Royalty Stacking Provisions

A “royalty stacking” provision refers to a commonly used term in license agreements where the a licensee of patented technology who intends to manufacture products under the license also expects that it will be necessary to obtain additional licenses from other parties who own rights in related, or actual or potentially overlapping, technologies.  A royalty stacking provision allows the licensee to control and hopefully reduce the cumulative cost of all the licenses—the “main” license and the additional third party licenses—by offsetting royalties paid under the third party licenses against the amount of royalties that would otherwise be due under the main license.  For example, the licensee may commit to paying a 10% royalty to the main licensee; however, if it turns out that the licensee must pay a 2% royalty to another party for a license deemed necessary for the licensee to manufacture and sell the products that generate royalties for the main licensee the royalty stacking provision might call for a reduction of the main licensee royalty rate by the amount payable for the other license (i.e., 10% – 2% = 8%).  This offset procedure is necessary in order for the licensee to be able to justify the overall costs associated with manufacturing the products and avoid the situation where the amount of the total accumulated royalty payments reduces the licensee’s margins to the point where it simply doesn’t make sense to engage in the manufacture of the products.

The terms of any royalty stacking provision should reflect the mutual commercial agreement of the licensor and the licensee as to the proper allocation of costs associated with third party licenses and it is the task of the draftsman to be sure that the agreement is clearly reflected in the agreement and that there is no ambiguity as to how the understanding of the parties will be administered.  From the perspective of a licensee that has undertaken a full commitment to manufacturing the licensed products the appropriate thing for the licensor to do is to make a fair and reasonable contribution to the costs associated with necessary licenses from third parties since the licensor will ultimately benefit substantially from the licensee’s decision to undertake the risks and other expenses of the manufacturing process.  The licensor, of course, would probably prefer to eliminate a royalty stacking provision completely.  However, this may not be practical in many instances and in those situations the parties should look for creative ways to reasonably limit and control the applicability of the royalty stacking clause.  Among the approaches that are commonly proposed are the following:

  • Placing a cap on the amount of royalties that are subject to the royalty stacking provision, thereby limiting the erosion in the main licensee’s royalty rate.  Using the above example to illustrate, the parties may agree that the aggregate royalty rate for “other licenses” cannot exceed 3%, which means that the main licensor’s royalty percentage cannot fall below 7%. 
  • Delaying the application of the provision until the overall royalty burden on the licensee reaches an agreed minimum threshold and then requiring that royalties be reduced pro rata for all of the licensors not just the main licensor.  In the example above if 10% is the minimum threshold and the other licensor demands 2% the royalty stacking provision with the main licensor should limit the reduction in the main licensor’s royalty rate to its pro rata share of all required royalties (i.e., 10%/12% time 10%, or 8.33%).
  • Including a floor on the reduction in the main licensee’s royalty rate which means that regardless of how many other royalty obligations the licensee might have the royalty rate for the main licensee after taking into account the royalty stacking provision will not drop below a specified minimum percentage.  In general, parties licensing “main” technologies rarely permit their base royalty rates to be reduced by more than 50% (i.e., 5% in the example from above).
  • Limiting the types of third party licenses that would be covered by the royalty stacking provision and/or requiring the licensee to consult with the main licensor before agreeing to any royalty arrangements that might fall under the scope of the provision.  For example, royalties payable under cross licenses might be excluded—or carefully scrutinized at the very least—on the grounds that their primary benefit to the licensee is settlement of a business dispute as opposed to facilitating production of the licensed product.

Before finalizing a royalty stacking provision the parties should have an honest and complete discussion about the economics confronting the licensee with respect to aggressively marketing the licensed products.  It is important for the main licensor to understand the licensee’s cost structure and for both parties to evaluate what “other licenses” are absolutely needed for commercialization of the licensed product and which would simply be “nice to have” and possibly foregone if the costs become excessive.  For example, the main licensor may argue that a royalty stacking provision should only apply when it becomes necessary to pay royalties to third parties for rights that would otherwise be infringed by the manufacturing activities of the licensee.  In any event, the decision about whether a royalty stacking provision is necessary, and the scope of such a provision if it is included, is strongly dependent on the licensee’s projected margins for the licensed product—lower margins mean more pressure to include such a provision while higher margins make it more difficult for the licensee to argue for such a provision.

In some cases the parties may decide that it is just too premature at the time the license agreement is originally signed to craft a royalty stacking provision that will make sense once all the other licensing requirements have been identified.  In that case the agreement may simply stipulate that the parties will return to negotiations on the issue at a later date once they have a better idea of the earnings potential of the licensed product and the arrangements with third parties that may be necessary.  In any event, when and if a royalty stacking provision is included in the agreement the parties should make sure that it is clearly written and should go through specific examples to be sure that the words in the contract will lead to the economic solution that the parties reasonably anticipate.

The content in this post has been adapted from material that will appear in Technology Management and Transactions (Fall 2008) and is presented with permission of Thomson/West.  Copyright 2008 Thomson/West.  For more information or to order call 1-800-762-5272.

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