Many manufacturers regard licensing as an entry mode to be used only when they cannot use exporting or equity investment to penetrate a foreign target country. As a consequence, they treat licensing as a marginal activity undeserving of any careful evaluation of its benefits and costs. This casual approach encourages bad decisions of two sorts. On the one hand, manufacturers may ignore licensing when it is a more profitable way to gain entry into a target market than alternative entry modes. On the other hand, they may enter licensing agreements without assessing all relevant revenues and costs over the duration of those agreements. Thus the neglect of systematic analysis heightens the risk of both underlicensing (not licensing when one should) and overlicensing (licensing when one should not).
Managers can rationally choose licensing as a primary entry mode only when they compare the expected profitability of a proposed licensing venture with the expected profitability of alternative entry modes, notably export and equity investment. Moreover, they can do a good job of negotiating licensing agreements only when they are aware of all prospective revenues and costs. Not to undertake profitability analysis is to treat licensing as a tactical, ad hoc decision when it is truly a strategic decision that will determine a company’s long-run position in a target market and possibly in third markets as well. In this section we suggest how managers can apply profitability analysis to a proposed licensing venture, but a fuller treatment of profitability analysis in the context of all entry modes is postponed until Chapter 6.
1. Projecting Incremental Revenues
Profitability analysis requires that managers make estimates of both incremental revenues and incremental costs projected over the life of a proposed licensing venture. The profit contribution of the venture is then calculated by subtracting all incremental costs from all incremental revenues.
Licensing revenues are dependent mainly on the ability of a prospective licensee to manufacture and market the licensed product over time. Hence the licensor-manufacturer first needs to research the foreign target market to ascertain the market potential for his kind of product. Next, he needs to estimate the sales potential (market-share potential) of the prospective licensee by evaluating his capacity to manufacture the licensed product at a competitive cost and quality and to sell it in the target market. The manufacturer’s estimate of the licensee’s sales potential is the basis for his projection of royalty revenues calculated as a percentage of sales at an expected royalty rate.
After projecting running royalty revenues, the manufacturer needs to identify and estimate other kinds of licensing revenues, including:
Lump-sum royalties (including disclosure fees).
Technical-assistance fees.
Engineering or construction fees.
Equity shares in licensee firm.
Dividends on equity shares.
Profits from sales to licensee (machinery, equipment, raw materials,
components, or nonlicensed products).
Profits from purchase and resale of goods manufactured by licensee.
Savings from use of licensed products in licensor’s own operations.
Commissions on purchases or sales made for licensee.
Rental payments on licensor-owned machinery or equipment.
Management fees.
Patents, trademarks, and know-how received from licensee (grant-backs).
Since the licensing venture is prospective, these revenues are based on the agreement that the manufacturer plans to negotiate in view of his knowledge of the target market and the prospective licensee, his licensing experience, and other factors. After estimating all revenues, the manufacturer projects the aggregate cash inflows that are anticipated over the life of the proposed licensing venture.
2. Projecting Incremental Costs
The next step in profitability analysis is an estimation of all costs incurred by the manufacturer in transferring technology and related services to the prospective licensee over the agreement’s life. The possible costs are classified as opportunity, startup, and ongoing costs:
Opportunity Costs
Loss of current export or other net revenues.
Loss of prospective revenues.
Startup Costs
Investigation of target market.
Selection of prospective licensee.
Acquisition of local patent/trademark protection.
Negotiation of licensing agreement.
Preparation and transfer of blueprints, drawings^ and other documents.
Adaptation of technology for licensee.
Training licensee’s employees.
Engineering, construction, and plant installation services. Contribution of machinery, equipment, and inventory to licensee.
Ongoing Costs
Periodic training and updating of licensee.
Maintaining local patent/trademark protection (including policing and litigation costs).
Quality supervision and tests.
Auditing and inspection.
Marketing, purchasing, and other nontechnical services.
Management assistance.
Correspondence with licensee.
Resolution of disputes.
Maintenance of licensor staff.
The licensor’s opportunity costs are the revenues that are forsaken if he enters the prospective licensing venture. The licensor may give up actual and future net revenues from exports or other operations in the target country that are ruled out by the licensing agreement. Furthermore, the licensor may lose net revenues in third markets if the licensee enters those markets. The most obvious opportunity cost is incurred when the licensor must discontinue export sales of the licensed product to the target market. Prospective opportunity costs can be assessed only by reference to the manufacturer’s international business strategies over the planning period. At one extreme, a manufacturer may have no plans to enter the target market in any other way and is not concerned with possible licensee competition in third markets. In that event, he will assess prospective opportunity costs of a licensing venture as zero. At the other extreme, a manufacturer may want to keep its options to enter the target market as an exporter or investor or may be fearful of licensee competition in third markets. Such a manufacturer may assess prospective opportunity costs as so high as to prohibit a pure licensing agreement, rejecting licensing altogether or combining it with equity investment in the licensee firm. Admittedly, it is difficult for managers to place a dollar value on prospective opportunity costs, but an appraisal of those costs is nonetheless important, as testified by the unfortunate experiences of many manufacturers that entered licensing agreements without considering prospective opportunity costs.
Startup costs include all transfer costs incurred by the licensor to establish the licensing venture and to get the licensee into volume production and marketing of the licensed product. Startup time depends mainly on the complexity of the technology package and the ability of the licensee to assimilate it. Startup time probably runs from one to two years for the majority of licensing ventures. It is common for licensors to demand lumpsum payments to cover all or part of their startup costs.
Ongoing costs include all costs incurred by the licensor to maintain the licensing agreement as a profitable venture over its duration, which is ordinarily five to ten years.
The manufacturer is now ready to calculate the profit contribution of the proposed licensing venture by subtracting aggregate costs from aggregate revenues. Since the time paths of revenues and costs will differ, it is desirable to use net present values in calculating the profit contribution.6 The resulting figure should then be compared with the estimated profit contributions of alternative entry modes to help managers decide which is the most appropriate entry mode for the company. Assuming that the company chooses a licensing venture, its managers can use the profitability analysis as a framework for negotiations with the prospective licensee.
The reader may note that we have not included the “cost” of the manufacturer’s industrial property rights in our discussion of licensing costs. Treated as an overhead cost, R&D has usually been charged off against domestic sales by the time the technology is licensed to a foreign company. Moreover, the same technology may be licensed again and again to different licensees. Thus any assignment of R&D cost to the technology package of a specific licensing venture would be arbitrary and bear no relationship to its value. As we shall see, the economic value of a technology package is determined by negotiations between the manufacturer and its prospective licensee. Since industrial property rights are not capitalized in the ordinary licensing agreement, the value of these rights is implicitly expressed in the licensor’s profit contribution.7
Source: Root Franklin R. (1998), Entry Strategies for International Markets, Jossey-Bass; 2nd edition.
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