As published in Les Nouvelles, Vol. XXXVI, No. 4, December 2001

(Journal of the Licensing Executives Society)

Frank W. Sudia, JD

October 11, 2001

This paper outlines a "structured licensing" model to facilitate negotiation of multi-party patent agreements. Principles of legal engineering developed on Wall Street over the last several decades, in fields such as asset securitization, derivatives, and structured finance, are applied to aggregate and commercialize split IP positions, using special purpose legal entities (SPEs) created to carry out a single transaction. The role of an independent director serving as a neutral decision maker is also discussed.

Problems of this type take many forms.  The following is not highly fact specific, and you could be playing any of the roles.

One of your scientists creates a technology innovation that could have a dramatic market impact. However, it’s an improvement that reads on a more generic method invented and patented elsewhere. And both inventions are merely core concepts that will require considerable additional effort and money to commercialize.

It doesn’t matter whether you hold the generic patent or the improvement, because both you and the other IP holder are blocked from practicing the "good" embodiment that end customers will really want to buy. (This problem can also arise out of the failure of a prior development effort, after which the core and improvement positions were separated.)

To get an attractive return for this IP, a commercialization licensee must be found that will commit resources to create the optimally marketable product and make it a standard. An exclusive agreement would best enable the licensee to reap a solid return on its investment, with milestones imposed so that if they do not commercialize in a reasonable time period the IP holders can find another licensee and restart the effort.

Your first problem is to get the other IP holder to talk with you at all.  Most IP deals fail. Why should your potential collaborator incur management time and expense to negotiate, since you cannot assure them your deal will not fail downstream? Perhaps your licensee will patent all over (and around) their IP position, impairing its value, and then not bring the technology to market successfully, yielding a less-than-zero return.

Projects can fail for any reason or no reason. A corporate licensee may change its strategy, key personnel may depart, and a startup can run out of money.  The most promising deals may even have an above-average failure rate, as parties may become "jazzed" about their compensation opportunity, leading to poor performance.

Worse yet, the other IP holder, allegedly seeking to mitigate these risks, may demand an active role in your out-license negotiations, seeking to know and control every detail of the transaction before committing to it. Then, as you work to assemble a deal, their share of the economic pie goes up and up, and they demand unreasonable risk allocations that scare off potential licensees.

How can you get them to accept your leadership, while providing solid assurance they will be protected from poor performance downstream?

To assure freedom to operate, you would like to generate a "covering position" of improvement patents as soon as possible. These could include further embodiments, related processes, applications, test methods, control systems, user interfaces, packaging, and so on. Few firms would undertake such a task knowing of the senior patents -- except competitors, who might file patents over your IP to prevent you from introducing it, or to force you to sell out to them, etc.

Can you initiate an enrichment process before finalizing the out-license? This can broaden your field of licensees to include those with weak engineering ability, and reduce the improvements likely to be made by the out-licensee.

No matter how carefully you select your out-licensee and negotiate their license, there’s a real chance the product will not be introduced, often without regard to the merits of your technology. Similarly, parent corporations may forget that spinouts are just out-licensees and neglect to impose commercialization requirements on them, losing valuable technologies if a spinout performs poorly.

One way to mitigate potential damage to the IP position is to require a grant back of licensee improvements, coupled with termination for default on the milestones. However there is room for unfairness by the licensors, who may impose arbitrary termination provisions, allowing them to "harvest" the licensee’s technology without compensation, chilling its incentive to pursue further innovation in the field.

If the out-license fails, the licensors want to find a new licensee and restart the project quickly, without litigation. Yet from a pro-competition standpoint it would be preferable to compensate the licensee for improvements filed by the failed project, treating it like a de facto (albeit, inefficient) enrichment project. Even if your grant back is non-exclusive, their improvements will be of little value after your senior license terminates. To restart more rapidly, you may also wish to acquire other materials from the defaulting licensee, such as design documents, prototypes, software copyrights, or work in process.

How can you speedily acquire and fairly compensate the licensee’s improvements from a failed commercialization attempt?

While IP contributors may seek to shift risks to others by demanding uncompensated grant backs, financiers often seek to shift risks by demanding a liquidation preference. If accompanied by a right to veto terms for additional financing or other necessary actions, this can also confer an effective right to "harvest" a company’s technology and IP rights. Yet there is little justification for giving IP to venture capitalists, or other company creditors, as their track record of realizing value for IP assets is minimal.

Without impairing their prerogative to shut down the project, could you offer them something with more practical value than residual IP rights?

During its long lifetime a commercialization agreement may experience major changes in its underlying facts and assumptions. Supplier and customer markets can change, competing technologies may arise, commercialization may hit unforeseen snags, and any party can invent something unanticipated.

Language can be drafted to address problematic areas such as access to background technology, adjustment of milestones, grant backs, and sublicensing, but interpreting these provisions in light of changing circumstances may pose difficulties that could lead to litigation.

It is important to prevent such issues from causing a failure, because it upsets the terms under which the parties agreed to contribute their IP, incurring risks and foregoing other options. If one party can exploit changed circumstances to demand a renegotiation in their favor, then you have broken your commitment to protect the other parties.

Can you provide a fast, effective dispute resolution method to keep the project on track?

When every patent holder and financial sponsor can veto or potentially terminate the project, it feels like a classic "Mexican standoff." Everyone in the room has a gun, pointed at everyone else, and no one can move. Put another way, the parties have many rights and powers, but in their raw form these are useless for getting the job done.

In large financial deals, it is common to transfer all property rights to a special purpose entity, typically a limited liability company (LLC) or business trust (originally known as a "Massachusetts Trust") formed to carry out the transaction. The terms of the equity interests can then be drafted to create any desired set of economic and governance rights. The parties’ raw rights are "rolled-up" into the structure, in return for new and more useful synthetic rights.

Special purpose entities (SPEs) are commonplace in the securitization of mortgages, credit card receivables, and auto loans; in derivatives and credit risk management; and in non-recourse "project finance" when, for example, you are building a power plant and it is not meaningful for the creditors to repossess it. They are even used to securitize copyright or patent royalties.

In a typical securitization, income-yielding assets are transferred to an SPE, which issues bonds backed by anticipated revenues and uses the bond sale proceeds to purchase the assets from the transferor.  The SPE has its own credit rating and is insulated from the bankruptcy of any party.  Much can be learned from prior uses of SPEs, but they must be redesigned to meet our unique property management requirements.

For the deal manager (DM) an SPE can provide many benefits. If you wish to protect the downstream parties from the upstream parties, and vice-versa, it is critical to achieve a two-stage close, illustrated in Figure 1. The following assumes that technical, market, and valuation issues are adequately understood.

The general process flow is as follows:

1. The DM identifies the scope (technical and market) of the proposed pool, the desired IP and contributors, a basic commercialization plan, a proposed economic allocation among contributors, and conditions precedent (minimum IP required) for the first close.

2. To provide continuity and assistance in managing the deal on behalf of all parties, a corporate trustee and servicing agent may be retained.

3. Armed with the above, the DM approaches the IP holders, promising them minimum terms and stable deal management. The allocation and commercialization plans may be adjusted as needed to secure their consents.

4. Once enough IP holders consent to one version of the terms (to fulfill the conditions precedent) a first close occurs. The operating agreement of an LLC or business trust can be a single document. IP rights are transferred to the SPE and the contributors become equity holders. If a contributor cannot accept equity (or prefers not to) they can receive deferred income plus certain decision approval rights.

5. Appointments of officers to manage the SPE are ratified. The DM will typically be appointed chief executive. The bank trustee, servicing agent, and law firms will be retained. An independent director (such as a seasoned patent litigator) may be appointed to provide binding resolution of disputes under the agreement.

6. An enrichment contractor can be hired to perform engineering services, to generate a more complete "product package" of IP rights, and, if desired, can be granted an equity interest in the pool as partial compensation for its contributions.

7. Armed with aggregated and enriched IP rights, the DM has a free hand to identify and negotiate with potential out-licensees, without interference from the IP holders, provided that the resulting out-license meets the requirements agreed among the contributors.

8. The out-license must be ratified by the beneficiaries, who may object if they feel it does not meet the requirements.  All beneficiary objections are reviewed by the independent director.  As his or her first act, the independent director will review and approve the proposed license, thus setting the project on its way.

9. Payments from the licensee are passed back through to the IP contributors, net of administrative expenses. The out-licensee may feel more comfortable assigning new patent applications to the SPE, since it is truly separate and independent from the contributors.

If the project is successful, all IP rights can be conveyed to the licensee and the SPE dissolved. If it fails and must be restarted, the terms and allocations between the original parties need not be renegotiated, because only the second deal is failing, not the first one. The SPE operating agreement will provide that the DM may or must find another licensee and continue.  The overall process is illustrated in Figure 2.

In lieu of a liquidation preference, the financiers of the failed project can be offered (a) a first right to present a new commercialization plan that meets the original requirements, or (b) an arbitrated percentage of the pool based on the incremental value of IP rights granted back by the venture, although such rights should not dilute the original contributors prior to the project’s failing.

If the parties, and the independent director, concur that exclusive commercialization has become unlikely, due to market or technology changes, the pool can be downgraded to general non-exclusive licensing, or dissolved with the IP being returned to contributors.

The DM is a manager of the entity, and if a specified percentage of the IP contributors have lost confidence, perhaps because the first out-license failed, he or she can be removed and a new DM can qualify and be ratified by a vote of the contributor beneficiaries.

The bank trustee, servicing agent, independent director, and any law firms are service providers, and can be replaced by qualified substitutes. If the independent director resigns or is disqualified, his or her replacement must also be free of conflicts of interest.

When constructing an SPE these and many other contingencies must be addressed.

Patent pools are routinely reviewed by the US Department of Justice and/or the Federal Trade Commission for potential anti-competitive effects. Patent antitrust issues must be handled with care, but our arrangements do not appear to pose insurmountable problems.

Pooling to clear blocking positions is a permissible business objective. Bringing new products to market promotes competition with existing ones, benefiting consumers.

New technologies rarely have market power, and normally are struggling to obtain financing.

Joint price-setting violations are avoided by centralizing negotiating power in the SPE, and the DM, an objective of many pooling arrangements.

Regulators prefer non-exclusive licenses, both in and out, but there is little chance that many products will be commercialized unless the licensee can protect its investment. In many cases only certain patents need be exclusive, and other rights can be non-exclusive.

Other red flags, such as exclusive cross-licensing, can be avoided by diligence to steer clear of them. The servicing agent can help the parties spot and avoid such issues.

The presence of responsible disinterested third parties with duties to promote antitrust compliance may also provide comfort to regulators.

We have provided an overview of a "structured license" for technology transfer based on legal engineering principles. Similar legal structures may be useful in other situations where shared ownership of IP rights with independent governance are desirable, such as spinouts, joint-ventures, settlements and competitor cross-licensing, and financing of patent applications.

Frank W. Sudia, JD is a licensing consultant in San Francisco. Previously he was a vice-president at Bankers Trust Company (1991-98), where he co-managed early stage investments. In 1995-96 he authored the award-winning Identrus digital signature business model, which was adopted by over 65 large global banks.