Marketing Science Institute Special Report 09-209

Intellectual Property Rights and Licensing: The Importance of Brand Protection

Satish Jayachandran, Kelly Hewett, and Peter Kaufman

Copyright 2009 Satish Jayachandran, Kelly Hewett, and Peter Kaufman

MSI special reports are in draft form and are distributed online only for the benefit of MSI corporate and academic members. Reports are not to be reproduced or published, in any form or by any means, electronic or mechanical, without written permission. Intellectual Property Rights and Brand Licensing: The Importance of Brand Protection

Satish Jayachandran Associate Professor Moore School of Business University of South Carolina Columbia, SC 29208 USA

Kelly Hewett Senior Vice President Bank of America 101 S. Tryon St. Charlotte, NC 28255 & Research Affiliate The Media Laboratory Massachusetts Institute of Technology 20 Ames St. Cambridge, MA 02139

Peter Kaufman Assistant Professor College of Business Campus Box 5590 Illinois State University Normal, IL 61790-5590

1 Intellectual Property Rights and Brand Licensing: The Importance of Brand Protection

Abstract Brand licensing is an increasingly popular approach for established to leverage their to generate financial returns through royalty and to protect the brand from misappropriation. In a brand licensing arrangement, a brand is essentially leased to another firm for selling different products or services for a financial consideration. The authors examine the impact of institutional characteristics such as intellectual property rights (IPR) and economic characteristics such as market potential and brand strength on royalty rate in brand licensing contracts. Using data obtained from actual licensing contracts, they find that concerns of moral hazard on the part of the licensor firm as well as the licensee firm influence royalty rates. IPR protection in a country allows licensees to benefit from lower royalty rates while higher market potential allows licensors to demand higher royalty rates. Stronger brands seem to emphasize brand protection over revenue generation when licensing contracts are drawn up. Overall, the results underscore the importance of brand protection in shaping brand licensing contracts.

2 Intellectual Property Rights and Brand Licensing: The Importance of Brand Protection

Intellectual property (IP) is an asset that springs from intellectual activity in the industrial, scientific, artistic, and literary fields. While firms can leverage their IP to generate revenue streams, intellectual property violation and consequent loss of revenue for IP owners are not uncommon. Therefore, firms also consider it important to protect their intellectual property.

Complicating the efforts made by firms to protect their IP assets is the fact that there is substantial variation across nations in the extent of protection afforded to intellectual property

(Maskus 2000). Consequently, firms often vary their approach to leveraging and protecting their

IP assets across country markets.

Brands encompass a significant portion of the intellectual property held by firms

(Ramello 2006). Brand licensing is employed by firms to generate revenues by leveraging the intellectual property in the brand and to protect the brand. In brand licensing, the owner of the brand (licensor) enters into a contract that permits an external entity (licensee) to use the brand name for specified commercial purposes in a geographic territory over a defined period of time.

The revenue that the licensor firm earns is usually in the form of royalty payments, a percentage of the licensee‟s revenues from the sale of products or services that incorporate the licensed property (Raugust 1995). In addition, continued utilizing a brand is often necessary to prevent the firm from losing its rights to the brand name in a particular market. Mere registration will not help the firm to retain its rights to a brand name after a grace period of three to five years.1

From this perspective, licensing also serves the purpose of protecting the brand.

The practice of licensing a brand has become a global multi-billion dollar industry.

International licensing of brands is growing and the total worldwide revenues from licensed products were $187.4 billion in 2007, an increase of 3.6 percent from the previous year

1 http://www.wipo.int/export/sites/www/about-ip/en/iprm/pdf/ch2.pdf (p.77)

3 (www.licensemag.com). Licensed products are estimated to make up between 25-35% of toy industry (Friedman 2004), and generated royalties of about $950 million in the food industry (Byrne 2004). Disney Consumer Products was the largest licensor with $26 billion in sales from licensed properties, double its revenue from licensing six years ago (!

Global 2008). Licensing revenues are often a significant part of a company‟s total revenues.

The consumer products firm Cadbury, for instance, earns about 20% of its revenue from licensing its brands (Bass 2004).

Despite its growing prominence, brand licensing has not received much attention in the marketing literature. While there has been a fair volume of research into brand extensions, brand licensing is different from brand extensions in one important aspect. Although with brand extensions a firm leverages a brand to enter a new or related product category, unlike in licensing, the brand is not contracted out to a different entity. Therefore, the licensor-licensee agreement in brand licensing is an agency arrangement (Jensen and Meckling 1976). The presence of agency relationships in the context of brand licensing creates problems not present in brand extensions because the goals and risk preferences of the principal (licensor) and the agent

(licensee) may not be perfectly aligned. This leads to moral hazard, a post-contractual opportunism problem, where one party to the agreement might act in its self-interest at the expense of the other, because actions are not freely observable (Milgrom and Roberts 1992).

The licensor‟s interest might be in protecting and enhancing the equity of the brand. The licensee, however, might focus on generating maximum revenue over a short time frame by exploiting the licensed brand name, even at the risk of long-term damage to the brand (Quelch

1985).2

2 Brand licensing is also different from franchising, which involves the contractual arrangement between a franchisor and a franchisee to run a business based on the franchisor‟s business model. As such, the franchisee‟s

4 A second reason to examine brand licensing is that intellectual property rights (IPR) protection in different markets is likely to have an impact on brand licensing. IPR has an important influence on how firms manage brands (Anand 2008). Moral hazard concerns from a partner‟s behavior in the context of brand licensing could vary across markets depending on the legal and other protections afforded to brand owners from misappropriation of licensed property.

Such protection is dependent on the extent of IPR enforcement, which varies across nations

(Maskus 2000). Hence, key contract terms could differ systematically across markets based on

IPR protection.

In effect, brand licensing 1) is of increasing managerial importance, 1) is different from traditional brand extensions because of agency considerations, 3) is likely to be affected by market characteristics such as IPR, and 4) has not been examined in the marketing literature, especially from the perspective of brand protection. The key objective of this study, therefore, is to assess how moral hazard concerns shaped by market characteristics including IPR protection influence royalty rate, a key way in which a brand can contribute to marketing performance.

Apart from this, given our desire to provide guidance to managers, we assess the impact of other market and brand characteristics on royalty rate.

Using data obtained from 90 international brand licensing contracts, we examine factors that influence royalty rates. We study whether economic and institutional characteristics of the market that drive the possibility of moral hazard on the part of both the licensor and the licensee influence royalty rates. We find that market characteristics that reduce the likelihood of licensee moral hazard allow licensors to offer lower royalty rates, thereby benefiting the licensee. Market

operations are subject to considerable control by the franchisor through the use of operations manuals, site approval, personnel policies, accounting procedures, co-op , operations training, etc (Choo 2005). Underscoring the difference, from a legal perspective, franchising falls under the purview of securities law while licensing falls under contract law.

5 characteristics that enhance the possibility of licensor moral hazard lead to higher royalty rates.

Specifically, IPR protection in a country allows licensees to benefit from lower royalty rates while higher market potential allows licensors to demand higher royalty rates. Stronger brands appear to emphasize brand protection over revenue generation when licensing contracts are established. Overall, the results underscore the importance of brand protection in shaping brand licensing contracts.

Brand Licensing: The Role of Moral Hazard

A licensee obtains the rights to use a brand property within a territory, and for a specified duration, for the purpose of generating profits by leveraging the brand‟s equity. This arrangement is formalized through a contract. In agency arrangements such as these, the interests of the licensor and the licensee may not be perfectly aligned. Therefore, moral hazard is quite likely in a brand licensing situation (Milgrom and Roberts 1992).

Misalignment of Licensor-Licensee Interests in Brand Licensing

The goals of licensor firms are to protect and enhance the brand, and earn additional revenues.

In many cases, revenues should even be seen as less important than protecting the brand (Bass

2004). However, similar to what Dant and Nasr (1998) observe in the context of franchisor- franchisee relationships, the licensee may be far less interested in protecting the brand.

Opportunistic licensees may free-ride on licensors‟ investments in the brand by shirking their efforts to maintain quality. A licensing industry trade magazine states “It‟s difficult to imagine that something that can mean so much as your brand/property has to be given over to entities that do not necessarily share the same motives of growing long term brand value. But that‟s exactly what licensing executives face every day” (Bottom Line 2002, p. 6).

6 The licensee might attempt to free-ride on the licensor‟s efforts to sustain brand equity and withhold effort or cost, similar to what Garg and Rasheed (1998) observed in the context of franchising. For example, a licensee may offer products of lower quality than agreed upon with the licensor, sell through inappropriate channels, or offer low prices that alter the brand‟s in the marketplace. By doing so, this specific licensee will lower its cost of operation or enhance its profits by selling to market segments not considered appropriate for the brand‟s positioning. In addition, the licensee hopes that it will not pay a price for its actions because the licensor and other licensees act as required and sustain the brand. Furthermore, the licensee may not spend adequate resources to act as the licensor‟s agent in terms of protecting the brand from being violated by other firms. In effect, the licensee pursues such short-term actions anticipating spillover benefits from brand building actions undertaken by the licensor.

Overall, owners of IP face risks of inappropriate use of their property, not only losing revenue, but also risking damage to the equity or value of the property itself (Park and Ginarte 1997). For example, Quelch (1985) notes how Izod‟s brand value faded as a result of the failure of its licensees to meet quality standards.

However, the risk of moral hazard is not limited to actions undertaken by the licensee.

From the licensee‟s perspective, the licensor might seek to enter the market directly or appoint other licensees after the licensee has built the business and its contract with the licensor expires.

Furthermore, the licensor might shirk on some of the support that it is expected to provide to the licensee, such as cooperative or market development funds, if a larger share of the benefits from the support might accrue to the licensee (Quelch 1985). The licensee risks the investment it needs to make to market the licensed product, such as one-time fixed costs associated with market development research, new product development, channel development, and general

7 commercial or launch expenses. Often these investments are made expecting support from the licensor to market the licensee‟s products. If the licensor shirks on such support or seeks to enter the market on its own, the licensee may not be in a position to generate sufficient returns from its investment.

In effect, the licensee, in general, will desire to minimize the royalty paid to the licensor and ensure required support from the licensor. From the licensor‟s perspective, the issue is to reconcile the sometimes conflicting objectives of maximizing royalty earnings and ensuring brand protection. To balance these objectives, the brand licensing contract will be drawn up to limit moral hazard on the parts of the licensor and the licensee.

Limiting Moral Hazard in Brand Licensing

Moral hazard can be limited either by aligning incentives between the licensor and the licensee or through monitoring. Most licensing experts advocate that licensors constantly monitor product quality, distribution, sales, and marketing by the licensee as a guard against brand dilution (Fraley 2004). Monitoring, however, is expensive and difficult, especially when the licensee is in a foreign market subject to different legal standards. Long distance observation of licensee behavior is not easy, and external auditors may not be particularly adept at monitoring licensee behavior. Therefore, monitoring licensee behavior in foreign markets will involve direct visits or use of local company task-forces. For example, to police violations of their brand properties in China, Unilever, a multinational consumer products firm, employs a brand protection team of six employees (Wong 2008). An important goal, then, for licensors is to design their licensing agreements to maximize the outcomes from individual contracts while minimizing the need to monitor the activities of individual licensees.

8 The risk of moral hazard, and therefore, the need for monitoring, will differ with market characteristics, especially because IPR protection varies across nations. Emerging markets such as India and China are considered major licensing opportunities for a variety of brands.

However, licensing in these markets often entails a higher degree of risk. License! magazine

(June 2005) reports that in the specific case of India, government regulations and lack of transparency are problems that affect the repatriation of royalties. In general, business press reports indicate that across markets, underreported royalty revenues from non-domestic licensees are a significant problem. Royalty compliance examinations in overseas markets by the consulting firm KPMG have found underreported royalties in excess of 20%, and sometimes even 100% (Blum 2007). If there are transgressions of the licensing agreement, the licensor will often have to resolve the issue subject to the prescripts of the legal system in the foreign country.

The laws prevailing in a country might make it difficult to prosecute violators of brand properties, or gain adequate compensation. In China, for instance, it has been reported that while the laws for IP protection are adequate, enforcement remains weak (Gonzalez 2007).

In general, IPR enforcement varies substantially across markets. Licensors are likely to perceive greater risk of moral hazard by licensees in markets with weak IPR enforcement.

Licensees could try to take advantage of the weak regulatory environment to increase their profits in a manner in which the interests of licensors are compromised. First, they could falsely report lower revenues from licensing activities because they know the licensor cannot easily determine the actual revenues. Second, if the licensees know the law is not strong enough, or is likely to favor the domestic party, they may be more prone to violating the terms of the licensing agreement.

9 Overall, unlike typical agency relationships where the principal is supposed to be risk- neutral, in brand licensing situations, as in exporting situations, both the principal and the agent face risks. In other words, the brand licensor (principal) does not necessarily have more power nor is less risk averse than the licensee (agent). The licensee‟s knowledge of the local market, and the IPR laws and enforcement that prevail in a country, might even tilt the power in the relationship in its favor. Reflecting the power of licensees in brand licensing arrangements, conditions imposed by licensees in foreign markets sometimes limit the extent to which licensors can monitor licensing contracts. The licensor-licensee relationship, therefore, is one of dependency, where both the licensor and the licensee can be harmed by the actions of the other party (Zacharakis and Eshgi 1997). However, and as previously discussed, licensees could be at risk of being replaced through direct entry by the licensor or could receive less support than expected. Therefore, the licensing contract is likely to be a compromise between the need to motivate both the licensor and the licensee.

In summary, it will be in the interest of the licensor and the licensee to ensure that contract terms offer sufficient incentives that are adapted to the conditions that prevail in foreign markets to limit moral hazard. As such, it is likely that the royalty rates charged for licensing brands internationally will vary with market characteristics that influence the risk of moral hazard. Next, we develop hypotheses that describe the impact of various market characteristics on royalty rates in international brand licensing.

Hypotheses

Royalty rates are also likely to differ depending on market characteristics. The international business literature suggests that economic, institutional, and cultural characteristics determine the behavior of firms in foreign markets. Economic characteristics have long been seen as

10 influential in determining foreign market entry and performance of firms in foreign markets

(Dunning 1993). Of late, scholars have started emphasizing the role of institutions in influencing the performance and behavior of firms in foreign markets (Kostova and Zaheer 1999; Jackson and Deeg 2008). Institutions, in this context, imply the “the rules of conduct” that are designed to control human interaction (North 1990), the regulative, normative, and cognitive forces that shape firm behavior (Scott 1995; Grewal and Dharwadkar 2002). The international business literature also considers cultural factors an important influence on firm behavior in international markets (Hofstede 1980).

Consistent with the international business literature, we suggest that institutional, economic and cultural characteristics in the licensee market influence the nature of licensing contracts, and therefore, royalty rates. The specific market characteristics that we consider are: intellectual property right protection (institutional), market size (economic), brand strength

(economic), and uncertainty avoidance (cultural). Overall, our choice of these variables has been influenced by prior research (e.g., Dunning 1993; Kostova and Zaheer 1999; Grewal and

Dharwadkar 2002), and their relevance to the research context. These variables are not only consistent with research in international business and institutional theory, but they are also relevant from an agency theory perspective.

Institutional Factor: Intellectual Property Rights Protection

Firms leverage their IP for trade, foreign direct investment (FDI), and licensing across borders.

Intellectual property rights (IPRs) are the legal strictures or “rules of conduct” through which property is instituted in intellectual assets. Intellectual property rights lay out the degree to which the rights holders may prevent others from activities that violate the property (Maskus

2000). Lack of secure property rights is likely to constrain entrepreneurial activity. Weak

11 property rights may also discourage firms from investing (Johnson, McMillan, and Woodruff

2002). IP includes trademarks such as brand names, “any sign that individualizes the goods of a given enterprise and distinguishes them from the goods of its competitors.”3 Trademarks provide firms with the rights to market products under recognized names and symbols, and may be denied registration only if they lack distinctive character or run counter to morality and public order.4 Trademark rights are protected on the basis of registration and use. Mere registration, as such, may not confer rights, as they could be lost to the first-user of a trademark. Often firms have to use the trademark within a grace period of three to five years, or risk losing the right to the registered property.5 Therefore, from the perspective of protecting the brand, licensing serves an important function for firms that do not seek to operate directly.

The global protection of IPR has been enhanced by the implementation of the Agreement on Trade-Related Aspects of Intellectual Property Rights (TRIPS), guided by the World Trade

Organization (WTO) (Maskus 2000). Despite the efforts of the WTO and the conclusion of the

TRIPS agreement, there is substantial variation across nations in the extent of protection afforded to intellectual property. IPR policies are controlled by national governments. National IPR policies are often focused on short-term sectarian national interests, and not on maximizing global consumer welfare. Implementing a stronger IPR regime in a country might have long- term benefits in terms of technology transfer and domestic growth (Johnson, McMillan, and

Woodruff 2002). However, as nations enhance their IPR protection to be consistent with the

TRIPS agreement, they could face negative short-term consequences because of the higher cost of imitation and resource transfer to foreign IP owners (Maskus 2000). In addition, countries

3 http://www.wipo.int/export/sites/www/about-ip/en/iprm/pdf/ch2.pdf, p.68) 4 Distinctiveness relates to the property of a trademark to inform the consumer about the identity of products or services (e.g., the term „apple‟ is not distinctive in the context of apple products but is so in the case of computers). As such, generic terms cannot be trademarked. 5 http://www.wipo.int/export/sites/www/about-ip/en/iprm/pdf/ch2.pdf (p.77)

12 may not benefit from a strong IPR system if they lack a base of research and commercial activity that develops intellectual property. Therefore, the incentive for developing and enforcing a strong IPR regime will vary across nations (Park and Ginarte 1997). The consequent variation in intellectual property rights protection across countries influences the extent to which firms are able to safeguard their brands.

In effect, IPR protection in a country will influence the risk perception of licensors. IPR protection includes the extent to which a country formulates policies based on the TRIPS agreement as well as the degree to which these policies are enforced. Overall, inadequate enforcement of contracts will put the profits generated from licensing at risk (Johnson,

McMillan, and Woodruff 2002). Essentially, the risk of moral hazard is lower in markets with strong IPR protection. Furthermore, as IPR enforcement improves, the cost of monitoring to limit moral hazard and infringement by other parties will also decrease. Generally, as observed by North (1990), when existing property rights protection is insufficient, economic agents will have to devote more resources to undertake and manage transactions. As such, better institutional development that results from the financial market and economic policies such as

IPR lowers transaction costs (Chan, Isobe, and Makino 2008). Consistent with this argument, licensors will face higher costs in markets with lower levels of IPR protection. Therefore, licensors are likely to charge higher royalty rates to license their brands in such markets to recoup the higher costs. Hence:

H1: The level of IPR protection in the licensee’s market is negatively related to royalty rate.

Economic Factor: Market Potential

Market potential in this paper refers to the extent to which business from the licensed products can generate profits and has the opportunity to grow. Research in the area of foreign direct

13 investment (FDI) suggests that the host country‟s market size is positively associated with investment inflows (Dunning 1993; Caves 1996). With higher market potential, the motivation of the licensee to take a longer-term perspective in developing business with the licensed brands is likely to be enhanced. As market potential increases, the licensee will also benefit to a greater extent from the licensor‟s support and efforts to protect and enhance the value of the brand.

However, in the absence of sufficient returns from its efforts, the licensor might shirk efforts on market development because a greater portion of the returns from such efforts accrue to the licensee (Quelch 1985). The licensor may also be tempted to enter markets of higher potential directly or to appoint multiple licensees. Thus, as the potential in the market increases, to prevent the licensor from shirking on support or opting for other mechanisms of entry that have negative implications for the licensee, the licensee will be willing to offer higher royalty rates.

In essence, the licensee‟s concern regarding moral hazard by the licensor will play a key role in determining royalty rates as the market potential of licensed products improves. Overall:

H2: Market potential in the licensee’s market is positively related to royalty rate.

Interaction of IPR Protection and Market Potential

As we noted previously, a key consideration of the licensor is the need to protect the brand from misappropriation or abuse. This implies that if IPR protection in a market is low, the licensor will have to devote more resources to protect the brand. As such, licensors are also likely to demand higher royalty rates to compensate for the higher risk and cost of monitoring.

Correspondingly, when IPR protection is considered appropriate, the licensor will perceive lower risk and face lower costs, and hence, will be willing to offer lower royalty rates to the licensee.

However, we also noted that as the market potential increases, so does the licensee‟s incentive to develop the business with the licensor‟s property. Therefore, to ensure licensor support and

14 prevent direct entry, the licensee could be more willing to pay higher royalty rates and achieve incentive alignment. In this sense, the negative impact of IPR protection on royalty rate will be diminished by market potential. In other words, for a certain level of IPR protection, the royalty rate will increase with market potential. Essentially, the higher market potential changes the incentive balance between the licensor and the licensee, allowing the licensor to charge higher royalty rates.

H3: Royalty rate for a given level of IPR protection will be enhanced by market potential.

Economic Factor: Brand Strength

Brand strength or equity should theoretically allow the licensor to negotiate a higher royalty rate.

However, many prominent brands enter foreign markets through licensing to ensure brand protection. The nature of IPR laws are such that mere registration of a brand in a foreign market may not be sufficient to ensure its protection. The firm that registers a brand in a market may not retain its IPR unless it uses the brand within a certain period.6 Licensing the brand for use in the market will ensure that the brand is not dormant, and thus at risk of appropriation by other firms.

Therefore, firms may license their brands in a foreign market to ensure that they retain the rights to the brand and protect it from unauthorized use. In such situations, the firm may be focused to a greater extent on the protection of the brand in the foreign market than on the revenues that are generated. Firms that desire to protect their brand may be willing to offer lower royalty rates as an incentive to the licensee to avoid moral hazard and ensure licensee cooperation (Quelch

1985). In this regard, as the strength of the brand increases, the value in protecting the brand increases. Therefore, a negative relationship between brand strength and royalty rate is possible.

However, there is much literature in marketing and the resource based view of the firm that would argue that stronger brands should generate higher royalty rates because they allow

6 http://www.wipo.int/export/sites/www/about-ip/en/iprm/pdf/ch2.pdf (p.77)

15 licensees to build more successful businesses (e.g., Srivastava, Shervani, and Fahey 1999). From this perspective, brands are intangible assets and stronger the brand, the greater the potential for the licensee to generate profits by building an enduring business. As such, brand strength should allow licensors to appropriate higher royalty rates from licensees.

It is difficult for us to predict which of these effects will manifest. If the protection of the brand is of paramount interest when the brand is licensed, brand strength could be negatively associated with royalty rates. But, if revenue generation concerns dominate, stronger brands should result in higher royalty rates for the licensor. In the practitioner literature, Bass (2004) notes that revenue generation should be of lower concern than brand protection in licensing.

Quelch (1985) makes the observation that if brand protection concerns are dominant, licensor firms may be willing to settle for lower rates of royalty. Regardless, given the lack of strong theoretical guidance, we consider the impact of brand strength on royalty rates an empirical issue. A positive effect for brand strength on royalty rate implies that revenue generation concerns are dominant while a negative effect suggests that brand protection concerns prevail.

Cultural Factor: Uncertainty Avoidance

As we noted before, the international business literature considers cultural factors as important determinants of firm behavior in international markets. Hofstede (1980) has identified several cultural mechanisms that influence firm behavior in foreign markets – uncertainty avoidance, long-term orientation, masculinity, power distance, and individuality. We consider one of these cultural characteristics, uncertainty avoidance as a likely influence on contracting behavior.7

Uncertainty avoidance is a reflection of the extent to which a society deals with the risk perception that arises from the lack of clarity of future events. High uncertainty avoidance

7 From the perspective of agency theory and moral hazard, the other cultural factors are unlikely to have a bearing on contracting behavior.

16 societies will be prone to utilizing institutional mechanisms to compensate for perceptions of insecurity. Licensees in high uncertainty avoidance cultures are likely to perceive higher risks from licensing contracts and would require higher incentives. Therefore:

H4: Uncertainty avoidance index in the licensee market is negatively related to royalty rate.

Other Contract Characteristics and Royalty Rate

Contract Duration: The duration of the licensing contract is likely to be associated with the royalty rate. When a licensor signs a long-term contract, it would expect that the licensee will protect the brand and make the investments required to grow the business. For instance, in the context of franchising, Brickley, Mishra, and Van Horn (2006) find that contract duration is positively related to franchisee investments. As such, to limit moral hazard by providing incentives to the licensee, the royalty rate may be lower as the contract duration increases.

H5: Contract duration is negatively related to royalty rate.

Sales Guarantee: In some licensing contracts the licensee guarantees the licensor a certain level of sales for the licensed products. It is possible that a sales guarantee might enable the licensee to benefit from lower royalty rates. As noted previously, brand licensing has two key objectives – brand protection and revenue generation. Sales guarantee will help alleviate the risk perceived by the licensor as far as the revenues expected from the licensing deal are concerned. In turn, this will allow the licensor to focus on brand protection, and to ensure that the licensee‟s incentives provide the necessary motivation to protect the brand, offer a lower royalty rate.

H6: Sales guarantee by the licensee is negatively related to royalty rate.

Exclusivity: Whether the licensee has exclusive rights to the brand for that territory could influence the royalty rate. When a licensor offers exclusive rights to a licensee where the

17 licensee is the only entity authorized to sell products using the brand name, the licensor may expect higher royalty rates. However, given the exclusive arrangement, the licensor is also more dependent on the licensee to generate revenues using the brand as well as to protect the brand.

Therefore, the licensee may benefit from lower royalty rates in case of exclusive contracts.

Given the uncertain theoretical guidance, we leave this issue to be determined empirically.

Data and Measures

Data

We obtained most of the data to test our hypotheses from RoyaltyStat®. RoyaltyStat® has compiled a database of license agreements from the US Securities and Exchange Commission

(SEC) Edgar Archive. We did not consider technology licensing contracts and franchising contracts due to the different nature of these contracts compared to brand licensing contracts. We also eliminated contracts with missing data and ended with a usable sample of 90 contracts.

Brand strength ratings were obtained from experts in the licensing industry. Country-market characteristics were obtained from secondary sources. The measures are explained next.

Measures

Royalty Rate: Royalty rate (RR) is measured as a percentage of sales made by the licensee for the licensed products.

Contract Duration: Contract duration (CD) was measured in years as provided in the contract.

When the contract duration was declared as perpetuity, we considered the duration of the contract to be 99 years.

Country Characteristics: We obtained the data on countries from external sources. Gross domestic product or GDP was used as a proxy for the market potential in the licensed markets.

The GDP figures for the nations where the licensee received permission to operate were obtained

18 from the International Monetary Fund‟s World Economic Outlook Database (International

Monetary Fund 2007). When the contract pertained to multiple countries, we aggregated the

GDP measures for each market as it represents the total market potential in the licensed markets.

The IPR protection afforded in a country was measured using the Intellectual Property

Rights Index (IPRI) developed by the Property Rights Alliance.8 The IPRI consists of eleven factors that are divided into three main categories (legal and political environment, physical property rights, and intellectual property rights). In general, the approach of developing an index to capture property rights is widely employed (e.g., Johnson, McMillan, and Woodruff 2002).

We obtained the data for uncertainty avoidance (UA) from Geert Hofstede‟s listing of cultural index values (www.international-business-center.com/geert- hofstede/geert_hofstede_resources.shtml). For this measure also, we took an average of the measures for each country when a contract spanned multiple countries.

Brand Strength: External measures of brand strength (BS) were available through sources

(Euromonitor) for only a third of the brands in our database. Therefore, we turned to licensing industry experts to assess the strength of each brand in its primary industry relative to competitors on a seven point rating scale ranging from extremely poor to extremely strong reputation. Eleven industry experts provided brand evaluation information, and these experts reported an average of 21 years of experience in the licensing industry. The experts had specific experience in the major product categories pertaining to the contracts in our database. For all but four brands, we were able to obtain multiple respondent evaluations, and in these cases, their responses were averaged. Self-reported confidence in their brand evaluations was rated an average of 6.5 out of 7 with 7 representing extreme confidence. To assess the validity of these expert ratings, we correlated the expert brand strength ratings for the brands with archival

8 www.InternationalPropertyRightsIndex.org

19 measures of worldwide brand share obtained from Euromonitor for a subset of the brands, and obtained a significant correlation of 0.53 (p <.001). Thus, we are confident that the expert ratings we obtained reflect the strength of the brands in a licensing context.

Dummy Variables. The other variables, exclusivity (E) and sales guarantee (SG) were captured using dummy variables. We also included a dummy variable (M) to capture any effect of using multi-country versus single country contracts in the data.

Testing of Hypotheses

The hypotheses were tested through regression. We examined VIF statistics and did not see any evidence of multicollinearity. We took natural logs of all measures given the vastly different scales on which some of them were measured, and the skewness of the data (e.g., GDP). No evidence of heteroscedasticity was observed in the data (White‟s heteroscedasticity test, p>.23; see White 1980). The correlation matrix is provided in Table 1 and the results are discussed next and summarized in Table 2.

(Insert Tables 1 and 2 Here)

Results

The adjusted R-square for the equation was 0.31. The estimation provided support for several of the hypotheses proposed in the study. H1, which stated that IPRI will have a negative impact on royalty rate, was supported (p < .10). H2, which proposed that market potential had a positive association with royalty rate was supported (p<.05). H3, which predicted that market potential will enhance the royalty rate for a given level of IPRI was supported (p<.05). Brand strength had a negative association with royalty rate (p < .05). H4 was not supported. Therefore, uncertainty avoidance did not have an effect on royalty rate. H5, which suggested a negative association for contract duration with royalty rate, was supported (p < .05). Exclusivity had a negative impact

20 on royalty rate (p<.10) and sales guarantee (H6) did not influence royalty rate. Furthermore, using contracts which covered multiple countries did not affect the results. The implications of these findings are discussed next.

Discussion

Effect of IPRI on Licensor Risk Perception

Moral hazard can be limited through monitoring and incentives. In licensing contracts that span different countries across the globe, monitoring is difficult, and this difficulty varies from country to country. In addition, the risk of losses due to licensee moral hazard will vary based on the legal and regulatory protection afforded to the licensed property in various country markets.

Our results show that royalty rates are lower when the IPRI in the markets granted to the licensee through the contract is higher. This result suggests that licensors perceive lower risk from licensee moral hazard and brand violation by other entities because of the legal and regulatory framework in the licensed markets when IPRI is high. That is, the cost of licensing is lower when IPRI is higher, by virtue of the lower levels of monitoring required as well as the lower anticipated litigation costs to enforce intellectual property rights. The expectation of lower licensing costs in these foreign markets permits the licensor to lower royalty rates at higher IPRI levels. In essence, IPR protection lowers the risk of licensee moral hazard and the cost of licensing for the licensor. This allows the licensor to accept a lower royalty rate, and enables the licensee to retain more of the earnings from the licensing contract. This view received support from the managers that we interviewed to verify our results. To quote a manager, in markets with poor IPR protection “go for a higher royalty rate because that way you are getting incremental revenue to fight that battle, basically you‟re saying it‟s tougher, you‟re going to pay

21 me more so I‟m not incurring all the cost to protect myself because your country doesn‟t do a good job.”

Market Potential and Licensee Risk Perception

We find that market potential has a positive association with royalty rate, as expected. When the market potential is high, the licensee has sufficient incentive to build a strong business with the licensed product, and is more desirous of ensuring that the licensor supports this endeavor effectively. Furthermore, in markets of high potential, the licensee will potentially want to prevent licensor opportunism such as direct entry or contracts to multiple licensees. In effect, the potential loss to a licensee from licensor moral hazard will be higher when the market potential for licensed products is higher. Therefore, in markets of higher potential, concern amongst licensees about licensor moral hazard moves the negotiating position in favor of the licensor.

In addition, we find that market potential enhances royalty rate for a given level of IPRI.

On examining the interaction through the Aiken and West (1991) procedure (see Figure 1), we observed that at low levels of the moderator, market potential, royalty rate decreases as IPRI increases. However, for high levels of the moderator, royalty rate does not change appreciably as IPRI increases. This demonstrates that at low levels of IPRI, brand protection is the predominant concern resulting in higher royalty rates to account for the risk and costs of monitoring the brand. At high levels of IPRI, royalty rate varies with market potential. At high levels of IPRI, royalty rates are lower when market potential is low, and increase with market potential. At high levels of IPRI, increase in market potential changes the incentive balance between the licensor and the licensee. When the market potential increases, the licensee‟s dependence on the licensor increases relative to when the market potential is lower, allowing the licensor to charge higher royalty rates. The mantra for several of the firms where we interviewed

22 the managers seemed to be that in licensing, the priority seems to be protecting the brand first, with promoting the brand and profiting from it, important but secondary considerations. This viewpoint explains why, when IPRI is low, the royalty rates are high regardless of market potential, whereas when IPRI is high, brand protection is more assured and the focus shifts to revenue maximization based on market potential.

(Figure 1)

Brand Strength

We find that brand strength has a negative effect on royalty rate. In many instances, the brand may be licensed in a foreign market more for the purpose of ensuring that the licensor retains the rights to the trademark, which rights might lapse due to lack of use. In such cases, the incremental revenue that accrues to the licensor, while welcome, might be less of a concern relative to the focus on protecting the brand (Quelch 1985). When concerns about protecting the brand dominate relative to concerns about incremental revenue generation, the licensor might accept lower royalty rates. It can be argued that stronger brands can command higher royalty rates, especially because the licensee would now depend on the brand to a greater degree for its success. However, the owners of strong brands are also likely to provide stronger incentives to licensees to protect the brand, as reflected in the lower royalty rates. As mentioned previously, we discussed this issue with managers involved with licensing in 12 multinational firms.

Managers considered brand protection as a critical issue in licensing. To quote one manager, in the context of licensing, “It‟s brand first, revenue second.” Another manager mentioned that the

“the bigger the company the bigger the brand the less the revenue importance.” Another comment that reflected this sentiment was “The more we want that protection the more we are willing to accept that lower royalty rate.” The importance assigned to protection did vary across

23 firms, but there were firms that licensed primarily for the purpose of protecting the brand. This is understandable against the background that IPR laws allow only limited period protection for brand names on the basis of registration. If a firm does not use its brand in a specific market within the grace period, it may not retain the rights to the brand. Licensing is considered the least expensive way to ensure usage of the registered brand and its protection.

Other Contract Variables

Exclusive rights given to a specific licensee for the licensor‟s property had a negative effect on royalty rates. This shows the licensors‟ dependence on exclusive licensees. Sales guarantees offered by licensees did not affect royalty rates. However, contract duration did have a negative effect on royalty rates, suggesting that long-term contracts enhance the dependence of the licensor on the licensee.

Summary

We find that royalty rate in contracts is determined by two-sided moral hazard concerns, and therefore, is based on risk-sharing between the licensee and the licensor. Overall, the royalty rate is based on market and regulatory conditions that influence risk perceptions of the licensor and the licensee. Our results suggest that the licensee is not a „naïve‟ participant in the licensing process subject to the unilateral dictates of the all-powerful licensor, but an active one that negotiates licensing contracts to protect its interests. Overall, our findings are consistent with standard economic theory, as price adjustments through royalty rates provide incentives to account for market-based uncertainty.

Implications for Practice and Theory

Brand licensing, especially in international markets, has received scant attention in the marketing literature. As we noted before, brand licensing is different from brand extensions, although both

24 activities share the goal of leveraging the brand to enhance cash flow. Brand licensing, in addition, has the goal of protecting the brand from misappropriation or misuse. Furthermore, in brand licensing, the brand owner cedes some control over how the brand is used in markets that are at times difficult or costly to monitor. Therefore, moral hazard concerns occupy a key role in formulating the contract and providing incentives to both the principal and the agent. Our results demonstrate that brand licensing contracts are guided by concerns of two-sided moral hazard.

The results show how risk perceptions of moral hazard vary based on market characteristics that limit the need for monitoring by the licensor and enhance the need for licensor investment in the brand. Therefore, our results have implications for licensors as well as licensees.

Implications for Licensors and Licensees

The results demonstrate what factors can be used as indicators of moral hazard risk on the part of the licensee. Brand licensors can focus on IPRI to estimate the risk of moral hazard and vary royalty rates on the basis of such assessment. Brand licensors can also use the results of the study to see how market potential can be employed to negotiate higher royalty rates. From the perspective of licensees, the reverse indications would apply. Overall, from the standpoint of structuring brand licensing contracts, the study offers findings that can enhance the efficiency of such contracts by providing insight into factors that allow licensors and licensees to balance their interests. The findings are particularly useful to licensors because they demonstrate how brand licensing is different from technology licensing. In technology licensing, incentives in terms of low royalty rates are offered to limit licensee moral hazard when IPRI is low (Park and Lippoldt

2005). In brand licensing, our results show that the reverse is the case – higher royalty rates prevail when IPRI is low. This is so because, and as discussed previously, brand protection is a key consideration owing to higher risks of misuse and longer life of brand assets relative to

25 technology assets. Therefore, when IPRI is low, the higher costs of monitoring necessitate higher royalty rates.

From the perspective of licensors, the study also highlights the importance of brand licensing as a means of brand protection, especially in international markets. As we noted previously, mere registration of a brand may not afford it the protection that the firm desires.

Licensing as a means to brand protection is why stronger brands seem to opt for lower royalty rates, consistent with Quelch‟s (1985) observation that licensors might compromise on royalty rate to contract with reliable licensees. The role of licensing in protecting the intellectual property rights embedded in a brand does not get much attention. By addressing brand licensing from an agency perspective, and by focusing on the role of IPR, this study provides guidance to brand owners on the importance of brand protection.

In effect, the conclusion is that while firms may license a brand to generate additional revenues as much anecdotal evidence points to, the drive for enhancing the revenues is balanced by the need to protect the brand from licensee moral hazard. But, the perceived risk from licensee moral hazard and the corresponding need for incentives to motivate the licensee do not entirely tilt the power in these negotiations towards the licensee. The licensee is also dependent on the licensor to make investments and support the brand. Therefore, as the market potential goes up, and the importance of the brand to the licensee is enhanced, the licensor is able to extract higher royalty rates. As such, the concern for moral hazard on both sides seems to ensure that royalty rates are determined to meet the needs of both parties to the agreement.

Overall, the study offers insights into factors that allow both licensors and licensees to balance their interests in brand licensing in external markets.

Implications for Theory

26 First, this study addresses the important issue of brand protection. Marketing scholars have long addressed the importance of brand assets, and the ability of firms to leverage brand assets to enhance cash flows. Traditionally, theories of firm performance emphasize developing and leveraging assets to sustain and enhance cash flows, but do not focus on the steps to be taken to protect the property. As we have noted, such steps to protect brand property are critical, especially as brands fall into the category of intellectual property where violations of property rights are relatively easy and widespread. Violation of intellectual property rights associated with brands do not merely take away revenue that rightfully belongs to the owner of the brand, but could also devalue the brand such that the owner‟s ability to leverage the brand to generate future revenues is compromised. From a research perspective, this study emphasizes the need to protect marketing assets, an issue that does not get as much attention as leveraging such assets.

Second, the study provides greater insight into the potential of brand licensing as a mode of market entry. International business literature has examined in great detail the role of arms- length mechanisms as a means to enter foreign markets where the firm does not have sufficient experience, or where the market potential may not warrant a direct entry. Licensing is one such approach to entering unfamiliar markets, and can be considered a market experiment where the firm assesses the potential for success in a foreign market at a low investment. Licensing, as such, provides firms with the ability to monetize the brand asset in unfamiliar markets without the need for substantial investments. Brand licensing as a mode of entry in a foreign market has not received the attention it deserves.

Third, the study emphasizes situations where two-sided moral hazard concerns matter in marketing. The results from the study show how both sides to brand licensing contracts can protect their interests through effective structuring of contracts. From a theoretical perspective,

27 the study shows the two-sided nature of agency issues in marketing contracts. While two-sided agency issues have been addressed in the economics literature, they have not received much attention in the marketing literature. In marketing, agency problems are examined from the traditional perspective where the principal is seen as risk-averse. The two-sided agency formulation employed shows situations where the principal is not risk-averse, and both the principal and the agent take into account their relative risk while structuring agency contracts.

Implications for Public Policy

From a public policy perspective, the study provides some guidelines into the advantages of strengthening IPR regimes. Countries could be net IP exporters or importers. In general, it might be expected that countries that are net IP exporters will benefit from strong IPR protection in foreign markets (Park and Lippoldt 2005). Net IP importers might suffer, at least in the short- term, from higher costs of copying, monopolistic behavior of IP owners, and higher rent transfer to IP exporters, although they might benefit in the long-term because of enhanced technology transfer and domestic innovation (Maskus 2000). In other words, IPR reform is based on the premise that IP importers will benefit because IP rights-holders will be less reticent to transfer knowledge (Park and Lippoldt 2005). Regardless, the concern that strong IPR will shift income to IP exporting countries might impact the establishment of such regimes in a country (Maskus

2000). However, in this study, we find that higher IPRI benefits firms in the importer nation because the licensee is likely to get a lower royalty rate. As such, the licensee gets to retain more of its earnings when the IP regime in its country provides adequate protection to IP rights. This would help generate more taxes for the nation that imports IP. These benefits are over and above the advantages that accrue to a nation when they strengthen IPR, such as attracting higher investment and advanced technology transfer.

28 Limitations and Future Research Directions

The study is based on cross-sectional data, and the ability to draw causal conclusions is usually limited with such data. However, in the context of this study, this is not a critical issue as our objective really is to compare the differences in royalty rate based on market characteristics that influence risk propensities of both the licensor and the licensee. A cross-sectional comparison is more feasible in this context, especially because some of the country characteristics that we consider do not change much over relatively short time-frames.

We could not obtain brand strength measures for all brands in our dataset from secondary sources. This led to our decision to get industry experts to rate the brands. The strong correlations of the expert assessment of brand strength with archival measures of brand strength for those brands where such measures were available should alleviate concerns of the validity of this measure. Furthermore, we managed to obtain multiple raters for most of the brands included in the study.

Based on data from licensing contracts, we find evidence that supports a two-sided moral hazard argument based on agency theory. We find that moral hazard concerns are the primary determinants of royalty rate. What we could not examine, because of limited data availability, were the conditions under which different payment structures such as fixed fee and royalty rates are employed. Fixed payments are also more popular when licensed products are components in a system, and individual sales for the licensed products are difficult to establish (Johnson 2001).

It will be worth examining whether such differential payment structures are the result of the nature of the knowledge that underlies technology products and brands.

We are not in a position to determine whether specific licensor characteristics, other than brand strength, play a role in determining royalty rates. It is quite likely that the experience of

29 the licensor in foreign markets might influence the structure of the licensing contract. Similarly, licensee characteristics such as experience might also influence the licensing arrangement. The data for these characteristics are not available from secondary sources and obtaining such data would require primary data collection efforts.

Collecting primary data will also allow researchers to examine the relative impact of the motivations of the licensor regarding protection of the brand and leveraging the brand to enhance cash flow through licensing. In this study, an underlying postulate is that the negative impact of

IPRI on royalty rates is driven by the desire of the licensor to protect the brand. While our findings lend credence to this assumption, a direct test of the impact of the motivation to protect the brand in contrast to the motivation to generate maximum revenue by leveraging the brand property will help managers gain greater insights into the interplay between these two, sometimes conflicting, objectives. We also suggest that the royalty rates increase with market potential because of the desire of the licensee to ensure support from the licensor, who might shirk from such resource provision in the absence of adequate incentives. A direct test of this premise through primary data will help shed further insights into the incentive-alignment process that shapes brand licensing contracts.

30 TABLE 1 CORRELATION MATRIX

Royalty Brand Contract Uncertainty Long-Term Exclusivity Rate IPRI GDP Strength Duration Avoidance Orientation Royalty Rate 1

IPRI -.16 1 GDP .28 .27 1 Brand Strength -.16 .11 .17 1 Contract Duration -.41 -.04 -.30 -.03 1

Uncertainty Avoidance -.01 .20 -.04 -.12 .22 1

Exclusivity -.16 .04 -.09 -.17 .24 .22 .12 1 Sales -.04 .00 .15 .09 .07 .13 -.19 -.01 Guarantee

31 TABLE 2 Dependent Variable: Royalty Rate

Vqariables B Std. Error IPRI (H1) -0.95* 0.55 GDP (H2) 0.19** 0.07 IPRI x GDP (H3) 1.05** 0.43 Brand Strength (H4) -0.61** 0.23 Contract Duration (H5) -0.26** 0.08 Exclusivity -0.36* 0.21 Sales Guarantee 0.44 0.34 Uncertainty Avoidance 0.01 0.29 Multiple Country Dummy -0.35 0.22 **p<.05 *p<.10

32 FIGURE 1 Interaction Effect of IPRI (IV) and Market Potential (Moderator) on Royalty Rate

5

4.5

4

3.5 Log Low Market Potential 3 (Royalty High Market Potential Rate)2.5

2

1.5

1 Low High IPRI IPRI

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