Marketing Science Institute Special Report 09-209 Intellectual Property Rights and Brand 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 brands to leverage their value 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 sales (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 retail sales from licensed properties, double its revenue from licensing six years ago (License! 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 advertising, 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