Know how royalties: are they ever justified?

When patents and know-how are licensed together, a question that often comes up is whether there should be a know-how royalty.

In other words, should the licensee be required to pay royalties on products that are not covered by a licensed patent in the country of manufacture or sale, but whose manufacture or development benefitted from the licensed know-how.

Licensees argue that, unless the know-how provides a clear competitive advantage for the licensee’s product over other products, it should not attract a royalty. This argument is particularly acute where the product can be easily reverse-engineered by a competitor; for example, the chemical composition of many pharmaceutical drugs can be established by a competent chemist once the product is on the market. An additional argument, sometimes, is that the upfront payment is, in effect, a payment for access to the licensed know-how, and that a royalty on the use of know-how is inappropriate.

Licensors point out the head start that the know-how provides to the licensee. Often, patents have only been obtained in key markets (countries), and it is appropriate (says the licensor) for a royalty to be paid throughout the licensed territory, given the protection of the patents in the key markets. They may also argue that a know-how royalty is a standard practice. If pushed, they may be prepared to concede that, if the licensed product receives significant competition in the (unpatented) country of sale, the royalty rate may be reduced or suspended.

Ultimately, these issues are for commercial negotiation. In our experience, it is notable how often these points come up only in a late stage of negotiations, when the commercial deal is being recorded in a detailed licence agreement. The parties’ term sheet states that the licensed products will attract an X% royalty. But what does this statement mean? Does it refer to any licensed product, or is it only products that are covered by a granted, valid patent? And X% of what, particularly in the case of sublicensing – X% of net sales or X% of net receipts?

Licence negotiations involve many detailed issues of this kind, which are difficult to reduce to a “high level” summary document such as a term sheet. Commercial negotiators who know their way around these points and don’t leave negotiating them to the last minute can significantly reduce the costs of legal advice on the transaction.

We have recently been involved in licence negotiations where the compromise that was reached was, in summary:

– royalty of X% on products covered by licensed patents

– royalty of X/2% on products that are only protected by licensed know-how, where “the manufacture of the Licensed Product used all or part of Licensed Know-how”, and for as long as the licensed know-how remains confidential (remember the requirement under Article 1(1)(i) of the EU Technology Transfer Regulation for know-how to be “secret, substantial and identified”)

– a renegotiation of the X/2% royalty, where the licensed product is subject to “significant competition” (as defined) in the country of sale.

This compromise is fairly conventional, but is not the only solution that we have seen.

Some people would like to see the development of a standard patent and know-how licence agreement that parties could use by default, that has wide industry acceptance and where issues of this kind are addressed in a conventional way. We have some sympathy for this view (and the Gowers Review recommended that such a document be developed), but we are doubtful whether it would ever work in practice. We may come back to this theme in a later posting.