What is licensing and its types?

A software license is a document that provides legally binding guidelines for the use and distribution of software.

Software licenses typically provide end users with the right to one or more copies of the software without violating copyrights. The license also defines the responsibilities of the parties entering into the license agreement and may impose restrictions on how the software can be used.

Software licensing terms and conditions usually include fair use of the software, the limitations of liability, warranties and disclaimers. They also specify protections if the software or its use infringes on the intellectual property rights of others.

Software licenses typically are proprietary, free or open source. The distinguishing feature is the terms under which users may redistribute or copy the software for future development or use.

How do software licenses work?

A software license is a document that states the rights of the developer and user of a piece of software. It defines how the software can be used and how it will be paid for. The following are some examples of specifications a license might include:

• how many times the software can be downloaded;
• what the software will cost; and
• what level of access users will have to the source code.

Licenses typically are expressed as an end-user license agreement or an enterprise license agreement. The license is a contract between the user or user organization and the developer. It defines the terms of the license. A user must agree to the terms of the license when acquiring the software.

Software also comes with a license key or product key. The key is used to identify and verify the specific version of the software. It is also used to activate the software on a specific computer or device.

Why software licenses are important

A software license establishes the rights of all parties involved with the software: the author, the provider and the end users. It defines the relationship between the software company and users and explains how they are protected.

How license agreements protect developers

How license agreements protect users

• They define what users can do with software code they did not write.
• They establish how users stay in compliance with software licenses, protect themselves from infringement claims and limit their legal liability.
• They help users maintain a positive relationship with software developers and vendors.
• They prevent overspending on licenses by establishing clear parameters of how many licenses an organization needs.

What are the different types of software licenses?

There are two general types of software licenses that differ based on how they are viewed under copyright law.

• Free and open source software (FOSS) licenses are often referred to as open source. FOSS source code is available to the customer along with the software product. The customer is usually allowed to use the source code to change the software.
• Proprietary licenses are often referred to as closed source. They provide customers with operational code. Users cannot freely alter this software. These licenses also usually restrict reverse engineering the software's code to obtain the source code.

A more detailed list includes five types of software licenses. It makes finer distinctions among various types of open source licenses and proprietary licenses. This list includes the following:

• Public domain. This software is freely available. Anyone can use and change it or incorporate code from this software into an application. However, businesses should use caution as altered code may not meet enterprise quality and security standards. Companies should be wary of ambiguous licenses that appear to be public domain but do not explicitly say so.
• Lesser general public license. Developers can link to open source libraries within their software and use any licensing type for the code.
• Permissive. This type of license will establish some requirements for distribution or modification of the software. It also has requirements for preserving license notices, copyrights or trademarks. There are several variations of permissive licenses, including Apache, BSD (Berkeley Source Distribution) and MIT licenses.
• Copyleft. Licensed code may be distributed or modified as part of a software application or project if all code involved is distributed under the same license. New products containing old code with a copyleft license must comply with the restrictions laid out in the old code's license.
• Proprietary. This is the most restrictive license type. Proprietary software licenses make it illegal to copy, modify or distribute the software. These licenses provide the software owners with the most protection from unauthorized use of the software.

How much does a software license cost?

The cost of a software license depends on the type of license, the type of software and the pricing model. There may be a one-time fee that gives the user ownership rights to the software program. This approach is considered the traditional way of owning software -- buying the license up front and gaining the rights to use the software indefinitely. This type of purchase agreement is known as a perpetual license.

Alternatively, the user may pay an initial fee followed by a subscription plan where payment is made at regular intervals.

License costs are often based on the number of users and devices that use the software. They may also depend on the software deployment method. Costs can increase with add-ons, upgrades, maintenance fees and other fees. Depending on these factors, software license costs can vary from free or nearly so, to many thousands of dollars.

Tracking software licenses and costs can be particularly difficult across virtualized servers, mobile devices and the cloud operations.

What does a software license agreement include?

End-user license agreements typically include basic information about the parties entering the agreement, such as full names of the parties involved, contact information and address of the parties. It also likely includes information on the following:

• when the conditions of the agreement go into effect (i.e., the moment the user accepts the terms and conditions);
• charges owed per user;
• the duration of the agreement;
• terms of cancellation and terms for recovery of charges if cancelled during the period covered by the original agreement;
• distribution permissions and limitations;
• user rights for copying the software and making modifications;
• software performance guarantees;
• the number of eligible users;
• maintenance, upgrades and support that is included;
• how many devices will be allowed to use the software;
• disclaimer of warranties;
• transferability of the license to another business or person;
• exclusivity or non-exclusivity of the software to any one customer; and
• governing law and which entity will have jurisdiction over legal disputes about the license.

Software licensing and the pandemic

The COVID-19 pandemic underscored some of the more serious challenges involved in managing software licenses. Many companies were not prepared for the sudden increase in demand for software licenses when their workforces went remote. They needed additional licenses for web conferencing, messaging and communications software. They also needed quick access to more security software licenses.

For many companies, this unexpected demand and expense meant they had to get creative in their approach to software licensing. Buying everyone a license for every application was not always the best answer. Instead, some organizations opted to buy licenses according to an employee's function. They also looked at shared license models, setting up portals where employees can request licenses as needed.

Understanding a Licensing Agreement

In a typical licensing agreement, the licensor agrees to provide the licensee with intellectual property rights such as the licensor’s technology, brand name, or product creation know-how. In exchange for the licensor’s intellectual property, the licensee typically plays an upfront fee and/or a royalty fee to the licensor. A royalty fee is an ongoing fee paid for the right of use of the licensor’s intellectual property.

It is important to remember that:

• The party that is providing intellectual property rights to another party is called the licensor
• The party that is receiving intellectual property rights from another party is called the licensee

Example of a Licensing Agreement

In May 2018, Nestle and Starbucks entered into a $7.15 billion coffee licensing deal. Nestle (the licensee) agreed to pay $7.15 billion in cash to Starbucks (the licensor) for exclusive rights to sell Starbucks’ products (single-serve coffee, teas, bagged beans, etc.) around the world through Nestle’s global distribution network. Additionally, Starbucks will receive royalties from the packaged coffees and teas sold by Nestle.

The licensing agreement provided Starbucks with the ability to drive brand recognition outside of its North American operations through Nestle’s distribution networks. For Nestle, the company gained access to Starbucks’ products and strong brand image.

Advantages of Licensing

The advantages of licensing can be viewed from two perspectives: licensor and licensee.

Advantages to the licensor include:

1. The licensor being able to utilize the licensee’s distribution network to quickly enter into new geographical regions and foreign markets
2. The licensor facing lower capital requirements and lower costs due to not having to invest in distribution
3. The licensor having the ability to generate passive revenues through royalties
4. The licensor being able to gain the expertise and skills of the licensee

Advantages to the licensee include:

1. The licensee gaining access to established intellectual property and being able to enter the market more quickly
2. The licensee not having to pool resources to conduct research and development to develop their own products or services
3. The licensee being able to generate revenues by using the intellectual property of the licensor

Disadvantages of Licensing

The disadvantages of licensing can be viewed from two perspectives: licensor and licensee.

Disadvantages to the licensor include:

1. The licensor having loss of control of their intellectual property
2. The licensor having to depend on the skills, abilities, and resources of the licensee to generate revenues
3. The licensor being exposed to intellectual property theft by the licensee

Disadvantages to the licensee include:

1. The licensee being responsible for production, marketing, selling, etc.
2. The licensee potentially being dependent on the licensor’s intellectual property
3. The licensee having to pay an upfront fee and/or royalty to the licensor

Related Readings

CFI is the official provider of the Financial Modeling and Valuation Analyst (FMVA)™ certification program, designed to transform anyone into a world-class financial analyst.

To keep learning and developing your knowledge of financial analysis, we highly recommend the additional CFI resources below:

• Copyright
• Equipment Lease Agreement
• Intangible Assets
• Products and Services