Best Practices in Structuring Royalties in License & Collaboration Agreements

The increased prevalence of royalty-related disputes under license and collaboration agreements in the life sciences industry reflects the complexity and stakes of these arrangements. Companies may confront litigation concerning the interpretation, duration, and scope of royalty provisions (i.e., provisions requiring the licensee to pay the licensor certain percentage(s) of annual net sales of products licensed under the relevant agreement). Negotiators and drafters of royalty provisions should be aware of several key issues as they define parties’ rights and obligations and endeavor to avoid costly and unpredictable disputes.

Defining Key Terms 

As with any commercial contract, clearly defining key terms helps avoid and efficiently resolve litigation. Ambiguity can lead to good-faith disputes about the terms of a contract and makes it difficult for companies to predict litigation outcomes. Ambiguity also increases the cost of disputes. Litigation is materially more expensive if extrinsic evidence—such as testimony from employees who negotiated the agreement or expert evidence of custom and practice—is necessary to interpret the terms of a license agreement, which, under agreements governed by US law, is the case where the relevant terms are not clear.

In particular, parties to a license agreement should carefully define the products on which the licensee must pay royalties and the legal basis—such as patents or know-how—on which royalty payments are to be made, as a significant share of these disputes are likely to implicate at least one of these concepts. For example, one court recently held a license agreement was ambiguous as to whether royalties were owed on products manufactured before the relevant licensed patent expired but sold afterwards.[1] There is also case law interpreting “patent rights,” finding the term ambiguous when the parties’ license agreement did not clearly define the patents that are relevant in certain contexts. In these US cases, ambiguity in the license agreement precluded the parties’ dispute from being resolved on a motion to dismiss or on summary judgment, thereby significantly increasing costs to both parties.

Brulotte & Post-Expiration Royalties

The relationship between the timing of expiration of certain licensed patents and timing of sale of a product covered, or formerly covered, by such patents is something that parties to license agreements should expressly address in US law-governed agreements. Brulotte v. Thys Co., 379 US 29 (1964), holds “that a patentee’s use of a royalty agreement that projects beyond the expiration date of the patent is unlawful per se.” Id. at 32. It is, however, possible to structure a license agreement under which licensors collect royalties after patents covering a product expire, but other rights remained licensed thereunder (e.g., rights to use proprietary or confidential know-how). Kimble v. Marvel Ent., LLC, 576 US 446, 454 (2015) (“post-expiration royalties are allowable so long as tied to a non-patent right—even when closely related to a patent.”). Under such “patent-and-know-how” license agreements, the period during which royalties remain payable may extend beyond loss of patent coverage—very often, for a certain number of years following first commercial sale of the product in a given country and/or until loss of “regulatory exclusivity” conferred by the FDA or a similar ex-US regulatory authority, even where no patent coverage remains. To address the Brulotte doctrine, parties will typically provide for a material royalty reduction if the royalty payment term continues beyond the loss of patent coverage, which is intended to reflect the “lost” value of the license attributable to the loss of market protection that was previously conferred by the licensed patents.

Importantly, royalty provisions in a license agreement are unenforceable under Brulotte only if they call for royalties to be paid for post-expiration use of the patented invention. Post-expiration royalties may be permissible if, for example, they are paid in exchange for a patent-and-know-how license, as described above. Parties may also choose to structure the economics of their contract such that the licensor pays the licensee royalties on products that are discovered or created using patented technology (or on products which are directed to targets identified using such technology), even if the licensed patents do not cover the licensor’s products themselves.[2] This situation can arise, e.g., in so-called “target discovery” deals where the licensor uses its patent-protected platform technology to identify and validate novel targets with potential therapeutic value, with the licensee then conducting its own work to identify products that modulate such targets to produce a desired therapeutic effect. In such a scenario, the licensor’s patents covering its platform technology would not be necessary to develop or sell the licensee’s products, but the licensor would have created value for which it would justifiably seek compensation, including through royalties on the sale of such products. All that being said, whether royalty payments are enforceable under the US’s Brulotte doctrine is ultimately a question of law, and US courts are therefore likely to make this assessment based on the terms of the contract rather than considering the parties’ intentions.

Affiliates & Acquirors; Royalty-Bearing Products

Negotiators and drafters should also consider royalty provisions’ reach and the impact of an acquisition of either party. Royalty disputes are not always limited to licensors and licensees. If, for example, a licensee is acquired, there may be disputes concerning whether the acquiror’s products are royalty-bearing and which entities are bound by the agreement.

Typically, royalties are payable on “net sales,” which is defined in most cases to include sales of the licensee, its affiliates, and their sublicensees (sometimes excluding distributors or wholesalers). An acquisition of the licensee may lead to the acquiror becoming a new “affiliate” of the licensee, thereby potentially capturing products of the acquiror which were developed independently from the licensee’s pre-existing license agreement—and, as such, possibly materially affecting the economics of the license agreement.

To avoid this scenario, licensees would be well-advised to define the licensed products to, e.g., require a nexus to the licensor’s IP so as to avoid unintentionally subjecting independent products (such as those with the same, or a substantially similar, mechanism of action as the licensed products) to these payment obligations. It would also be prudent to consider whether concepts that are often proposed by licensees to ensure they receive sufficiently broad rights to the licensor’s technology—such as language capturing molecules that are substantially similar to the lead licensed product as of signing, or improved versions thereof—may have unintended consequences where the licensee is acquired.[3]

Conclusion

Careful drafting with a focus on key terms, the duration and scope of royalty payments, and the impact of future acquisitions or other corporate changes can help licensors and licensees avoid royalty-related disputes. Potential acquirors should also be aware of these nuances and should consider thorough due diligence on these issues. Freshfields will continue to monitor developments in this space closely.