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The Hardest Part of a License to Negotiate:
Diligence Obligations Part 2
Part 1 concerned strategies to consider employing to successfully negotiate this hard issue, as well as some strategies that do not work and should be avoided. It also looked at what diligence obligations were and why they are important. It also dealt with the implications to a licensor of overlooking or not securing diligence obligations if its licensee turned out to underperform or be idle.
This Part 2 now considers how diligence obligations may be framed.
Types of diligence obligations
There are many types of diligence obligations, and there are a myriad of ways in which they can be provided for.
No one way is necessarily better or superior to another. They can all be useful. Having regard to the technology, and its state of development at the time of negotiating the license, some ways may be more advantageous than others, or may be easier to negotiate than others.
The two main types of diligence obligations are:
obligations that a licensee travel along the development pathway to market, and
obligations that a licensee achieve a stipulated level of success in the market, which is aimed at ensuring that the licensor receives a minimum level of remuneration.
The most common way of framing diligence obligations is stipulating:
milestones or events that a licensee must achieve, and
minimum product sales.
Technology in development
If at the time of negotiating the license the technology is still in development, a licensor needs to ensure that the licensee travels the development pathway expeditiously, or at least at an acceptable pace.
Further research may be needed, and the licensor wants to ensure that the licensee undertakes that research. Product development may need to be undertaken to transform technology into a product, and the licensor wants to ensure that the licensee undertakes that product development. A regulatory or clinical pathway may need to be travelled, and the licensor wants the licensee to travel it. A regulatory approval may be needed and the licensor wants to ensure that the licensee obtains it.
Technology in development - mature
Where a technology is at a relatively mature stage of development so that a product launch can be anticipated on the horizon, say between 1 and 3 years, milestones with dates by which they are to be achieved are often employed.
For an engineering technology for example, milestones might be:
the completion of specified research
the completion of specified product development
producing a prototype
conducting a trial
completing a pilot plant
obtaining a regulatory approval
the first sale of a product in [key market #1]
the first sale of a product in [key market #2].
These are just examples. There are numerous other milestones which might be formulated having regard to the specific technology and its stage of development. Milestones need to be written much more precisely than these examples are.
The more mature the technology, and the closer the time is to product launch, the fewer the milestones to be specified.
Generally, the number of milestones to be achieved should be a modest number – perhaps 4 to 6. The greater the number the more difficult the negotiation. Sometimes, a milestone may be omitted, in the confidence that it will be achieved if another milestone that is included is achieved. Some milestones may be merged with another milestone. For example, in the list above, producing a working prototype could be a component of the completion of product development, instead of being a stand-alone milestone.
For technology that is fully developed, or where the completion of development is so close, there might be only one milestone, and that is the date of the first arm’s length sale of a product, which is effectively a product launch.
Technology in development – early stage
For technology that is licensed at a very early stage, with market launch being much further away, say 3 years or more, milestones from the time of the license right up to product launch will be very unlikely to be agreed to by a licensee. The timeframe is too long and unpredictable, and the licensee’s investment too great, for a licensee to be able to agree to milestones extending out so far.
But this does not mean that milestones cannot be negotiated. Milestones relating to events on the short term to medium horizon should still be able to be negotiated.
Technology in development – pharmaceutical
For a pharmaceutical technology licensed at any early stage, milestones on the short term to medium horizon may be:
completing animal studies
completing toxicology studies
filing an IND (or equivalent) with the FDA (or equivalent)
enrolling the first subject in a Phase I clinical trial.
When licensing an early stage pharmaceutical technology it will be optimistic for milestones to go any further than what can be expected to be achieved in the 2 to 3 years following the grant of the license.
It is true that the licensor is not protected from an underperforming or idle licensee for the period after the last milestone. But that is the nature of early stage licensing. Confidence has to be placed in the licensee by this time having made such an investment, that it is motivated to continue along the clinical pathway.
A licensee of a pharmaceutical technology such as a biotech company that wants to further develop it, and then sub-license it to a pharmaceutical company will be concerned that milestones being stipulated in the license will deter a pharmaceutical company from having interest in a sub-license. This is not an unreasonable concern. Milestones in such a license to a biotech company may therefore be confined to milestones that are anticipated to be achieved during the period of the biotech company’s further development, with an overriding provision that the obligation to achieve milestones ceases upon the grant of a sub-license to a pharmaceutical company. The result is that there cannot be any impact on a pharmaceutical company’s willingness to take a sub-license.
All the examples so far illustrate milestones that relate to the technology. But milestones do not need to be confined to these. Milestones may for example be commercial events.
If a licensee lacks capability in a key market, a milestone may be granting a sub-license to a strategic alliance partner in that market.
If a licensee needs to have on its staff a person with particular skills and expertise, a milestone may be employing a person with those skills, for example, to be the CEO.
If a licensee is a start-up company without the capital to progress the technology, a milestone may be procuring and receiving a minimum capital investment.
Minimum license payments
For the period commencing after product launch, a different type of diligence obligation is necessary – one that is aimed at ensuring that a licensor receives a minimum remuneration.
A common mechanism is to provide for minimum royalties. This works by stipulating the minimum royalties payable. If actual royalties based on actual product sales fall short of the minimum, the licensee must pay the shortfall in addition to the actual royalties.
A disadvantage of this mechanism is that a licensee may be very successful in one region of the licensed territory, but underperform or be ide in other regions. Having achieved sales for actual royalties that exceed minimum royalties, there is nothing that a licensor can do about the underperformance or idleness in the neglected regions.
An alternative approach to minimum royalties is to define separate regions in the licensed territory, such as a country or group of countries, and to specify minimum sales quantities that must be achieved in each region. This is a proxy for the minimum license remuneration that the licensor will receive in each region, ensuring that there is no underperformance or idleness in any region.
These minimum sales levels can be approached in many ways, including:
specifying the applicable fixed quantity for each region of the territory, for each applicable period, such as each year of the license term,
a ramped-up model, with increasing quantities for each region, for each period, until an agreed level
a sales holiday being included, where no minimum sales must be achieved in say the first 6 or 12 months, followed by fixed or ramped up minimum quantities.
For a new technology where sales levels cannot be predicted at all, a milestone approach can be used, where the milestone is spending a minimum stipulated amount on the implementation of a marketing plan.
Some approaches and links to example agreements
The most commonly employed approach to diligence obligations is to provide that a licensee must use “commercially reasonable efforts” to for example, commercialise. In some negotiations, that is all that can be achieved. But as mentioned in Part 1, an underperforming or idle licensee will dispute any complaint that it has not used commercially reasonable efforts, and this may take years to resolve. This does not allow a licensor to confidently terminate the license and seek another licensee that is able to perform, which is what the purpose of diligence obligations is.
However common this unsatisfactory mechanism is, there are also many examples of more precise and reliable diligence obligations being negotiated.
There are at least 3 possible approaches, all of which will work more satisfactorily:
The first is employing the vague “commercially reasonable efforts” mechanism but then defining it by reference to specific milestones or activity that must be achieved. Example:
Whitehead Institute for Biomedical Research (licensor) and Rubius Therapeutics (licensee). (2016) License of pharmaceutical, clause 3.2.
The second is not employing the unreliable phrase at all, but instead framing precise milestones with precisely framed timeframes for their achievement. Examples
Memorial Sloan-Kettering Cancer Center (licensor) and Y-mAbs Therapeutics (licensee). (2015). License of antibody. Clause 4 requires clinical milestones to be achieved, from the end of Phase 1 until regulatory approval, with stipulated dates for achievement.
Evogene (licensor) and Monsanto (licensee) (2015). License of genetically modified crops. Clause 5.10 requires Monsanto to undertake certain trials and tests within stipulated timeframes.
The third is a combination of both 1 and 2. Examples:
FB Health S.p.A (licensor) and Alzheon, INC (licensee). (2013). License of pharmaceutical. Clause 3.1.2(a) refers to the general “commercially reasonable efforts”. Clause 3.1.2(b) and (c) require the commencement of a clinical study by a stipulated date.
Whitehead Institute for Biomedical Research (licensor) and Rubius Therapeutics (licensee) License of Pharmaceutical. Clause 3.1(iii) requires the filing of an IND within a stipulated time.