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Licensing Intellectual Property Rights

A new startup may find an established company which may be willing to provide equity capital in exchange for obtaining a license of rights to manufacture or market the product or to purchase the output on a preferential basis. Although financing by licensing the product rights may avoid equity dilution to the founders, the startup may be trading away profitability. Thus, what is saved in equity dilution may be lost in profitability and control of marketing and manufacturing of the startup's technology or products. In this type of arrangement, the issue may arise for tax purposes whether in actuality the investment is an equity investment by the financial partner, a partnership between the two companies or simply a license arrangement. Assuming that the financier obtains no equity ownership rights other than the right to manufacture or market the product or to purchase the output, it is unlikely that the payment would constitute a form of equity investment, or an intent to form a partnership. Consequently, the tax treatment to the recipient company would be ordinary licensing income. If the payment is to support research and development, and if the proper contract is drawn, this type of arrangement may entitle the financier to deductions as well as research and development credits.

Fundamentally a license agreement is a contract, just like any other agreement between private parties. A nonexclusive license is much like a simple covenant not to sue, which generally conveys no property interest in the underlying intellectual property. The same principles of contract formation that apply to contracts in general also apply to licenses. Among other things, there must be an offer, acceptance, consideration, and mutual assent. The universal principle hat one who assents to an agreement will be held to its terms – whether or not she read them – applies to licenses just as to other contracts. Licenses are generally interpreted in much the same way as are other contracts. They are normally interpreted narrowly. That is, licenses are normally construed to reserve all rights in intellectual property not explicitly conveyed. More generally, licenses are construed according to the same objective standards of reasonableness that apply to contracts of all kinds; if a proffered interpretation of a license would seem objectively unreasonable to ordinary persons in the parties' positions, the courts will reject it. In particular, the courts will reject an interpretation of a license agreement that, under circumstances known to both parties at the time, would have deprived one party of its realistic expectations or of a realistic chance of making money from its activities under the license. When terms in license agreements are clear, courts apply them as written. When terms are ambiguous under the circumstances, courts may interpret the ambiguous terms to the disadvantage of the license's drafter, if, for example, the license is a contract of adhesion.

Although courts may consider industry customs and practices in construing licensing agreements, they are cautious in so doing, lest they allow assertions of customs and practices to undermine intellectual property rights. As with all contracts, courts interpreting licenses seek to determine the parties' intent. That intent, however, must have been expressed in the language of the agreement; courts will not supply terms that the parties did not include. Like any other document, an alleged license "agreement" may be deemed a mere "agreement to agree" and held unenforceable if it does not specify fundamental terms or reveals an intent not to be bound until formal agreements are drafted and executed. Preliminary agreements or "agreements in principle," however, may be treated as enforceable if they appear intended as such, for example, in the context of additional agreements, ongoing discussions with e-mail exchanges or the settlement of litigation. In determining whether a document is an enforceable agreement or an unenforceable agreement to agree, what matters is business substance, not contractual boilerplate. The key question is whether essential terms remain unresolved. Even a signed document disclaiming agreement in the absence of a formal, signed contract is not necessarily conclusive.

Like all contracts, license agreements contain implied covenants of good faith and fair dealing, including a duty to bargain in good faith. There is no breach of an implied covenant to bargain in good faith, however, when bargaining has in fact occurred, there are substantial business reasons for not reaching agreement, or there is no contract at all. Duties to bargain in good faith also may arise out of substantive law other than the law of contracts. The implied covenant of good faith and fair dealing, however, applies only to conduct during performance of the contract, not to conduct during contract formation. Explicit "best efforts" obligations may have greater effect. If, for example, a licensor is obligated to exercise its "best efforts" to acquire rights necessary to expand the scope of a license to include additional technology, its failure to make any effort, even to acquire rights from its own grandchild subsidiary, will constitute a breach of that obligation, justifying equitable imposition of a license covering the additional technology. Courts have the power to order such licensing, applying the maxim that "equity treats as done what should have been done."