Creating a Licensing Agreement to Benefit Both Parties

While product licensing is offered by corporate brands ranging from Disney to John Deere, small businesses also have a viable opportunity to license their own products and services to licensees that can then leverage that intellectual property (IP). To get that license, however, you'll need to create and sign a licensing agreement.

What Is Licensing?

The term "license" has two meanings—one in common terms (like a driver's license, for example), and the other in business and commerce. A license in its most general sense is like a permit to enable someone to do something.

In business, licenses are typically given by a company that wants to give rights to its property in return for payment. Usually, these rights are to make, sell, or use something the business owns.

Types of Licenses

Licensing often involves intellectual property (IP), like trademarks, copyrights, or patents. Digital assets like apps and trademarks are also licensed, as are music rights.

Here are some example:

• Sports teams sell trademark licenses to companies that create products with the team's trademark attached. 
• A movie company sells licenses to companies that create products based on trademarked characters in the movie. 
• Copyright licenses involve the right to reproduce and sell the copyrighted asset, including derivative works (works based on the original work). The right to perform the work publicly might be licensed. 
• Patent licenses are used to make, sell, use, distribute, and export patented products. 
• Trademark licenses give businesses the right to use a popular trademark on specific items and in specific ways. 
• Trade secret licenses involve the right to market processes, perhaps adding them to apps.

Franchise Agreement vs. Licensing Agreement

A franchise agreement is a type of licensing agreement that gives someone (the franchisee) the right to market a product or service of someone else (the franchisor) using:

• The trademark or trade name of the franchisor
• The operating methods of the franchisor

In return for these rights, the franchisee must pay the franchisor and the franchisor must give certain rights and support to the franchisee. Compared to a franchise, where the franchisor has significant control over the franchisee's operations, a licensor mainly collects royalties and supervises the use of the license.

How a License Agreement Works

A license agreement is a business contract between two parties. The licensor (the seller of the license) owns the asset being licensed and the licensee (the buyer) pays for the right to use the license. The licensee pays the owner in exchange for the right to sell the product or use the technology. 

A licensing agreement inclludes several sections and factors, with details that must be negotiated by the parties.

Exclusivity and Territory

The licensee is granted the exclusive right to make and sell the product in a specific territory. The licensor agrees not to allow anyone else to sell the product in that territory. This part of the agreement usually has a term limit attached to it. 

Subsidiary Licensing

The licensee may or may not be granted the right to allow someone else to make or sell its products. This depends on the specific terms of the licensing agreement. 

Payments

Many license agreements involve royalty payments for use of a license. How royalties are paid varies with the type of product being licensed. For example, music royalties are calculated on performances, and royalties for a specific product, like a book, are based on the number of units sold. There may be an initial advance against royalties. Consider which method is best for both parties (and don't forget inflation and currency exchange rates). 

Monitoring and Quality Assurance

To protect their product, licensors require specific tests and monitoring of sales. The tests might include an initial sample of the product to make sure the quality is acceptable. In addition, the licensor may claim the right to monitor sales to check that products are not being too heavily discounted and that quality is kept high.

Sub-agreements

Within the license agreement, as with other types of contracts, there may be sub-agreements. For example, the licensor may require a non-disclosure agreement to keep the licensee from disclosing proprietary product features or processes to others. The licensee, in turn, may require the licensor to sign a non-compete agreement, which can keep the licensor from breaking the agreement by allowing someone else to sell the product within the licensee's exclusive territory. 

Tips for Creating a Licensing Agreement

Establish Ownership

For all IP, make sure the ownership of that product is clearly stated. Do a search to make sure that no one else is using the asset (a trademark, for example), and that the ownership is properly registered. You don't want to get into a licensing agreement and then find out that someone else questions ownership.

Pay Attention to Definitions

Make sure the product or process is described completely and clearly, so there's no misunderstanding about what is being licensed.

Explain the Process of Monitoring and Quality Assurance

There should be an initial test sample of the product that must be approved before the products may be created. Periodic checks should be done on product quality. Product sales monitoring should be spelled out. Check to see who determines product price, and if products may be discounted. 

Check on Government Regulations

Depending on the type of product being sold and who it is being sold to, there may be restrictions on the licensee. For example, some products (like weapons) may not be allowed to be sold in certain countries or U.S. states.

Do Your Due Diligence Before Signing

Both parties should thoroughly vet the other party through the process of due diligence. Check business credit and management resumes. Ask for financial statements. Visit the other company's offices and manufacturing facilities. Leave no stone unturned. 

Consider Other "What-Ifs"

As you work with an attorney to write the contract, it's a good idea to consider some circumstances that might be a problem later. For example:

• What if the licensor goes bankrupt?
• What if the licensee goes bankrupt?
• What if either party can't fulfill its obligations?
• Can the licensor transfer its ownership to another party?
• What are the penalties for breaching (violating) the contract? 

Understand Taxes

The royalties paid by the licensee are counted as a business expense. Royalties must be counted as income to the licensor and reported on Form 1099-MISC. Check with your tax professional about the tax effects of royalties. 

A Word of Warning

This article is only a general overview of licensing agreements; it's not intended to be complete and shouldn't be used to prepare a legal document. Using a template you find on the internetis dangerous because it can't address specific laws and your own situation.

Get an attorney who has expertise in licensing agreements. These agreements are complicated and specific to each situation. Many attorneys know how to construct a general contract, but they may not know the details of licensing agreements. An intellectual property attorney might be a good place to start.