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.
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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
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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.
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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)
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(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
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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.
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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).
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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 distribution channels, or offer low prices that alter the
brand‟s positioning 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
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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.
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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.
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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
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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
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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)
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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
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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
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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)
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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.
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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
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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
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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
20
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
21
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
22
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
23
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
24
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
25
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
26
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
27
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,
28
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.
29
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
30
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.
31
TABLE 1
CORRELATION MATRIX
Royalty
Rate IPRI GDP
Brand
Strength
Contract
Duration
Uncertainty
Avoidance
Long-Term
Orientation
Exclusivity
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
Guarantee .15 .09 .07 .13 -.19 -.01
-.04 .00
32
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
33
FIGURE 1
Interaction Effect of IPRI (IV) and Market Potential (Moderator) on Royalty Rate
1
1.5
2
2.5
3
3.5
4
4.5
5
Low
IPRI
High
IPRI
Log
(Royalty
Rate)
Low Market Potential
High Market Potential
34
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