deal was not consummated, the parties planned to destroy the contents of the cabinet.

Physical protection of documents, files, and data is a necessary first step in protecting the licensor/licensee relationship, but only the first step. Both companies must agree to use and enforce nondisclosure agreements with each other and with the vendors and employees that each company engages. Ideally, the contract should provide for indemnification so that each employer bears the risk of its own employee's breaches of confidentiality - an approach that should create incentives for the employer to take its obligations seriously. In a major joint venture, the nondisclosure agreements should include a statement that the non-employee participant in the joint venture is a third party beneficiary of the contract. This allows that party to enforce the contract to stop disclosure or seek damages even if the employer cannot because it has gone out of business or otherwise refuses to take legal action.

The trade secrets, software code, inventions under development, and business plans disclosed in a major licensing relationship must be treated as valuable and highly confidential by the parties. Documents should be labeled, employees trained, employee policies adopted, and physical security respected to show that confidentiality is a legitimate concern of the company. If this is done, then the cultural norms will help discourage casual disclosure. Without these steps, the legal documents will provide only marginal protection.

Term & Territory

Another critical aspect of maximizing the value of intellectual property rights comes from negotiating the length of the license. Here, the difference between a sale and a license becomes meaningful. A sale is forever, a license lasts only as long as the contract provides. Since the consumer generally receives a "perpetual" license, the transaction truly is a sale.

In commercial transactions, however, the content licensed may be made available for much shorter terms. Annual licensing provides a continual revenue stream for the licensor that may allow for larger investments by the licensee. Such a license structure can incorporate upgrades automatically, providing the licensor better control over support demands for legacy programs.

The term of the transaction also has significant ramification when dealing with the license usage and modification provisions. A licensee should be wary of a short-term contract if the licensee is investing heavily in software development or integration of patents into its own products and services. In contrast, a long-term contract limits flexibility for the licensor. Often companies extend long-term contracts a discount when in fact the length is a benefit that should cost a premium.

Similarly, the geographic or media territory can also provide multiple marketplaces, even in the emerging global marketplace. If a potential licensee only publishes in English then sell the Spanish, French and Chinese versions to someone else. If a software licensee does not publish for Mac of Linux, then restrict the license to Windows/DOS and seek other licensees for those markets. The Mac marketplace, for example, reflects approximately five percent of the marketplace that is simple to identify and is often under served.

Warranties

In the commercial setting, the representations and warranties between parties has gained increasing importance as the days of "as is" software and service agreements draw to an end. Licensees paying huge sums for software and consulting services are no longer willing to accept a shrug and a finger pointed at the hardware manufacturer. Particularly when the hardware and software are provided by a common source, the attempt to deny responsibility is a poor business practice and increasingly difficult to defend legally.

Warranties regarding the performance of software (or goods) reflect only one of the many warranties in any licensing agreement. In addition to product performance, the licensor must warrant the ability to license the content, its ability to deliver ongoing services, and its employees. This is an area often relegated to the boiler plate discussion that takes place exclusively between the attorneys rather than the parties to the contract, but the scope of these agreements shapes the real legal risk undertaken by the licensor.

One particularly common mistake is to warrant that the licensor is the exclusive owner of the content when some of the material has itself been licensed from third parties, used from public domain, or quoted in reliance of fair use principles. Another mistake is to warrant all claims or documents without first reviewing the schedules or content of those documents. Warranties can often incorporate policies, contracts, or even regulatory compliance indirectly. Without direct statements, companies often fail to check first, thereby breaching the contract at the time of signing and giving the other party an automatic opt-out of the agreement.

Particularly in the rapidly changing arena of regulatory compliance, statements that the software, content, or services complies with the regulations are often quite difficult to defend. If the warranties are required to continue to be true throughout the course of the license, then the licensor should be aware that it has contractually agreed to a compliance program even if it cannot anticipate what the future regulations will be. While such guarantees may be appropriate in many contracts, such guarantees should be entered into knowingly, and the contracts priced appropriately.

Five Bonus Licensing Tricks

In addition to the core contractual issues already discussed, there are a few additional practices that differentiate the successful companies from those that have fallen victim to the current economic downturn. These five serve as illustrations on an approach that places problem-solving ahead of ownership in the structuring of licensing agreements.

First, ignore trade association standards. Most business opportunities are created by differentiation in the marketplace. Compliance with trade association standards puts a company squarely in the middle of the legal and business strata. Use trade association agreements or protocols as checklists, but carefully monitor them to see where new opportunities can be developed. (I am not speaking about technical specifications here. While the same rule probably applies - just ask Microsoft about Java - interoperability is a highly prized commodity that should only be sacrificed when the mousetrap is not merely better but fundamentally different.)

Second, purchase only those rights that the company can exploit. Everything comes at a cost. If a company purchases the rights to software code on an exclusive basis, it will generally pay significantly more than if it purchases rights on a non-exclusive basis. This may be a sound business choice if the code could otherwise be used by a direct competitor, but often it is an unnecessary expense.

Third, examine the company's intellectual portfolio to maximize opportunities. Patents, copyrights and trade secrets tend to go stale when not exploited. If a company cannot sell or license its rights, give away short-term usage rights to see if others can generate new life in the material. Entertainment content, like fashion, has a twenty-year life cycle, so Asteroids and Breakout became "classic" products in the late 90's (along with a revival in 70's Big Hair Rock Bands). Over the next few years, the first growth period of the PC will be ripe for a revival. Other materials may similarly have new or revived markets.

Fourth, differentiate markets. Using the example of PowerCAD and Kiddie-CAD discussed earlier, the producer of PowerCAD could have segmented the market by creating a "light" version of its software for public use. Rather than cannibalizing the higher-end market, by controlling both the consumer and commercial market, the company can cross-promote its products, help users lock into the training provided by a common product design, expand revenue, and broaden its revenue base. Companies must anticipate creating multiple products off of intellectual property licenses early in the process to account for the necessary flexibility.

Fifth, structure licenses to manage relationships rather than gather dust in drawers awaiting disputes. Often the true transaction and the paper transaction do not match. Invariably this will lead to difficulties. Sometimes the problem arises because the parties disagree as to the true transaction, while in other cases, the dissonance between the documents and reality will make it difficult for new individuals to step into roles in the transaction. Limit the lawyering so that the provisions adopted by the parties will be followed. The contract should not reflect the wishful thinking of an attorney who does not understand the realities of the transaction or the parties.

The key to these five tricks and the other licensing techniques remains focus on the underlying goals of the transaction rather than the mechanics of the agreement. The license may be no more than the rights transferred by copyright law on the sale of a copy of a software program to a consumer, or it may include every patent, trademark, trade secret and copyright owned by the licensor. Regardless of the scope of the license, the keys to the relationships remain the same. By focusing on generating revenue, maximizing exploitation of the intellectual property, minimizing risk, and building a common understanding between the parties, the licensing agreement will serve both parties. Every deal point and provision in the contract should speak to one of these four keys. Any that do not are probably counter-productive.

By reviewing the transaction to maximize revenue, minimize risk and carefully explore the uses of the licensed works for scope, term and territory, both companies in the transaction will receive more of what they bargained for. Such a license will reflect the best type of agreement - not the document collecting dust in the file, but the working blueprint for a long-term relationship.

 

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