Licensing is the process of allowing others to use ones property without granting them ownership of it. A license can cover any type of property. In the context of modern startup companies, however, licensing almost always relates to intellectual property. Licensed subject matter may consist of patents, patentable inventions, copyright, copyrighted works, topologies for semiconductor chip products, trademarks, trade secrets, know-how, or simply confidential information. In technology businesses, licensing is often the most important, if not the only, source of revenue. Although executives in high-technology business may refer to sales or selling, these terms are usually misnomers. For example, a business seldom sells software or manufacturing processes except in connection with a general sale of its assets. More often, it licenses the use of software or manufacturing processes to others for royalties. It is therefore preferable, both in speaking and drafting agreements, to refer to the process of generating revenue through license agreements as licensing, or more generally marketing, rather than selling.
Reasons for Licensing
A fully vertical integrated startup is one that itself performs all the functions of research and development, refinement of products for manufacturing, manufacturing, distribution, sales and service. In such a startup, there may be little reason for licensing if the startup is efficiently run and sufficiently large to penetrate the available markets. Licensing of technology used at a particular stage of the business for example, a production process would simply create competition for such a vertically integrated business. If that business were truly efficient and achieved full market penetration, it would be unlikely to realize a greater profit from licensing competitive activity by others than from performing that activity itself. In fact, however, very few businesses, least of all startup companies, are truly vertically integrated. Particularly technology startups may have the resources for only a few of the general stages of business involved in a fully vertically integrated operation.
For example, a startup might be involved in research and development and have insufficient resources and experience for effective marketing and distribution of its products. Biotechnology research firms often license their technology to large pharmaceutical firms for the purpose of running clinical trials and obtaining pre-marketing approval for products from regulatory authorities because of the high cost of those activities and the advantages of experience in surmounting regulatory hurdles. In these situations, the natural solution is for the startup to license its technology to others and to delegate to them the responsibility for completing the business cycle and bringing the start-up company’s products or services to market. Even those few startups that are fully vertically integrated usually are not large or diverse enough to satisfy the demands of all available horizontal markets. A startup, for example, may be able to serve only a small number of the geographical or product markets that are theoretically available using its technology. Licensing the use of that technology to others allows the company to expand the geographic distribution of its technology, the range of product lines that use its technology, or both.
Timing, of course, also plays an important role in licensing. A startup may wish to delegate responsibility for particular functions of its business, or for particular geographic or product markets, only for limited periods of time. For example, a startup might delegate responsibility for manufacturing to a custom parts house to obtain an early entry to the market while developing full productive capacity. More frequently, startups use independent distributors and service organizations to support their sales and field service functions or to expand their markets geographically while they are developing national or regional sales and service forces of their own. In these cases, long range plans are important to ensure that the delegated responsibilities dovetail properly with the company’s developing role and that the governing agreements provide for amicable and timely termination of the delegation. From the licensees point of view, the reasons for licensing are more obvious.
A licensee, particularly a startup company, may require the use of another company’s technology to develop or even to begin its business. For example, a microcomputer manufacturer will need operating systems software to make its computers useful to customers. Unless the manufacturer wishes to develop its own operating system, which is a difficult, time-consuming and expensive process, it must license the use of an operating system from a software house or must arrange for its customers to do so. Growth and development of science and technology are now so rapid that no one company has all the pieces to the puzzle, even in a limited area of science and technology. Accordingly, both large and small companies continually seek to license from others technology that they discover in the marketplace, or during patent searches, to make their own products or services more competitive. This trend toward inward licensing has accelerated in recent years, as firms with an insular not invented here philosophy have fallen behind their competitors, particularly in rapidly developing fields such as computers and biotechnology. Several other current business trends are likely to make licensing more important in the future.
First, advanced research and development in many technologies is conducted in many different countries, with the result that valuable technology may be developed in geographically remote areas. Second, efforts to make business more entrepreneurial and competitive reflect what may be a trend toward increasing fragmentation of firms, in order to create the strong human incentives and flexible work environment often found in small, entrepreneurial organizations. If this trend continues, larger research and development establishments over the long term may be replaced by a number of smaller, independent organizations, which will have to deal with each other and exchange technology through licensing arrangements. Finally, the rapid growth and development of technological research worldwide means that systematic procurement of others technology is a necessary supplement to internal research and development. Many Canadian businesses are now aware of the disadvantages of the not invented here syndrome as compared to the Japanese practice of searching everywhere for new technology that may be of use in domestic business. As a result, more businesses are now involved in the practice long observed by large companies of making international patent searches and worldwide reviews of technical literature routine parts of their researchand-development functions. For all these reasons, licensing both domestically and internationally is likely to become an increasingly important factor in startup businesses, as well as in businesses at more advanced stages of development.
Advantages of Licensing
For many startup companies, licensing in some form is not an alternative, but a necessity. For example, a software developer can make money only by licensing the use or distribution of its software to others. For many startup companies, however, the decision whether to license their technology to others, or what form the licensing should take, will depend on evaluation of the benefits of licensing. Some of these benefits are:
Obtaining Early Entry to Market
A startup company may have only a short lead time over its competition in which to introduce new technology to the marketplace. If it has insufficient capital or personnel resources to enter the market quickly, it may choose to delegate responsibility for certain stages of the business cycle to others with greater resources in order to achieve earlier entry to the marketplace. This benefit of licensing most often occurs in licensing for purposes of marketing and distribution, but manufacturing and earlier stages of the business cycle also may be involved.
Broadening the Marketplace
Even if a startup company has adequate resources to perform as a fully vertically integrated enterprise in a particular geographic or product market, it may wish to broaden its products in other geographic regions or to develop new product lines for other fields of use. For example, a microcomputer software vendor may develop software that could be used on mainframe computers, but may not have the personnel needed to convert the software for use on mainframe computers and to provide appropriate service and support. This vendor might achieve penetration of the secondary market by licensing a mainframe software supplier to use that suppliers own software technology to develop and support the vendors product for the mainframe marketplace. Or a European pharmaceutical company might license a patented new drug to a Canadian firm for purposes of obtaining pre-marketing regulatory approval in Canada and subsequent marketing and distribution.
Increasing Market Penetration through Complementary Products
By licensing the use of its products or technology to others, particularly larger companies, a startup company may increase public recognition of its products and increase its market share. A large manufacturers choice of a startup company’s technology from among several similar alternatives may give that technology a substantial boost in sales and customer acceptance. This happened, for example, when IBM Corporation chose Microsoft Corporations MS-DOS operating system software as the basis for the PC-DOS operating system of IBM’s original personal computer. A secondary effect of this choice was the development by independent, third party vendors of numerous PC-DOS-compatible software programs for the IBM personal computer. The dependence of these independent software developers software programs on the PC-DOS operating system served to lock in users of those programs to that operating system, because each user of those independent developers programs had to have an IBM or compatible computer with an MS-DOS operating system.
By licensing technology to others with greater capital or personnel resources, a licensor can fill gaps in its business and make up for insufficient resources.
Obtaining Additional Revenue
A licensor may wish to license technology to others simply as an additional source of revenue. Unless the licensor limits the licensees use of the licensed technology, however, the price of that additional revenue may be competition in the licensors principal markets.
Benefiting from Technology Exchanges
As a condition of licensing its own technology to others, a startup company might demand the right to use technology developed by the licensee. That is, a startup company might cross-license its own technology in exchange for others technology. In this way, the startup company could hope to minimize the disadvantages of small scale and duplicate some of the advantages of large scale research and development.
Expanding into Auxiliary Product Lines
A startup company, particularly one involved in significant research and development, may discover technology useful in products outside the scope of its business. By licensing other companies, large or small, to exploit this technology, the startup company can create an additional source of revenue.
Enhancing Reputation and Goodwill
Widespread use of a startup company’s technology redounds to the company’s credit in the marketplace, especially if that use is accompanied by the start-up company’s name or trademarks. By licensing its technology in conjunction with its name and trademarks, a small company may receive publicity and increase its goodwill through the efforts of others.
Through its licensing agreement with others, a startup company may achieve some degree of control over the direction of technological development in its field and over the way its own technology is used in the marketplace. Although in the absence of licensing other companies would not have the same technology, they would be free to develop the same or similar technology independently on their own, as long as the technology was not protected by a patent. Through licensing, the startup company trades a technological head start for money and whatever contractual restrictions on use and exploitation of the technology it is able to negotiate in the license agreement.
Disadvantages of Licensing
From the point of view of the licensor, licensing also may have a number of disadvantages. Some of these are:
Loss of Control of Exploitation
The primary disadvantage of licensing as a business philosophy is that it necessarily surrenders some degree of control over exploitation of technology to the licensee. Although the licensor may try to maintain control through covenants in the license agreement, as a business and practical matter the licensee necessarily has a good deal of discretion. For startup companies particularly, licensing requires trust and confidence in the licensees ability and willingness to continue to develop and/or to promote the licensed technology and related products and services without misappropriating the licensed technology.
Dependence on Others for Revenue
A licensor of technology depends on the licensees business for revenue. This dependence is especially acute when the license is exclusive.
Risk of Piracy
Whenever a startup company licenses technology to others, it risks piracy, whether by the licensee, its employees or customers. Piracy may take the form of unauthorized exploitation of the technology or the illicit production or copying (for example, of software or mask works) by employees or customers. A more subtle form of piracy involves unauthorized use of licensed technology in products or services that are similar to, but not recognizably the same as, those for which the license is granted.
Loss of Technological Edge
When a startup company delegates too much responsibility for research and development or product improvement to others, it may lose its technological edge. Unless properly structured, a license may inhibit, rather than enhance, the licensors (as well as the licensees) attempts to strengthen its research and development.
Loss of New Business Opportunities
By virtue of its use and exploitation of licensed technology, a licensee may be able to recognize and seize upon business opportunities in related fields before the licensor has the chance to do so. Technological development is to some extent synergistic, and the opportunity for additional research and development may be lost if the licensor does not maintain a day-to-day contact with exploitation of its own technology.
Loss of Contact with Customers
If a startup company exploits its technology only through licensing to, and marketing and distribution by, others, it may lose contact with its ultimate customers, the end users. Since contact with these customers is a vital source of new ideas for products and services, this loss of contact may reduce the startup company’s ability to compete.
Loss of Public Recognition
If a licensor does not insist on receiving credit for its licensed technology in the licensees advertising and product literature, the licensors contribution to the licensees final product may be hidden. Public recognition for the technology then may inure to the licensees benefit only.
Loss of Incentive or Opportunity for Vertical Integration or Horizontal Expansion
If a startup company depends upon others to perform important functions in the business cycle, or to develop and exploit new geographical or product markets, it may lose the incentive to perform those functions for itself. In addition, unless the startup company has and exercises the right to terminate its delegation of responsibility, its formation of organizations to perform those functions may be hindered by competition with its licensees, both in the product marketplace and in the marketplace for qualified personnel.
Tax Aspects of Licensing
One significant tax aspect of licensing is its potential for generating passive income, as previously discussed. Another is the possibility of its generating net capital gain, rather than ordinary income. The tax treatment of net capital gain has been a perennial political football and is likely to remain so, but the historical tendency has been to treat capital gain more favourably than ordinary income and to tax it at lower rates. Today, for example, net capital gain enjoys a substantial tax rate advantage for individual taxpayers and a small but significant tax rate advantage for corporate taxpayers. As a result, it makes a difference whether the income from licensing is properly characterized as capital gain or ordinary income.
Receipts from sales or exclusive licenses of technology may constitute capital gains in two ways. First, if the sale or license involves patentable technology, may apply. Under this section, a transfer of all substantial rights to a patent, whether by sale or exclusive license, entitles the transferor to capital-gain treatment without regard to the normal holding period if the transferor is the inventor or has acquired an interest in the patentable technology from the inventor prior to the actual reduction of the invention to practice. The inventors employer and certain parties related to the inventor, however, are ineligible for this treatment.
Receipts from sales or exclusive licenses of technology may also constitute capital gains if the technology or the rights conveyed are viewed as capital assets. With the exception of copyrights and other similar property in the hands of the creator of the work or the creators successor, intellectual property or interests in it may constitute a capital asset. However, capital-gain treatment would depend on the normal requirements for capital gains, such as the holding period for long-term capital gains.
While sales and exclusive licenses may be treated as capital-gain transactions, nonexclusive licenses generally are not treated as such. Revenue from nonexclusive licenses generally constitutes ordinary income. In loss situations, however, ordinary income may be advantageous because of the statutory limitations on the use of capital losses to offset ordinary income. Thus, for individual taxpayers expecting losses from technology transfers who are able to use those losses for tax planning, it may be advisable to structure the transaction as a nonexclusive license.
If a licensor receives capital gains treatment, the licensee will have to treat the acquisition of the license as the acquisition of a capital asset, to be amortized rather than expensed for tax purposes. There is some authority, however, for amortization based on the amount and timing of the royalties actually paid, if the royalties are dependent on productivity or use of the licensed subject matter. This type of amortization has the same economic effect, if not the form, as a current business deduction for royalties paid. In any event, nonexclusive licenses produce ordinary income to the licensor and provide the licensee with deductible business expenses to the extent that the license fees otherwise qualify as deductible expenses.