What are the Pros and Cons of Technology Licensing for Startups?
Many Tech Startups in Switzerland start as spin-offs from Universities such as EPFL, ETH, University of Lausanne, etc. and have one common denominator: their high level of technology innovation, often protected by patents.
After the product development comes the moment to enter the market. And that’s when companies need to make an important decision: should they enter the market by themselves or should they look for partners to whom license their technology.
In this article, we’ll see what the main advantages and disadvantages of licensing are for tech startups.
Pros of Licensing:
The profitability of your company depends greatly on the amount that was invested in order to generate your net revenue. By licensing your technology, you let your licensee make the heavy investments (commercialization efforts, production, logistics, marketing, etc.) and you limit yourself to mainly investing in a support structure (legal, audit).
Your risk is hence limited, and the returns on investment are relatively higher.
Here’s a simple example:
In this example, the total sales of the Licensee amount to 10’000, and direct costs of goods sold are 50%. After deducting SG&A (Sales, General and Administrative) costs and the depreciation related to the initial investment, the company closes with an EBIT of 2’000. Which considering the initial investment of 10’000 represent a return on investment of 20%.
For the licensor, the picture is different: it has much less revenue (only 10% of the licensee’s gross sales), but has no COGS and a fairly limited administrative structure. It still has 200 of depreciation, deriving from the investment the company made to develop the product, but the return on investment is still superior (30%) to the one of the licensee.
Of course, situations may vary: the royalty rate of the licensor could be lower, the investment greater and so on. But the difference in the cost structure and the size of the structure tends to reflect the situation exposed above.
Limited investment needed
As a founder or early investor, you may want to limit dilution and therefore not be willing to raise more money.
By licensing your technology, you don’t need to raise as much money as you don’t need to invest in production or commercial activities linked to entering a new market. That’s particularly interesting if you don’t want to take the risk of things not going as planned in a specific market that would require an important investment, and you accept to limit your upside in exchange for this lower risk.
Taking advantage of your licensee’s distribution networks and production capabilities
By licensing your technology to established companies, you take advantage of their market knowledge, their distribution channels and production capabilities. This allows your product to achieve great scale much faster than if you had to start operations and build connections with customers from scratch.
That is especially true for markets that are highly competitive, and in which gaining market share would require a lot of time and resources.
Focus on the strengths of the founders’ team
An important, and often forgotten variable that comes into play is the ability of the founders to execute operationally and commercially.
Many times, patents are held by scientists or researchers, whose strength and interest doesn’t particularly lie in business. Licensing allows those companies to focus their work on developing solutions using their technology, and let companies who have the business ability take care of the rest.
Wide use case of the technology
Some inventions have such a wide variety of use cases that it would simply not be feasible for the owner company of the technology to cover them all. Hence, getting a very small portion out of every product that uses that technology is much more profitable than competing in one field and hoping to gain a substantial market share.
One of the best examples is the company Velcro Industries, who licensed its well-known fastener technology, and then focused on developing new technologies and building a brand.
Unfortunately, there is no such thing as a free lunch in licensing. Here are the main setbacks that you should expect and mitigate when closing a deal.
Cons of Licensing:
Loss of control
An important setback companies face when licensing their technology is that they’re not anymore in command of their own destiny: the success or failure of their product or brand depends on the execution of the licensee.
If the latter doesn’t manage appropriately your brand in one country, licensees in other countries could be affected; if he doesn’t put in its best commercial efforts in selling your product, you’ll get very little revenue. Worse, if the licensee feels your technology could harm other parts of its business or finds a more profitable substitute to your solution, you could be held hostage and spend time and resources battling in court.
You also have very little to say in terms of pricing strategies: another variable that could hit your royalties.
Finally, auditing the financials of your licensee to make sure it’s respecting the contract can be complex.
With limited risk, come limited rewards. If your product booms your royalties will increase, but you’re still leaving important profit to your licensee that could have been yours.
Furthermore, licensing deals usually have a decreasing marginal royalty rate. Meaning that as sales go up, royalties go down (you may get 10% on sales up to 5m, 7% on sales from 5-10m, and so on).
In conclusion, licensing allows startups to decrease risks as they limit the investments related to commercialization and production in a specific market or globally. By doing so, the company can focus on what it does best: developing solutions using its technology, and use the licensee’s own expertise and resources in order to get an important return on investment.
Nonetheless, licensing has its own drawbacks: from loss of brand and quality control to potential conflicts of interest, the licensor’s future relies on a good business execution from the licensee. Furthermore, as the risks taken by the licensor were limited, so are its potential rewards.
In order to mitigate those disadvantages, here are a few tips you should consider before entering a licensing agreement.
Take your time and invest resources in order to structure the right deal: many variables come into play and negotiating can be a long process. It’s important you have legal and financial advisors by your side that can help you make the right decisions and accompany you during the process.
Clearly define the geographies and the scope of use that the licensee gets, so that you’re protected in case opportunities in other domains or markets arise for the usage of your technology.
Set quality controls and audit rights in the contract, so that you can ensure that the licensee is making good use of your technology and respecting its financial obligations.
Show traction for your product prior to closing any licensing deal. This will allow you to negotiate better terms for your licensing agreement, and get a feel of what going to market on your own would mean.
Consider a mixed strategy of direct sales and licensing: that way you decrease risk by licensing in more competitive markets or in markets in which you don’t have the right resources to flourish, and you keep your product’s upside potential in markets in which competition is less fierce and where you can compete.
About the author: Itamar Ahrenbeck is the CEO of YourExternalCFO, a swiss-based company that provides financial partnership services for SME's and Start-ups in Switzerland and Latin America.