If you’re aiming for a licensing agreement with a company, this is the last lap. You’ve got a company interested and you want to negotiate a deal that nets you the best royalty rate possible. But even though things are looking good, there’s still a lot of scope for making mistakes that can leave you with no deal, or a much poorer one than you deserve. This Project runs you through the whole process of doing business with a half-interested, then a very interested, company. With luck, you may emerge from it with a licensing agreement good enough to make your marathon of pain and frustration seem highly worthwhile.

What companies look for in a new product idea
Understanding how companies have to look at new ideas is an important part of the battle to win them over. Their ideal is an idea that will give them a mountainous profit for no risk. They know they’re unlikely to get it, but that’s the direction they’ll be coming from. Not in a month of Sundays will they look at your idea and say: ‘Hey, this is so good we must do it, no matter what it costs us!’ Before taking any risk involving a hefty commitment of funds or time, a company must be satisfied that everything about your idea stacks up.

Key factors they’ll look at include -

If this list seems to duplicate tasks covered in other Projects, don’t think that because the company will do them, there’s no need for you to do them. First, you’ll look like a complete time-waster if you appear to have done nothing to make a case for your own idea. Second, if they find evidence that in their view demolishes your idea, you’d better have enough evidence of your own to argue that they’re wrong.

You also need to bear these points in mind when you strike up an initial relationship with a company interested in at least assessing your idea -

See also Project 4, as much of it will be relevant here too.

If you have a prototype, expect an interested company to want to keep it for a period of detailed assessment. This is where you can come unstuck, especially if you only have one prototype. You don’t want it locked inside one company for months on end, especially if you’ve filed a patent application.

It’s difficult to meet both your own and a company’s needs with a single prototype, but the following guidelines may help you to stay in control of what is after all your property.

Above all else, never be sweet-talked out of the two things that matter: a written agreement and proper payment where appropriate. Feedback from inventors suggests that many companies drag out the evaluation process far too long, so you need to ensure that (a) your initial relationship with them is strictly business and (b) you’re not going to come out of it worse off than when you went in.

Where does your royalty come from?

A few basic facts of life first -

How big a royalty should you ask for?
Most royalties experts agree that the maximum royalty you’re likely to get is about 25 per cent of the gross profit the company expects to make from your product. So your first task is to work out what that gross profit is likely to be.

Gross profit is the company’s ‘factory gate’ price per unit minus the cost of production and selling, and will depend on the number of units sold per year. The maths is simple as long as you have two pieces of information -

If the company is unwilling to estimate what these are, shoot out the lights and leave now, as meaningful negotiation will be next to impossible.

If you don’t already know the manufacturing cost of your product, there are two ways you can get reasonably close to it -

When you have a figure for gross profit, convert 25 per cent of it into cash and assume that’s the maximum you’ll get per year. If it looks stunning, be certain you’ll have to settle for less, so work out what you’d get at progressively lower percentages. This may help you to decide where to dig your heels in during negotiations.

Many inventors overvalue their products (or more accurately, don’t attempt to value them at all) and ask for an unrealistically high royalty. This can get negotiations off to a bad start from which they may not fully recover. A reality check like this can help you to bid more credibly, and thus more successfully. It may even make you realise you’ve undervalued your product. Simply adjust your royalty expectation up or down as you answer these questions. It’s all very approximate but it may help you to gauge whether the percentage the company offers is derisory or merely at the low end of realistic.

Even if you think you come out badly from the reality check, don’t make the mistake of assuming that for a product with good market potential, low royalty percentage = low income = insult. The size of your percentage ultimately doesn’t matter that much. What matters is the size of your bank balance. While you’d be an idiot not to push for the highest percentage the company will accept, don’t lose sight of the fact that a tiny share of huge sales could make you a lot richer than a large share of meagre sales.

A good indicator of value is an estimate of the product’s gross profit per unit and probable market size. You’ve already got a figure for gross profit per unit, so all you need to know is the size of the probable annual market for your product. The company’s sales forecast should tell you this but it may be overly conservative, partly out of sensible caution and partly to stop you getting ideas above your station. If you have reason to doubt the company’s forecast, do your own research into market size.

The bigger the potential gross profit per unit, the higher the value of the product. For example: Mousetrap X can be made for a penny and sold for a pound, while Mousetrap Y costs 50 pence to make but can’t sell for more than a pound. By this measure, Mousetrap X is far more profitable and thus more valuable and thus more deserving of a better-than- average share of gross profit as a royalty.

But that’s only half the picture. We need to take market size into account as well. For example, a product that promises to sell in huge numbers for several years has a higher value than a product with the same gross profit per unit but only a limited life in a small market. If our Mousetrap X has years of high- volume sales ahead of it, it’s a clear overall winner in the value stakes. But if the market for mousetraps is shrinking fast as fewer homes have problems with mice, its value will be diminished despite the healthy gross profit. And if Mousetrap X is a flimsy, throwaway product while Mousetrap Y is robust and reusable, Mousetrap Y might in the long term be a better seller.

Overall value therefore depends on averaging out several value-related factors. Depending on circumstances, exactly the same mousetrap could easily have anything from a very high to a very low value for royalty purposes. For example:

If you want to combine your reality check, gross profit per unit and market size values it might help to draw up a scale from 1 (very low value) to 10 (very high value). Give your product a score out of 10 for each factor -

Then average your scores to give an overall score out of 10. This final figure should give you some idea of the sort of royalty percentage - high, low or average - that you can realistically ask for.

Most royalties probably fall into the 2-7 per cent range of net sales price. The lower end is for products which sell in large quantities (typically hundreds of thousands), while the upper end is for products which sell at more modest levels (typically tens of thousands). A royalty of 4-7 per cent of net sales price for an ‘average’ product is good going, while some specialised products such as industrial software or medical equipment should exceed 10 per cent without too much trouble. Don’t however be outraged if offered a fraction of one per cent for a product likely to sell in endless millions. Do the sums and rejoice.

Don’t expect your royalty percentage to be forever. A typical product life cycle consists of three phases: modest but rising early sales, good peak-period sales, then falling sales as competitors catch up or the technology becomes obsolete. Whenever sales and profit change significantly, expect the company to want to renegotiate your royalty. This is quite reasonable, so a worthwhile negotiating tactic is to accept or even suggest a sliding scale of royalties based on the total royalty income involved. For example: seven per cent up to £20,000 per year of total royalty income, reducing to five per cent between £20-50,000 and to three per cent when your total royalty income exceeds £50,000 per year. This shows that you acknowledge the company’s falling profit margin as sales rise, and demonstrates your professionalism and willingness to be flexible in everyone’s best interests.

Don’t however let yourself be too easily persuaded to accept a lower royalty. In some situations gross profit may actually rise as sales decline. Production equipment may be fully paid for and thus cost next to nothing to run, and components may become cheaper by the same process or as market demand for them drops. To avoid becoming an easy touch, keep yourself fully up to date about the state of the company, its suppliers and purchasers, and that market or industry generally.

This is where you and the company sit down and thrash out the basics of an agreement, trying to find as much common ground as possible. The aim is to -

Heads of agreement are generally ‘subject to contract’, a term with much the same meaning as the ‘Sold subject to contract’ sign on a house: it’s sold only as long as neither side pulls out. Therefore, even if heads of agreement talks go well, you must never let the company exploit or ‘work’ your IP in any way until a full agreement is signed. The danger is again much the same as handing a buyer the keys to your house before you’ve got their money.

With some exceptions - see Professional help - heads of agreement talks usually work best without formalities or legal representation on either side. It’s therefore perfectly acceptable to conduct your own negotiations as long as something positive is emerging. (It’s up to you whether to negotiate alone or with one or more members of your team. There’s safety in numbers, but too many cooks can spoil the broth. Take your pick.)

If the company adopts a ‘take it or leave it’ stance that allows no room for movement, it may be bullying arrogance or it may be their genuine view, based on experience, that this is as good as it can get for both of you. You can’t be expected to know which it is, so you should immediately seek the professional advice of a patent attorney or solicitor, not least on whether an agreement is worth reaching at all.

For your part, be prepared. You must enter negotiations knowing broadly what kind of a deal you want, and be capable of disclosing it and justifying it as talks unfold. The time- dishonoured, reactive practice of simply saying ‘not enough’ to every offer the company makes is unlikely to get you anything better than ‘Goodbye’.

The following list gives you some idea of the component clauses that need to be talked through, then written up as a heads of agreement document. Its range is typical but by no means complete. Ask a patent attorney or solicitor to advise you on additional aspects specific to your idea which may need to be brought into the talks.

Expect all these clauses to be present in some form or other in your agreement, and make sure that anything else you can think of is covered too. Don’t expect the company to bat for anyone except itself, so try to work out the exact effect each and every clause will have on you. Do this by constantly asking ‘what if?’ questions, both at the negotiating table and elsewhere. Ignore any pressure to hurry up or accept clauses on the nod, and don’t be afraid to call a halt for hours, days or even weeks if you need time to think or consult someone. If any answer is unsatisfactory or you don’t understand it, insist on renegotiation until that point is clear and acceptable. Bear in mind though that ‘acceptable’ won’t always mean ‘in your favour’. Don’t forget what we said earlier about the purpose of negotiation being not to win but to reach agreement.

It may help to have your own heads of agreement drafted out in full before the meeting. Don’t disclose it, as you stand to lose too much face if the company rejects it clause by clause, as they will certainly try to do. Its better use is as a checklist to help you gauge how on- or off-track you are if the going starts to get confusing.

Let’s grapple for a moment with the issue of advance payments. Many inventors think they have a God-given right to a large up-front sweetener, but back on planet Earth the situation is more complex. Virtually no company will readily agree to an advance payment so a lot depends on how big an issue you want to make of it. If you push it too hard it could be a deal breaker, but in some circumstances the risk may be worth taking.

From the company’s point of view it’s one thing to discuss a fair sharing of future profits, quite another to hand out a hefty pre-sales sum when the inevitable accountant’s question: ‘What exactly is this money buying?’ may be very difficult to answer. A small company may genuinely be unable to afford it, especially if they’re already going to be stretched to finance your product. Therefore, one argument is that in the interests of conflict-free negotiations you should forget about a lump sum and focus on maximising your royalty percentage. That way, whatever money you eventually get comes technically from the product, not the company. The risk is that the product doesn’t sell, but that’s the company’s risk too.

A counter argument is that the company needs to show genuine commitment to selling the product rather than just acquiring a licence, and a fair way to do that is to pay you a golden hello. There may be force in this argument if -

One way of getting payment in advance of sales is to negotiate for a guaranteed minimum monthly income. Once sales rise above the level represented by that sum, you get royalties as well. This would normally take effect from the date production begins, but if that’s likely to be a long way off it’s reasonable to ask for a guaranteed income starting immediately but perhaps deductible from future royalties.

Ask for your guaranteed income to be a small proportion - 25-30 per cent - of your agreed royalty on projected annual sales. Let’s say you’ve agreed a royalty of 2 per cent on projected annual sales of 500,000 units at £4 net sales price. That means your royalty income should be £40,000. Twenty-five per cent of that - £10,000 or about £830 a month - is the sort of pre-production income you can justifiably ask for. If sales remain as forecast for some years, your royalties will soon recoup even several years of advance income.

To some extent you’re challenging the company to put its money where its mouth is and that may make them uneasy. If they respond by suddenly producing ‘revised’ sales projections 75 per cent lower than before - which is in effect what they’re doing if they say your request is unjustifiable - then maybe they shouldn’t be in business.

If you want to press for an advance payment from a company that can easily afford it, good luck to you. But unless you’re either a skilled negotiator or in an extremely strong bargaining position, it won’t be easy and you could end up doing yourself more harm than good.

Finally, a company may offer a fixed sum instead of royalties if they think that in the long term the idea will make them a fortune. Smell a faint rat if such an offer comes your way, as it could be a ploy to buy you out for peanuts. On the other hand it could backfire on the company. An inventor known to us was offered the choice of £1 million for a total buy-out, or a guaranteed minimum royalty of £60,000 a year. He chose the latter, estimating a £200,000-plus annual royalty over many years. In the event, sales never reached even the minimum royalty level and after only a couple of years the product was withdrawn.

If and when you’re happy with the heads of agreement, the next and final stage is to convert them into a full legal agreement.

This will inevitably be a complex and near- incomprehensible document, often scores of pages long, which neither you nor the company’s negotiators will be competent to draft. This is a job for legal specialists, though they’ll consult you on points of detail. The company will use its own advisers, so you must use your own patent attorney and/or solicitor to make sure that the final document is consistent with the heads of agreement and doesn’t conceal some elephant trap dug by the company since drawing up the heads.

For your part, don’t look on the full agreement as an opportunity to undo the deal. Best policy is simply to say to your solicitor: ‘Here’s the outline agreement. I’m happy with its terms and figures, so please draft a full agreement based on it’. Unless your solicitor or patent attorney finds evidence that something is badly wrong or unworkable, or spots a way of improving the deal for everyone, resist any temptation to try to alter what’s been agreed. Maybe you were steam- rollered here and there, but the deed must now be considered done and any attempt to wind the clock back is more likely to wreck the deal than improve it. In any case, most professionals charge by the hour, so any intervention that takes time to sort out may cost you a lot of money for not much gain and lose you valuable goodwill.

The following checklist is partly an action planner and partly a reminder of what matters. If you’re tempted to think ‘I don’t need to do all this stuff’, it may help to point out that we’ve modeled the checklist on questions professionals are very likely to ask if you want their advice, support or money. We therefore have to be stern and say that if you aim to be a respected and successful inventor, you can’t afford to duck any of it.