Licensing Your Patents? Make Sure the Federal Government Pays Its Fair Share.

Technology companies frequently enter into patent licensing transactions, sometimes in order to settle patent litigation, and sometimes as a simple licensing or cross-licensing deal. But the parties to such agreements frequently fail to account for the licensee’s sales to the federal government, and that oversight can have a substantial impact on the overall transaction.

It is not surprising that government sales are often overlooked in patent licensing agreements. First, sales to the federal government may not be counted as “commercial sales” by the potential licensee, and thus may not be reported to a potential licensor in the same way as other sales. In fact, many companies set up separate business entities specifically for the purpose of selling their products to the federal government.

Second, in many circumstances, damages for such sales can be recovered only by filing suit against the federal government directly in the United States Court of Federal Claims, and not via an action against the potential licensee in federal district court—a potential licensee may thus feel justified in withholding information concerning such sales since it may not be “on the hook” for damages associated with those products in litigation. Either situation can substantially impact the royalties ultimately paid pursuant to the license.

By way of background, patent license fees sometimes take the form of a lump-sum payment and are sometimes paid as a running royalty based on the licensee’s sales over time (among numerous other possible arrangements). But, for any form of payment, it is important for the licensor to have an accurate understanding of the licensee’s sales, including which sales will be included as part of the royalty base. As any licensor or licensee knows, the scope of the royalty base can have a dramatic impact on the royalties the licensor receives and is frequently the subject of intense negotiation. Nevertheless, it is common for neither party to consider the impact of sales to the federal government on the royalty base. And, depending on the industry, that oversight can have a substantial impact on license fees.

Accordingly, it is important for a licensor to determine whether a licensee’s royalty-bearing products include sales to the federal government and, if not, whether a separate claim for infringement should be filed against the federal government to recover royalties for government sales. Likewise, it is important for the licensor to determine whether it may be shielded from claims of infringement for products sold to the federal government, first by determining whether the government provided “authorization and consent” for such sales to the licensee (e.g., 48 CFR § 52.227-1) such that it has a defense to infringement claims as to government sales, and second whether the licensee may nevertheless ultimately be liable for such sales due to any indemnity obligations provided to the federal government. (e.g., 48 CFR § 52.227-3).

Determining whether government sales are relevant to the royalty base is a relatively straightforward extension of issues that already are commonly negotiated. For example, with respect to U.S. patents (or portfolios including mostly U.S. patents), experienced licensors and licensees frequently negotiate over whether and to what extent foreign sales should be included in the royalty base and will consider factors such as the strength and scope of any foreign patent protection, the sales volume and jurisdictions of any extraterritorial sales, and the administrative burden that keeping track of sales in individual jurisdictions may impose on the parties.

Assuming that the licensee sells to the federal government, the licensor may wish to include in the royalty base discussion at least the following issues:

• The relative split of sales between government and commercial customers—is the product for example, a computer operating system, in which case the government is likely to be one of the largest individual customers, or is it specialized technical software used largely in product development and as to which the government may have only a handful of licenses;
• Whether government sales are tracked separately from commercial sales;
• Whether government sales are made by a separate entity;
• The terms of sales to the government (e.g., commercial item, commercial software, noncommercial software); and
• Whether government authorization and consent and/or indemnity obligations apply.

The licensee will want to determine whether it is immune from suit for sales to the government and is thus justified in excluding such sales from the royalty base. This can occur, for example, if the government provided authorization and consent, but did not include the relevant patent indemnity provision in the contract, a scenario that occurs far more often than one would expect.

Ultimately, even if the licensee may be immune from suit for government sales, the parties may nevertheless wish to include such sales within the license royalty base for administrative efficiency and to avoid the cost and expense of a lawsuit against the government and potential disputes concerning indemnity claims.