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Getting a Royalty in Countries where you do not have Patents

Why licensors should not get a royalty when they don’t have patents

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An almost standard provision in a license is that a licensee is only obliged to pay royalties on the sale of licensed products in countries where there is a granted patent. As a result, no royalty is paid for the sales of a product in a country where there are no granted patents. 

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There are persuasive reasons why a licensor should not be paid a royalty on sales in countries where there are no patents:

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1. There being no granted patent in a particular country, and the licensor therefore having no intellectual property protection in that country, there is no use being made in that country of the licensor’s intellectual property, so why should the licensor be remunerated with a royalty?

2. There being no granted patent in a particular country, a competitor can manufacture and sell the product in that country, without infringing the licensor’s intellectual property, and without the overhead of a royalty. The licensee would be disadvantaged if the licensee had to compete in that country with such a competitor that had no royalty obligation.

However, the commerciality of these reasons needs to tested on each occasion that a license is negotiated. On some occasions, the circumstances of the transaction will validate these persuasive reasons. For example, an impecunious licensor, at the time of national phase may have pursued patent protection only in its own country, and the United States, as it is the world’s largest market. With patent protection in only two countries, there is no barrier to entry to competitors entering the market anywhere else in the world, and the rest of the world is a sizeable market. If competitors do enter the market in the rest of the world, without the overhead of a royalty, they can compete more effectively against a licensee that is burdened by a royalty obligation.

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Why licensors should get a royalty when they don’t have patents in a country

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But now consider the opposite extreme. Let’s say that patents are pursued in all significant markets, say in 20 to 25 countries which between them cover 90% of the global market. Let’s say as well that no patent was sought in a small country, such as Finland. But sales will be made in Finland. Should the licensor receive a royalty for product sales in Finland even though there is no patent protection in Finland? 

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With patent coverage that extends to 90% of the global market, there is likely to be an effective barrier to entry, precluding potential competitors achieving the economies of scale that they would normally need. The result, in this example, is that there will not be competitors in Finland. 

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But the licensee will be making profits on product sales in Finland. In this case, why shouldn’t the licensee share some of those profits with the licensor?

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There are commercial reasons why the licensee should share its profits with the licensor for sales in a country like Finland where sales of products take place, but there is no patent granted.

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1. The licensee is equipped to make sales in Finland only because it has the license to the 20 to 25 countries where patents have been granted that cover 9% of the global market. If it did not have that license, it would not be making sales in Finland nor other countries where no patents were pursued. The value proposition to the licensee of the license therefore includes sales in countries where no patents have been sought.

2. The licensee is making use of the licensor’s intellectual property, by making the products that are to be sold in the countries where no patents were sought.

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Contract basis, not patent law basis

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It might be argued that there is no patent law basis to justify a licensor receiving royalties on products sold in countries that have no patent protection. That may be so, but there is a contractual basis to justify those royalties. If the parties, as a matter of contract law come to a commercial agreement that the payment of the royalty extends to sales in countries where there is no patent, that contractual obligation is enforceable.

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The harder issue

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These two examples:

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1. patents in two countries only, therefore no royalty on sales made in countries where there is no patent, and

2. patents in countries that cover 90% of the global market place, so royalties are paid in all countries, including those where no patents were granted

are the easy examples.

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More complex will be an occasion where the patent coverage is 60%, 70%, or 80% of the global market. Now there is less certainty that the patent coverage is an effective barrier to entry that will deter competitors entering the market place in countries without patent protection.

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This might be assessed to be so likely that there is no real purpose in the license even anticipating the possibility that there won’t be competitors and trying to make provision for royalties in countries where there is no patent. But then again, the extent of patent coverage of the global marketplace might make that assessment an uncertain one. There may be some regions in the world where the extent of patent coverage will be an effective barrier to entry against competitors in that region. But other regions in the world may be such that the extent of patent coverage makes it inviting for competitors to enter the marketplace in countries with no patents in that region. In that case the license will need to anticipate both possibilities.

The characteristics of a product also impact on the question. For any number of reasons, a copycat product may be an inferior product and even in a country without patent protection, the competing product may only manage to obtain a modest share of the market so that the licensee still dominates the market in that country. In this case, a licensor not unfairly may argue that it should still receive its royalty.

A mechanism that is sometimes used is for the license to provide for two cumulative royalty rates:

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1. one rate that applies to the use of granted patents, such as X%, and

2. another additional rate that applies to the use of know how, such as Y%.'

The result is that:

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1. in countries where there is a patent, the licensee pays X% + Y%, and

2. in countries where there is no patent, the licensee pays Y% only.

The effects of this model need to be considered. If a competitor does enter the market place, the licensee might still have to pay the Y% for the use of know how. And if the know how enters the public domain, the Y% royalty may cease, even if there are no competitors that have entered the market place.

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A preferred model 

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A preferred model is:

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1. for sales in countries where there is a patent, the licensee will pay the full agreed royalty

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2. for sales in countries where there is no patent, the licensee will pay:

(a) the full royalty if:  

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(i) there is no competing product; or

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(ii) there is a competing product but its market share is less than an agreed percentage (say 10%)

(b) a reduced royalty (say decreased by 50%) if there is a competing product and its market share is greater than an agreed percentage (say 10%), but less than another agreed percentage (say 30%)

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(c) no royalty if there is a competing product and its market share is greater than an agreed percentage (say 30%).

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In these scenarios, the royalty should not be extinguished. Instead it should be suspended. In this way, if the competitor goes out of business in a country where there is no patent, the full royalty is automatically reinstated and becomes payable again.

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This basic model can be varied in many ways. The financial terms of a license are always highly negotiable, and this is one of those highly negotiable terms.
 

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