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The Hardest Part of a License to Negotiate:
Diligence Obligations Part 1
What are Diligence Obligations?
Diligence obligations are license terms that provide for the minimum commercialisation that the licensee must undertake.
For a mature technology whose products are close to market launch, or are already in the market, diligence obligations will often be minimum product sales that the licensee must achieve. These minimum product sales are a proxy for the minimum royalties that the licensor expects.
For a technology in development at the time of the license, such as technology licensed from a university or research organisation, other types of diligence obligations may be more appropriate – more on that later.
Why are diligence obligations so hard to negotiate?
A breach of the terms of a license may ultimately lead to the termination of the license.
Diligence terms in a license are no different. The failure to achieve or perform diligence obligations ultimately leads to termination. After termination, the licensor is free to grant an exclusive license to an alternative licensee that is better able to commercialise and achieve diligence obligations.
The prospect of termination is why diligence obligations are so hard to negotiate.
A licensee that invests significant monies in developing technology to market readiness, travelling any clinical or other regulatory pathway, setting up manufacturing facilities, and marketing. Termination for the failure to achieve diligence obligations means that this significant investment is lost.
Licensees will not unexpectedly resist diligence obligations being included in the terms of a license.
Diligence obligations are harder to negotiate than the financial terms of a license. A license expects a license to include royalty and other financial terms. But a licensee does not want diligence obligations included in a license at all.
The risk of not having diligence obligations in a license
A license without diligence obligations means that a licensor must accept an underperforming licensee, and even an idle licensee, and can do nothing about the underperformance or idleness. The licensor may be receiving little royalties, or even no royalties, but can do nothing.
A licensee’s underperformance or idleness may occur even with the best intentioned licensee. As time passes, the licensee may have resources to commercialise only its top two ranking projects, and the license ranks third. Prudent commercial decision making on the part of the licensee requires that it not spread its finite resources too thinly, but allocates them to the two top ranking projects.
“Best endeavours” obligations
“Best endeavours” obligations are not a satisfactory alternative to diligence obligations.
The point of having diligence obligations is to be able to terminate the license of an underperforming or idle licensee. All that “best endeavours” and the less onerous “reasonable endeavours” will do is ensure a dispute arises about what they mean in the context of the specific license. A licensee’s typical response to termination purportedly on the ground of breaching these types of obligations is to dispute the validity of the termination, and to carry on exercising the licensed rights. If a licensor wants to press the matter all it can do is to litigate, seeking a court determination whether the termination was valid or not. That can take years. In the meantime the licensor is unable to license anyone else, which is what it had wanted to do by having terminated.
Diligence obligations need to be crisp and precise so that there is no controversy about whether the diligence obligation has been achieved or complied with – more on this later.
Strategies that don’t work when negotiating diligence obligations
A common approach by a licensor seeking diligence obligations is to simply propose what the licensor seeks. What is proposed is often artificially assessed, or even “plucked out of the air” without any commercial assessment of the market, any competitor analysis, or analysis of competitors’ market shares.
The artificiality of the proposal makes it doomed. What ensures is not a negotiation over quantities or amounts or the like, but resistance to having any diligence obligations at all.
Where this approach is taken, there is a high probability of the licensor conceding, and dropping the matter.
There needs to be a strategy that involves more than merely proposing diligence obligations.
Strategies that do work when negotiating Diligence Obligations
There are two ways of removing the artificiality of a proposal for diligence obligations.
The first is that the licensor undertakes a robust assessment of the market, a robust competitor analysis, and a robust market share analysis, including its dynamics over time.
This equips the licensor to make robust proposals which are not so easily resisted or dismissed. But, most licensors do not necessarily have the skills, time, or resources to undertake these tasks.
The second way is to ask the licensee to submit a written Project Plan to the licensor, as part of the licensor’s process of qualifying a licensee. This Project Plan will then form the basis of the licensor’s proposal for diligence obligations.
The timing and mechanics of this are critical to the success of this strategy – more on this later.
The Project Plan which the licensee submits must set out the licensee’s plan for commercialising the technology proposed to be licensed. The licensor will need to provide guidance to the licensee of what it expects the Project Plan to include.
Some examples are:
What further research will be done, by whom, in what timeframe, with what anticipated outcomes?
What development, clinical and regulatory work will be done, by whom, in what timeframe, with what anticipated outcomes?
When will market launch take place in each key market?
If the licensee does not have demonstrated capability to itself take products to a key market, how will it get that capability?
If the licensee will rely upon strategic alliances or sub-licensees to service a key market, are these already in place, or how will they be put in place, and in what timeframe?
Does the licensee have the particular skills or equipment or resources to be able to commercialise? If not, when and how will it obtain these, and in what time frame?
If the technology is fully developed or full development is on the horizon, what sales forecasts does the licensee make?
Does the licensee have the monetary resources to do all the above? If not, where and how will it obtain those resources?
The Project Plan is intentionally not called a business plan, which is a different document.
A Project Plan does not need to be lengthy. Most Project Plans come in at 10 to 15 pages. They rely on a prospective licensee’s existing knowledge, and the licensee’s assessment, and considered reflection on its existing knowledge. It therefore should not be a time consuming task for a prospective licensee to undertake.
There are two factors which when present will ensure that acceptable diligence obligations can be formulated and proposed, and which will assist a licensor to secure diligence obligations in the license.
The absence of either factor will pretty much ensure that diligence obligations are unlikely to be successfully negotiated, and the most likely outcome is the licensor conceding and dropping the matter.
The first is timing. If a Project Plan is requested during the negotiation, the licensee believing that it is already a qualified licensee, will procrastinate preparing a Project Plan, or simple not do one. If it does one, it might be so poor as to not be useful to the licensor wanting to formulate diligence obligations. A Project Plan needs to be requested well before negotiations start, during the phase that the prospective licensee is being qualified, or believes that it is being qualified. This will ensure that the licensee prepares the Project Plan more robustly than otherwise, and will ensure that the Project Plan demonstrates the prospective licensee’s capability to commercialise. This will enable diligence obligations to be formulated by the licensor. A licensor may formulate diligence obligations drawn wholly or partly from the Project Plan. The licensee will find it difficult to resist diligence obligations based on its own representations of its capability and its own timeframes.
The second is procedure. If a prospective licensee believes that the request for a Project Plan is a requirement of the licensor’s staff member, as opposed to being a requirement of the licensor itself, it will be more likely to dismiss the request, or procrastinate, or to prepare a poor plan that is not useful. In contrast, if the licensor has a procedure for qualifying a licensee, and that procedure includes the consideration of a prospective licensee’s Project Plan, for example, by a Commercialisation Committee, the licensee wanting to become qualified and for negotiations to start, will prepare a Project Plan that is more robust than otherwise, and which can therefore be usefully used to formulate and secure diligence obligations.