Points of conflict to watch for are:

On the company side:

They have no previous experience of negotiating a royalty agreement (often the case with smaller companies). If you haven’t either and you both go in inadequately prepared, things can get messy very quickly.

They start to regard the idea as more theirs than yours - perhaps rightly if they’ve done a lot of expensive development work on it.

They start feeding you gloomier sales forecasts as launch date (and the prospect of paying you a royalty) approaches.

The company people with whom you get on well are replaced by accountants who just want to get rid of you as cheaply as possible.

History is rewritten, goal-posts moved. (That’s partly why it’s a smart move to keep copious records of all dealings with companies.)

On your side:

You think total credit for the idea should be yours, and don’t fully appreciate what the company has done to improve it. As a result You may be - or may appear to be - too demanding or inflexible.

A licensing deal usually involves two rounds of negotiation, each leading to the signing of an agreement:

Stage 1: Heads of agreement

Both sides do no more than establish basic common ground: the figures, terms and conditions that they’re broadly happy with. Once signed, the heads of agreement document is handed over to lawyers to be rewritten as a full agreement in dense legalese. It may help to write your own draft heads of agreement before the meeting, but use it only to help you gauge whether you’re gaining or losing ground as talks proceed and get your patent agent or solicitor to advise you on what else might need to be included:

Heads of agreement discussions usually work best without formalities or lawyers, so it’s perfectly acceptable to conduct your own negotiations as long as you know broadly what kind of a deal you want. If you don’t - or if your product has clear international potential - get a patent agent, solicitor or licensing agent to negotiate for you. If the company offers unacceptable terms and won’t budge from them, either walk away altogether or get an experienced professional to take your place.

Most heads of agreement are ‘subject to formal contract’, which means either side can still pull out, so NEVER let the company go ahead with the project before a full agreement has been signed. That’s like handing a buyer the keys to your house before you’ve got their money.

Agreements are made up as follows

Intention

A basic expression of what the agreement is about, covering: what is being licensed
A descriptive title of your invention/product and list of all the intellectual property on offer.
What the licensee intends
To request a licence to use the defined intellectual property to manufacture and sell the product (s) in a particular territory.

The licence

Level of exclusivity
Basic variants are: Exclusive: only the licensee can manufacture.
Sole: only the licensee and licensor can manufacture.
Non-exclusive: allows several licences.
Semi-exclusive: by territory, industry, application or time.
Assignment: the licensee takes over the intellectual property completely.

Territory, The country or countries to be covered by the licence. The market
which may be defined/limited by type of industry or application. (You may be able to grant several licences for different markets, increasing total market penetration and royalty levels.)

Payment

Basic royalty rate(s), and some guarantee of payment to stop the licensee just sitting on the idea indefinitely.

Advance lump-sum payment

Extremely unlikely, though you’re in a stronger position if you have not revealed know-how or other vital documentation to be handed over on signing.

Confidentiality

Always include a standard confidentiality clause, whether or not you already have a separate confidentiality agreement, as it forces the licensee to safeguard anything you disclose.

Duration

Usually the lifetime of the last patent but sometimes (and better for you) a short term - typically one to five years - with renewal options.

Other issues (Potential minefields, so beware!)

Who owns improvements?

If the licensee improves the product over time, who owns the improvements?
What if your intellectual property is successfully challenged?

Who challenges infringers, and who pays?

If you can, leave this to the licensee and accept a lower royalty for shedding the risk.

Infringement of third-party intellectual property rights

NEVER give any warranties that your invention does not infringe anyone else’s IP rights!

Manipulation of value of sales

You must limit the licensee’s scope for declaring an artificially low value of sales by, for example, selling at a derisory price to associate companies. Specify arm’s length transactions; this enables a court to arbitrate.

Standard clauses

Usually numerous, to clarify detail - such as when and how royalty payments will be made - and to cover important but less central issues such as termination and permission to sub-licence.
Make sure every point you can think of is covered and, to test for holes, ask ‘what if?’ questions for everything. If a point is ambiguous or unsatisfactory, renegotiate until it’s clear and acceptable.

Stage 2: Full agreement

The next stage is to convert heads of agreement into a full legal agreement - a complex and often very long document that must be drafted by legal specialists. You MUST use your own patent agent and/or solicitor to make sure that the final document is consistent with the heads of agreement and doesn’t contain hidden traps. Don’t look on this stage as an opportunity to alter the basic deal. Unless your legal adviser finds something badly wrong, resist any offer or temptation to renegotiate. For better or worse, the deal is done. Any late intervention is more likely to wreck it than improve it.

Working out royalties

Your financial expectations MUST be realistic, so before any talks find out what is an acceptable ball-park percentage for a product like yours, then attach a floor and ceiling to your negotiating position. The floor is the percentage below which you do not drop unless desperate. The ceiling is the maximum you feel you can justifiably ask for without making the company think you’re greedy or naive.

If your and the company’s floors and ceilings turn out to be several storeys apart, check your figures and assumptions and, if possible, theirs too. If you still think you’re right and you can’t convince them, it may not be worth even attempting to reach an agreement with that company.

How do you arrive at figures you can sensibly discuss?
The scale of your reward in percentage terms depends largely on three variables:

1. Your contribution to the product since approaching the company
(Anything earlier won’t normally count as ‘contribution’.)

2. How special is the product?
Usually, the more competition the product faces, the lower the profit margin and royalty percentage.

3. Estimated sales volume
The more sold, the lower the royalty percentage. This sounds perverse but reflects commercial reality and is still good news for you. For a product estimated to sell in boatloads you might be offered a fraction of one per cent, but it could still make you a multi-millionaire. Try to locate your product on these three scales, then average them out. It’s bound to be a hazy calculation, but it may help you to judge whether the company’s offer is an insult or merely on the low side of realistic.

Calculating royalty rates

Most royalties are expressed as a percentage of the product’s net sales price. But though that’s an easy calculation to make and verify, it won’t help you establish the value of the product for negotiating purposes and is thus no guide to the royalty percentage you should get.

A solution is to calculate your opening royalty bid on your estimate of the product’s likely gross profit per unit (selling price minus manufacturing cost) and probable market size, as both are relatively easy to estimate and a much better indicator of value.

Basically, the bigger the potential gross profit per unit, the higher should be your royalty percentage. For example: if your product can be made for a penny and sold for a pound, there is far more profit and thus more scope for a high royalty than if it costs 50 pence to make but still can’t sell for more than a pound.
Next estimate the size of the probable annual market for your product. A product that can potentially 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.

Once you have a clear notion of your product’s overall value, don’t bid for too high a share of gross profit as the company’s eventual net profit will be much lower. Your best shot is likely to be 10-25 per cent of gross profit per unit. For a company making a 20 per cent gross profit, 10-25 per cent of that gives an eventual maximum royalty (it may in practice be much lower) of 2-5 per cent of net sales price. Very few companies make net profits of over 10 per cent, so to get a significant share of that is a considerable achievement.

A worthwhile refinement is to accept or even suggest a sliding scale of royalties based on the total royalty income involved. For example: 7 per cent up to £20,000-worth of royalties, reducing to 5 per cent between £20-50,000 and to 3 per cent when your total royalty income exceeds £50,000. This (a) shows that you acknowledge the company’s falling profit per unit as sales rise and (b) demonstrates your willingness to be flexible in everyone’s best interests.

Advance payments

The hefty advance payment that many inventors think they deserve is in fact extremely rare, and for good reason. No matter how much you may have spent on your invention, it’s likely to be tiny compared to the sum the company must raise and gamble on the success of your product.

A more realistic way of getting pre-sales payment is to negotiate a guaranteed minimum monthly or annual income. Ask for this to be a small proportion - say 25 per cent - of projected annual sales. Once sales exceed the level that sum represents, 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 now, but perhaps deductible from future royalties.

If sales remain as forecast for some years, your royalties will soon recoup even several years of such payments.

Fixed-sum payments in lieu of royalties
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 be the best deal you ever do.

Example

An inventor was offered a choice of £1m outright or 3 per cent royalties with a guaranteed minimum of £60,000 a year. He chose the latter, estimating a £200,000-plus annual royalty, but at the time of writing - five years later - sales show no sign of reaching even the minimum royalty level.

1. Never agree to royalties based solely on profit
Sales figures can easily be manipulated to show no profit at all, and with a little ingenuity almost anything can be deducted from profit as a business cost.

2. Make sure the company sells the product fairly
To rob you, some companies may sell at an artificially low price to one of their own divisions or to an associate company. This can be hard to detect, so insist on arm’s length transactions in your final agreement. Then, if the company does pull a fast one, a court can adjudicate on the basis that it should have sold at a fair price.

Note:

This fact sheet is mainly based on the NESTA Inventors' Handbook, http://www.nesta.org.uk/ which is copyright to © 1999 Peter Bissell and Graham Barker (ex staff member). We highly recommend this site and their book, "The Business of Invention" (ISBN 0951 3856 31) to any inventor, as it is the best we can find relating to turning inventions into a business in the UK. This copyrighted material should not be used for commercial gain without the prior permission of the copyright owners being sought.