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The first article in the IP Licensing series, IP Licensing Basics: Understanding the Grant of Rights, introduced the foundation of licensing agreements by explaining how rights are granted and restricted through concepts such as scope, exclusivity, transferability, and duration. Building on that foundation, this second article turns to the financial side of licensing by introducing the key payment structures that are commonly used in IP licensing agreements.

I. Fixed Payments

Fixed payments are predetermined amounts specified in the licensing agreement that do not depend on external factors such as sales volume or performance milestones. They must be paid regardless of the technologies commercial progress. Although the amount remains constant, the timing and method of payment can vary depending on the parties’ negotiated terms.

(a) Up-Front & Lump Sum Payments

Upfront payments are fixed amounts due upon execution of the agreement or shortly thereafter. They typically form one component of the overall consideration and may be combined with other payment mechanisms to balance immediate and long-term compensation.

Upfront payments provide the licensor with an immediate financial return and tangible proof of the licensee’s commitment to commercializing the licensed technology. Beyond compensating for the licensor’s research, development, and intellectual property protection costs, these payments also recognize the inherent value and potential utility of the licensed technology. Moreover, it may act as guaranteed income to the licensor in case commercialization fails or is significantly delayed.

When an upfront payment serves as the sole form of consideration under a license, the arrangement is referred to as a lump-sum payment. In addition to the benefits outlined above, lump-sum structures provide greater clarity and administrative ease by eliminating the need for ongoing financial monitoring. The primary challenge with this approach lies in determining an appropriate amount at the outset since the true commercial potential of the licensed technology is often uncertain at the time the agreement is executed.

(b) Scheduled Payments

Fixed-schedule payments are predetermined amounts set out in the contract that are distributed on an agreed timetable. They are purely calendar-based obligations agreed to in advance and are not tied to any external metrics.

II. Equity Compensation

In certain licensing arrangements, particularly where the licensee is an early-stage company or a startup, the licensor may opt to receive equity compensation in place of, or in addition to, traditional cash payments. Equity compensation involves granting the licensor an ownership interest in the licensee’s business.

Equity compensation aligns the licensor’s financial interests with the long-term success of the licensee by tying their return to the company’s growth in value. This structure is particularly appealing when the licensed technology forms a central part of the company’s business model but immediate revenues are limited.

The equity stake granted can take several forms. A direct share issuance provides the licensor with immediate ownership in the company, while stock options or convertible instruments (such as warrants or convertible notes) defer ownership until certain events occur. The size of the equity interest is typically negotiated based on the technology’s contribution to the company’s value, the stage of development, and the perceived risk and future potential of the venture.

III. Royalty

A royalty is a periodic payment that is typically based on the licensee’s manufacture, use or sale of a licensed technology. In simple terms, it is a variable payment structure where the amount owed depends on commercial success of the technology. Royalties are the most common form of ongoing consideration in IP licensing because they align the licensor’s compensation with the commercial success of the licensee’s activities. In doing so, they create a shared incentive structure that encourages both parties to see the licensed technology succeed in the marketplace.

(a) Royalty Basics

At its core, a royalty is calculated by multiplying the agreed-upon royalty rate by the royalty metric (also known as the royalty base):

Royalty Amount = Royalty Rate × Royalty Metric

This formula reflects the essence of royalty structures: payments are determined by how much the licensee pays (the rate) and on what basis that payment is measured (the metric). For instance, if a license provides for a 5% royalty on $200,000 in net sales, the resulting royalty payment would be $10,000.

The royalty metric represents how the licensee’s use of the licensed technology is measured. While it can be based on nearly any quantifiable factor, such as the number of units produced, revenue generated, or hours of use, it is most commonly tied to sales or revenue. Typical examples include gross sales, net sales, or profits. Of these, “net sales” is the most widely used because it captures the technology’s true commercial performance after deducting returns, discounts, and allowances. This ensures that royalties scale with the market success of the licensed technology.

The royalty rate determines how much the licensee pays for each unit of activity measured by the chosen metric. There are two main ways to set this rate: per-unit or percentage-based.  

A per-unit royalty assigns a fixed fee for every product made or sold. For example, if the agreement requires a $5 royalty per unit sold and 100 units are sold, the licensor receives $500.

A percentage-based royalty, on the other hand, ties the payment to a share of the licensee’s sales or revenue. For instance, a 5% royalty on $100,000 in net sales would result in a $5,000 payment to the licensor.

(b) A Note on Tiered vs Fixed Royalties

Royalty rates can also be structured as fixed or tiered. A fixed rate remains constant throughout the license term, such as a steady $5 per-unit royalty or a consistent 5% of net sales. A tiered rate, on the other hand, changes based on performance metrics such as sales volume or revenue thresholds. For example, a license might apply a $5 per-unit rate for the first 100,000 units sold, dropping to $4 for additional units, or a 5% royalty on the first $1 million in sales that decreases to 3% thereafter.

IV. Milestone Payments

Milestone payments are conditional fixed payments made by the licensee to the licensor upon the achievement of pre-defined events (i.e., milestones) during the development and commercialization of a licensed technology. These payments are inherently performance-based: the agreed amount becomes payable only when the licensee meets a measurable target that signifies tangible progress. Such milestones may include the successful completion of a development phase, the receipt of regulatory approval, or the technologies first entry into the market.

Milestone payments are common in some but not all industries. They are particularly prevalent in sectors where products must progress through multiple stages of testing and/or regulatory review before reaching the market. In the life sciences sector, for instance, the results of clinical trials often determine whether a therapeutic product will receive approval from regulatory authorities such as Health Canada or the U.S. Food and Drug Administration (FDA). Milestone payments in these cases are typically structured around the successful completion of each phase of development.

V. A Note On Sub-Licensing Income

When a license allows the licensee to sub-license the technology to third parties, it is often in the licensor’s interest to include financial provisions that ensure they share in the value generated from those sub-licensing arrangements. In essence, these terms help the licensor maintain a fair stake in the downstream commercialization of their licensed technology.

A common approach is for the licensor to negotiate a percentage share of sublicensing income/revenue the licensee earns from sublicensing the technology. This payment is usually structured separately from other financial terms in the agreement. Under this arrangement, the license may specify, for example, that the licensor is entitled to 20% of all sublicensing revenue the licensee receives.

VI. Final Note

This article outlined the most common payment structures found in IP licensing agreements. It is important to note, however, that these structures are not mutually exclusive. In practice, licensors and licensees often combine multiple forms of consideration to create a balanced framework that shares both risk and reward. For example, a single license might feature an upfront payment of $100,000, continuing royalties of 5% of net sales, and milestone payments of $50,000 linked to key performance achievements. Ultimately, the most effective payment structure is the one that best aligns with the commercial objectives, financial circumstances, and risk tolerance of both parties.