Licensing as a Primary Entry Mode

As is true of any entry mode, licensing offers both advantages and disad­vantages to manufacturers.

1. Advantages of Licensing

The most obvious advantage of licensing as an entry mode is the circum­vention of import barriers that increase the cost (tariffs) or limit the quan­tity (quotas) of exports to the target market. Instead of transferring a physical product, the manufacturer transfers intangible assets and services that are not subject to import restrictions. Commonly, manufacturers have used licensing when exports were no longer possible to a target market with the sudden imposition of tariffs or quotas or when exports were no longer profitable with the appearance of more intense competition. A prolonged depreciation of a target country’s currency may also swing a manufacturer from export to licensing. In some instances, licensing may enable a manu­facturer to continue exporting to a restricted target market by replacing shipments of final products with shipments of intermediate products to a licensee firm. Licensing also overcomes the problem of high transportation costs, which make the export of some products noncompetitive in target markets.

Another advantage of licensing is lower political risks than with equity investment. For one thing, many host governments prefer licensing over foreign investment as a way to get technology. For another, licensing is immune to expropriation, because the licensor does not own physical assets in the target country. If the worst happens, the most that a manufacturer can lose is the licensing income. This may not be inconsequential, but the loss is far below the loss he would sustain with a manufacturing subsidiary.

In some situations, a manufacturer may be kept out of a target country by both import and investment restrictions, and licensing becomes the only viable entry mode. For that reason, the penetration of markets in Commit., nist countries frequently depends on licensing. Even in Western countries, manufacturers of military equipment or of other products deemed critical to the national interest (such as communications equipment) may be com­pelled to enter licensing agreements because the host government requires at least some of the product to be manufactured in its own country by indigenous companies.

Apart from these external factors, several factors internal to a company may favor licensing over alternative entry modes. For companies whose end product is a service (which cannot be exported), licensing or franchising may be a more attractive way to provide the service than through a branch or subsidiary. Again, if a manufacturer’s product requires substantial physi­cal adaptation to meet the needs of a target market, licensing may be advantageous because it can transfer much of the adaptation cost to the foreign licensee and, at the same time, avoid the higher resource costs and risks of equity investment.

This last remark brings up another internal factor, namely, the re­sources (managerial, technical, and financial) that a company is able and willing to commit to a foreign target market. As a low-commitment entry mode, licensing is especially attractive to small manufacturers. A low or uncertain sales potential in the target market adds to the attractiveness of licensing compared to that of equity investment or even direct export.

2. Disadvantages of Licensing

Clearly, a company cannot use licensing as an entry mode unless it pos­sesses technology, trademarks, or a company name that is attractive to potential foreign users. For companies lacking these assets, licensing is simply not an entry option. Apart from this limitation, licensing may have several disadvantages for manufacturers.

The foremost disadvantage of licensing from an entry strategy perspec­tive is the licensor’s lack of control over the marketing plan and program in the target country. Even when the licensor makes a good selection of his licensee, he remains dependent on the licensee’s market performance, and he can do little to compel a better performance short of terminating the license if the contract permits it. This disadvantage can be alleviated by developing a close working relationship with the licensee, but it can only rarely be eliminated even in franchising. In this respect, a foreign licensee resembles a foreign distributor.

Another disadvantage is the absolute size of income from a licensing arrangement as compared to that from exporting to, or investing in, the target country. Royalty rates are generally limited by rates in a company’s prior licensing agreements, by industry practice, by competition, and, in­creasingly, by host governments. Today royalty rates seldom exceed 5 per­cent. Furthermore, unlike export or investment income, licensing income is limited to the duration of the licensing agreement, which is usually five to ten years.

The absolute size of licensing income is not small in all circumstances, and it must be weighed against the lower direct risks of licensing. More­over, licensing income is not confined to royalties (a matter taken up later), and the duration of a licensing contract may be extended with product improvements and a continuing need by the licensee for technical assist-ance. A final qualification of this income disadvantage is that the profitabil­ity of a licensing arrangement can be high even when the absolute income size is small.

A disadvantage of licensing that is commonly ignored, to the licensor’s subsequent regret, is the risk of creating a competitor in third markets or even in the manufacturer’s home market. Although the political risk of licensing is low, the ultimate commercial risk can be very high. Armed with the licensor’s technology, the licensee may become a formidable competitor in world markets. Manufacturers can try to minimize this risk by restricting the licensee to sales in his own country and/or by contractually binding the licensee to discontinue use of the licensed technology after termination of the contract. But these efforts may be prohibited by the host government and may even be illegal under U.S. antitrust laws. Apart from these obsta­cles, legal action taken against a foreign licensee for contract violation is costly, time-consuming, and uncertain of success. Before licensing a foreign company, therefore, the manufacturer needs to assess the risk of creating a future competitor. In particular, the notion that licensing can be used to explore or test a new market with the prospect of later entry by the manufacturer as an investor deserves careful scrutiny. Finally, the competi­tive risk that arises from divulging trade secrets to a licensee may be compounded by the licensee’s inadvertent or purposive disclosure of those secrets to third parties. In some instances, the host government may not allow the licensor to bind the licensee to an “oath of secrecy.”

Another drawback of a licensing arrangement is its exclusiveness. The licensing agreement usually gives the licensee the exclusive rights to use the licensed technology and trademark in the manufacture and sale of desig­nated products in the licensee’s country. Hence with respect to those prod­ucts, the licensor cannot use an alternative entry mode over the agreement’s life. This opportunity cost of licensing (the cost of not being able to enter the market in another way) may be moderated, but not eliminated, by contract provisions that allow the licensor to terminate the contract for inadequate performance or to acquire equity in the licensee firm a thereby transform a licensing arrangement into a joint venture.

Source: Root Franklin R. (1998), Entry Strategies for International Markets, Jossey-Bass; 2nd edition.

3 thoughts on “Licensing as a Primary Entry Mode

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