Licensees have the Power?

Contracts are set in stone, correct? Right?

The answer depends on whether you are the licensor of a technology or a licensee. Let me explain.....

Licensors do have many ways to terminate a technology agreement: bankruptcy, failure to hit milestones, failure to provide reports, etc. However, the licensor cannot terminate a license agreement without cause. And....when they are terminating for cause, there is always a "cure period" during which the licensee can fix matters. This cure period greatly weakens the ability to terminate a license. Virtually every licensee in the history of technology licensing has been or is out of compliance with their reporting duties: they are not giving written semi-annual reports on the development of the technology like they said they would, their reports on sales of products do not conform to the agreed upon format, etc. However, if the licensor attempts to terminate the license on this basis, the licensee could buckle down and catch up on its reporting during the 30-45 day cure period and keep the license intact. Thus, the only effect of the termination threat is to annoy the licensee.

On the other hand, licensees can terminate a license without cause on 45-90 days notice. There is nothing the licensor can do about this and it puts a great power asymmetry into the relationship.

I've blogged before about my belief in "playing to win" in technology licensing, especially for university technology licensors. Basically this means that the only hope for a great return on a technology license is via royalties on sales and that receiving large upfront and fixed fee payments dramatically reduces the royalty rate than a licensee will agree to. Taking large upfront payments seems (to me) akin to hedging. For a university, technology licensing represents the high-risk/high-return portion of its revenue portfolio and it seems to defeat the purpose of high-risk/high-return to engage in hedging behavior. At the very least, hedging should probably only be done in consultation with the CFO of the organization.

However, there is a problem with playing to win..... Let's use an example. University licenses to NewCo. The university believes in playing to win and take zero cash upfront and a very small equity position in NewCo (equivalent to what NewCo gives to members of its scientific advisory board). In exchange for this concession, the university "wins" a 7% royalty on sales of the pre-clinical therapeutic drug candidate that is licensed to NewCo. If the university had taken a large equity position (say 20% of common stock on an as-converted, fully-diluted basis undiluted through $2MM capital raised) the university would have received a 2% royalty.

Years pass and eventually NewCo is able to attract a big-pharma partner. Horray! Only one problem..... The management of NewCo is primarily compensated with equity in NewCo. Thus, their primary goal in the sublicense with Big Pharma is to get a large upfront payment and large milestone fees. This will avoid future rounds of private fundraising which would be dilutive to their equity positions. So, NewCo negotiates a 8% royalty on sales from Big Pharma and a $20MM upfront payment.

Obviously, it is a problem for NewCo if they are only "getting" an 8% royalty and are immediately having to pay out to the University a 7% royalty. So, they call the university and explain that the 7% royalty that they agreed to several years ago "doesn't work in today's environment" and that they need the University to renegotiate the original license to reduce the royalty payable to the University downward to 3%.

What is the University to do? The entire deal with Big Pharma has been negotiated without the University at the table. Everyone is ready to sign, the University just has to take a haircut. If the University doesn't agree, Big Pharma will walk away (they have other options) and NewCo will fail. In that case, the University will get the technology back with no clear Plan B.

Everyone in University technology commercialization with much experience has been through these sorts of renegotiations. It has almost made me think of the license agreement as binding on the university, but representing no more than a call option for the licensor (except that the call is never in the money in the licensee's opinion). 

This circumstance hasn't made me want to revisit "playing to win", but it does point out that some steps might be in order on the university side of things. Here are some things you could do:

• Make crystal clear to the licensee that by "playing to win" you know you are getting a greater-than-market royalty rate. That is the whole point. Go ahead and have the discussion with your NewCo licensee that if they want to do a sublicense in the future that will require you to take a huge royalty haircut just to make the economics work for NewCo so that they can receive a whopping upfront fee that (a) you won't be too pleased to even have the discussion and (b) if you do, you're going to expect the company to revisit the University owning 20% of the company again. I almost think it could be worthwhile to have a recital of this sentiment in the actual license agreement, "The parties agree and understand that the University is forgoing a customary upfront payment in order to receive a larger royalty rate and this means that if NewCo signs a sublicense, University will almost certainly receive a larger portion of the royalty payable by the sublicensee than would be customary in the industry." Perhaps pre-negotiate what happens if there is a royalty haircut? "For each 1% the royalty payable to the University is reduced, NewCo will issue to the University equity equal to 5% of its common equity."
• Perhaps do not become so chummy with the NewCo? This is hard to do because NewCo's do need a strong relationship with the University TCO in many cases, but once those close bonds are formed, it makes renegotiation more difficult. 
• Negotiate into the license agreement with NewCo that in the event of termination, the University will receive (a) a royalty free, non-exclusive license to all data developed on the technology and (b) actual copies of all of that data and reasonable samples of the appropriate materials (compounds, prototypes, etc.) so that the University can more easily find a Plan B if the University sticks to its guns and refuses to just "take less".

When you boil it all down, there is just no good way around the power asymmetry. It is just something to be aware of. If your licensee will almost certainly have to sublicense the technology, recognize that your well crafted license is still open to negotiation.  

*Articles are reproduced with permission from Dean Stell, the owner of Technologycommercialization.blogspot.com