Continuing the topic of the “Net Sales” royalty base, this instalment relates to the important topic, especially in pharma licensing agreements, of how to deal with ‘combination products’, i.e., where the licensed product is sold in combination with one or more non-licensed products. Examples of this include a pharmaceutical product with two active ingredients, only one being a licensed product, or where a specialized device is used to administer the licensed product. The licensee’s claim in such cases is that royalties should only be payable on the licensed component of the combination product, not on the full sales price.
From the licensor’s point of view, though, if the licensed product is driving the sales of the combination product, then it will want to ensure it receives royalties on the total sales price. Deductions should only be allowed where the non-licensed component is a critical one that drives sales. This is a tricky point to address. For example, in the case of a drug product, one tactic is to limit the “combination product” allowance to instances in which the non-licensed product is an active ingredient. The licensee may resist this narrow language, however, because it might not accurately reflect the primary combination possibilities for the product. And even if the licensee doesn’t resist, an additional active ingredient might ultimately turn out to be a tangential element of the combination product that does not drive sales.
One way the licensor can seek protection is by way of the multiplication formula that will be used to reduce the royalty base of the product. Where each element of the product is sold alone, the market-standard solution is to multiply the combination sales price by A/(A+B), where A is the market price of the licensed product, and B is the market price of the non-licensed component. Disagreements mainly arise when one of the component of the combination product is not sold separately, and in this sense the licensor’s greatest concern is where it’s the non-licensed component that is not sold separately, meaning it might eat away at royalties even though it has not commanded a market on its own merit.
The licensor might address this by including an additional multiplication formula for cases where the non-licensed product is not sold alone: A/C, where A represents the market price of the licensed product when sold alone and C is the sales price of the combination product. Accordingly, the licensor would automatically receive the full royalty on the otherwise established market price of the licensed product. An even more favorable option for the licensor is to include a proviso that the market price ascribed to the licensed product in any combination product will never be less than the price the licensed product sells for when sold alone. This gives comfort the licensor even in cases where the non-licensed component is sold alone.
For the licensee, certainty is a vital element of any combination product clause. One might claim the licensee has the upper hand in any future combination product disagreement, because it can withhold the amounts it believes should be deducted from combination product-related royalty payments. However, because combination product language is generally integrated into the licensing agreement as an allowable deduction to the otherwise due royalties, the licensor might be able to claim that the licensee’s withholding royalty amounts during the ‘disagreement’ period is a breach of contract. The licensee should therefore insist on including a clear, specific mechanism for resolving combination product-related disagreements. And because determining combination product market values is a precise matter that requires industry expertise, it is best not to leave this to the agreement’s general dispute resolution procedure.
Ideally, the licensee would want to have the right to initially determine the unknown market values in respect of the combination product in good faith, notifying the licensor of its determination in the relevant royalty report. In such a case, it would have fulfilled its obligation under the licensing agreement upon payment of royalties, come what may in the form of licensor pushback. However, the licensor might not accept such language and insist that the market values be determined “by mutual agreement of the parties”. As discussed, this sort of indefinite language is not a good solution for the licensee. A middle ground between the above extremes is to include an expedited decision-making mechanism into the combination product clause, such as referring the matter to expert determination under WIPO Rules (for example), or to an expedited arbitration. These mechanisms generally assume a certain standard form and can be attached as an appendix to the licensing agreement.
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The above is intended for informational purposes only and does not constitute advertising, a solicitation, or legal advic
