As your business grows, there may come a time that entering into a licensing agreement sounds like a good idea.  You may either have built a product or brand that others are looking to promote or you may want to acquire rights to a product or brand you think you can make a profit with.  Either way, there are a number of things you must first consider before signing any sort of licensing agreement.

Firstly, licensing agreements are different than franchisesThough they share some of the same characteristics (as in, a universal brand, parent companies and sub-licensees), they operate in a different way and are subject to different federal and state regulations.

For example, a licensing agreement will allow a business to use an existing product or brand as they see fit – without interference from the parent company (so long as the business doesn’t violate certain established criteria).  On the other hand, franchises often involve more restrictions (and sometimes, direct control) of the licensee’s business practices by the parent company.

You can tell the difference between a licensing agreement and a franchise agreement by answering three simple questions:

  1. Is the licensee allowed to use the licensor’s brand identification (logo, trademarks, etc.) in its advertising, branding, and packaging?
  2. Is the licensee subject to the significant control of the licensor?
  3. Did the licensee pay more than $500 per year to either enter into a business relationship or continue in an existing one?

If you answered yes to all three of these questions, you’re describing a franchise rather than a simpler licensing agreement.  If you answered no to any one of these, the agreement is likely not covered under FTC franchise law.

Important Licensing Considerations

Whether you’re purchasing a license or offering one for sale, there are a number of blanket considerations that should be at the top of your mind.

Performance Requirements

Like franchise agreements, most licensing agreements come with performance or diligence clauses.  These clauses allow for the agreement to be dissolved or penalties to be levied if the licensee doesn’t live up to certain requirements.  For instance, if a business fails to reach certain sales goals or fails to properly market a product, the parent company may terminate the license.

A good example is the hospitality industry.  To be able to use specific brand names (such as Holiday Inn), hotel owners must ensure properties are well-maintained.  If they fail inspection, the right to use the name may be pulled.

Exclusivity Clauses

Exclusivity can be a wonderful thing, but it can also be dangerous to small businesses.  Exclusivity ensures that the licensee will only be doing business with one licensor (at least within a certain genre or sub-type of work).  This is good for the licensor because the licensee will be putting its full effort into promoting one product and won’t risk promoting competing products.  It can be good for the licensee as well because often, licensors will offer premiums or incentives for exclusivity (such as lump sum payments or performance bonuses).

However, if no incentives are offered, the licensor may – in effect – be penalizing the licensee for doing business with them.  Likewise, if a licensor enters into an exclusive agreement only to discover a better performing affiliate within the same geographical region, they’ve anchored themselves to the weakest link.

Demonstrating how important the management of exclusivity clauses can be is microchip processor Advanced Micro Devices (AMD).  Although the company has produced exclusively Windows OX chips in the past, it recently announced its intention to manufacture microchips for both Android and Chrome laptops as well.  Had the company been locked into an exclusivity clause with Microsoft, it would not be able to pursue this important business avenue.

Affiliates or Sub-Distributors

Many licensing agreements will allow the licensee to hire affiliates or sub-distributors.  This increases the product’s reach and total sales, but unrestricted access may lead to profit shifting and hurt the licensor.

Because licensors want (and should) keep some control over their products and services, most agreements will place requirements on affiliation or sub-distributing.  These can be as simple as requiring approval before the sub-distributor can begin work or as strict as making affiliates sign an additional agreement with the licensor.

Termination Clauses

Termination clauses are worked into just about every licensing agreement.  Generally, licensors want to be able to cut ties with a licensee at the drop of a hat, while – at the same time – being able to require licensees to jump through hoops if they want to dissolve the relationship.  This protects the parent company and the brand identity, while minimizing the overall liability.

Unfortunately, that means that licensees must be diligent about fulfilling the requirements of their licensing agreements.  Otherwise, they’ll be faced with early termination of their agreements which could, in effect, be disastrous for their companies.

To see how this could play out, consider the case of software licensing agreements.  If your company enters into a licensing agreement to either use or sell another business’s product, what happens if the software winds up not meeting your needs in the end?  Will you be faced with extensive fees to terminate your agreement or does your contract give you a graceful way to end the relationship?

In fact, even seemingly clear-cut termination clauses may not work as desired.  Take the case of TransCare – a medical transportation service that entered into a licensing agreement with software company Digitech to replace its dispatch program.  Though Digitech’s sales proposal included a mention of a “90-day satisfaction guarantee,” this exact phrasing was not found in the group’s licensing agreement.  When TransCare attempted to exercise this termination clause in response to buggy, malfunctioning software, Digitech denied the claim – the Court of Appeals in the U.S. Seventh Circuit upheld Digitech’s line of reasoning.

Product Liability

Generally, licensing agreements come with some sort of statement about product liability, as it’s in the best interest of both parties to have this spelled out as clearly as possible.  What these clauses boil down to is the question of which entity will be legally responsible, should the use, consumption, storage or transportation of the product cause harm.  As an example, licensees should be wary of toy companies that manufacture unregulated products in foreign countries if they’ll be held responsible for any harm that comes to children.

In most cases, licensors are willing to accept liability, provided that the licensee doesn’t change the end product or service beyond specifications.  However, most will not accept liability if the product is manufactured or purchased by a licensee who then simply applies the licensor’s logo, etc.

This clause will vary greatly depending on the type of product being sold and the exact manufacturing chain, but it’s an important thing to consider.  One wrong step or bad publicity event could stunt or even kill a small business before it gets it feet under itself.

A good bit of business advice concerning licensing agreements can be summed up as CYOA – “cover your own… behind.”  Whether your company is the licensee or the licensor, you should be looking out for your own interests and negotiating licensing agreements that are favorable to you.  There will, of course, be some give and take and, generally, licensees have less power when it comes to making requests.

However, seeing as how these agreements are designed to be mutually beneficial, both parties should be willing to compromise.  The trick is knowing when to give in and when to stick to your guns. For any legal questions regarding commercial agreements, you can easily connect with one or more contract lawyers to discuss your situation for free on UpCounsel today.

About the author

Matt Faustman

Matt Faustman

Matt is the co-founder and CEO at UpCounsel. Matt believes in the power of online platforms to change antiquated ways of life and founded UpCounsel to make legal services efficiently accessible. He is responsible for our overall vision and growth of the UpCounsel platform. Before founding UpCounsel, Matt practiced as a startup and business attorney.

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