top of page
IP Bits.jpg

Newsletter

IP Bits is an irregular newsletter that we send to subscribers. We aim to have 4 to 6 issues per year. Subscription is free. See all issues of IP Bits.

​

Royalty Stacking and How it Works

​

When does Royalty Stacking occur?

 

Royalty stacking occurs when a licensee anticipates the need to license in a second technology without which the licensee cannot commercialise the licensed technology.

 

Some examples:

 

  1. broadly: a licensor and licensee anticipate that the commercialisation of the licensed technology will infringe a third party’s blocking patent

  2. pharmaceutical: a licensor is licensing a drug which relies on a unique delivery system (such as an antigen as a vaccine delivery system, or a pre-filled injection pen) without which the drug cannot be administered as intended, or at all; the licensee needs to additionally license in the antigen or in the latter example, the injection pen

  3. software: a licensor develops a new AI computer program protected by copyright as well as a pending patent covering its unique algorithms; the computer program uses neural network training optimisations patented by a third party; in commercialising the AI program, the licensee will infringe the third party’s training optimisation patents; the licensee needs to additionally license in the training optimisation patents

  4. manufacturing / medical device: a licensor has invented a new asthma inhaler, which is subject to a patent application; the new inhaler uses a unique valve system which is patented by a third party; the commercialisation of the new inhaler will infringe the patented valve system; the licensee will need to license in the licensor’s new asthma inhaler technology, and additionally the third party’s valve system patent.

 

These are all freedom to operate (FTO) obstacles, and they occur in all areas of science.

 

In each case, in addition to the licensed technology the licensee needs to license in a third party’s technology, without which the licensed technology cannot be commercialised.

 

 

How do these FTO obstacles impact upon a licensor’s royalties?

 

The likelihood of a FTO obstacle arising can range from being a possibility, to a probability, to a certainty.

 

If a licensor assesses the possibility to be low or non-existent, it will resist any negotiation that seeks to lower royalties.

 

If a licensee assesses the likelihood to be probable, or certain, it will want to lower the royalty rate, perhaps significantly.

 

What shade of possibility will influence the parties’ negotiation? What shade of probability?

 

What if it turns out that a FTO license is secured at a lower royalty rate than was anticipated? Now the licensor has reduced the royalty on the licensed technology by too much and is disadvantaged.

 

What if the FTO license is secured at a higher royalty rate than was anticipated? Now the combined royalties to the licensor and the third party may be so high that the licensee is deterred from commercialising the licensor’s technology at all. It now remains idle and uncommercialised. Again, the licensor is disadvantaged.

 

A licensee might argue that the royalty payable to the licensor should be reduced by the royalty the licensee must pay under the FTO license. But this might hardly be fair to the licensor. The licensee has no incentive to negotiate the best deal with the third party, knowing that the licensor will be burdened by the whole of the royalty obligations under the FTO license. The licensee will be indifferent to those financial terms because the licensor is paying all of it. Again, the licensor will be disadvantaged.

 

As well, some, or even most FTO obstacles do not properly reflect a diminution in value of the licensor’s technology. The two technologies may complement each other.

 

Is there a model which addresses all these concerns and takes all possibilities into account, without disadvantaging the licensor?

 

 

How royalty stacking works

 

A royalty stacking mechanism does that.

 

The model works whether the likelihood of having to obtain a FTO license from a third party is low, or high, and every likelihood in between.

 

It also works to incentivise the licensee to negotiate the best financial terms in the FTO license from the third party.

 

The three features of royalty stacking are:

 

  1. Both the licensor and the licensee will share the financial burden the FTO license. This could be 50:50 sharing between the licensor and licensee, or 25:75 sharing or it could be some other agreed ratio.

  2. If the royalty stacking results in the licensor’s royalty reducing below the “floor royalty rate”, then the licensor’s royalty becomes that floor royalty rate and does not reduce further.

  3. Not just one FTO license is envisaged – a royalty stacking model usually anticipates that there may be a need for more than one FTO license.

 

​

Worked example

 

In the example below the following assumptions are made:

 

  1. the licensor and licensee will share the financial burden of the FTO license 50:50

  2. the floor royalty rate is 3%

 

 

 

​

​

​

​

​

​

​

​​

Royalty Stacking.jpg

​A licensor grants a license to a licensee (L1) with a royalty rate of 5%.

​

The licensee seeks out a license from a third party to solve a FTO obstacle. The licensor and licensee will share the burden of the royalty to the third party 50:50 so the licensee is incentivised to negotiate the best obtainable terms, with the lowest possible royalty.

 

The negotiation with the third party results in a license (L2) with a 4% royalty rate. The licensor and licensee will share that burden 50:50, that is 2% each.

 

The result is:

 

  1. the licensor’s royalty rates reduces by (50% of 4% = ) 2%, and becomes (5% less 2% =) 3% 

  2. the licensee must pat the royalty of 3% under L1 and the royalty of 4% under L2 (total 7%).

 

Another FTO obstacle arises and the licensee must negotiate another FTO license (L3).

 

Let’s say that L2 reflects the same assumptions of a 50:50 sharing, and a floor royalty rate of 3%.

 

In the L3 negotiation a royalty of 2% is agreed.

 

The result is:

 

  1. the licensor under L1 having reached its floor royalty rate of 3%, will not be burdened by the royalties payable under L3, and continues to receive 3%

  2. the 2% royalty under L3 will be shared by the licensee, and the licensor under L2 in a 50:50 ratio

  3. the royalty under the L2 license to is reduced by (50% of 2% = ) 1% and becomes (4%-1% =) 3%

  4. the licensee must pay the whole royalty under L3 of 2%, and together with the L1 and L2 royalties, pays a total royalty of 8%.

 

In this way, royalties in each consecutive license are “stacked” and operate to reduce the royalty rates in each earlier license, but not below the agreed floor royalty rate.

 

The licensee’s total royalty obligations under all licenses increases. Each licensor’s royalties, by each subsequent FTO license is partially reduced.

 

 

Some last words

 

Ensure that the definition of Net Sales (or other corresponding definition upon which royalties are calculated) are drafted in identical terms. If this is not done, there might be a sharing other than in accordance with the agreed ratio.

 

This worked model only takes into account royalties. If there are up front payments and milestone payments as well, the model may need to take this into account too.

bottom of page