This article was originally written and published in a longer form by the American Bar Association on March 22, 2023.
Non-fungible tokens (NFTs) are not likely to revolutionize all forms of intellectual property (IP) marketing, but in some use cases they can improve the efficiency of licensing and provide monetization opportunities that might not otherwise be available.
Like with any new technology, there are many uncertainties about how NFT markets will develop. Currently, there are significant challenges to tokenizing IP, including how certain legal requirements, such as a signature requirement for transfers included in the Copyright Act, can be harmonized with tokenized assets; how tokenization can be compatible with highly regulated industries such as franchising; and how tokens can be claimed by those with security interests or contractual rights that are breached.
Despite those roadblocks and uncertainties, every business that drives its revenue with IP should be closely watching blockchain developments to identify opportunities on the horizon.
What is Tokenization?
"A 'non-fungible token' or 'NFT' is an encrypted unit of data on a digital ledger, typically a 'blockchain.'" When an NFT is minted, code is embedded into a digital token associated with an underlying asset using a smart contract that governs the token's ownership, sale and transfer.
"Essentially, an NFT is a unique 'digital object' that someone can own, sell or buy." They are non-fungible in the sense that each NFT is unique, has no identical counterpart, and cannot be exchanged for another identical NFT. That does not mean, however, that they cannot be exchanged or transferred. It just means that no two NFTs are identical.
Tokenization of IP is attaching certain IP rights to NFTs. NFTs may provide a vehicle to streamline transactions involving those IP rights. By "tokenizing" IP rights and embedding smart contracts, it may be possible to:
- Reduce transaction costs
- Broaden the number of potential licensees
- Provide more flexibility for nascent or small businesses
Smart contracts are agreements where execution is automated to ensure performance by eliminating the need for human interaction. The smart contract self-executes at the time of transfer and enforces its terms without any human party interaction.
These smart contracts may include all manner of restrictions related to the sale of NFTs. For instance, should a franchise operation right be sold through an NFT, all the duties and obligations of a franchisee would have to be included in the terms governing the sale of that token.
One particularly attractive feature of smart contracts in the tokenization of IP is resale royalty rights. As discussed in more detail below, these resale royalty rights may incentivize IP owners to allow for a broadened range of licenses and provide protection for businesses seeking to license IP.
Tokenization Could Reduce Transactions Costs
One of the biggest transaction costs in selling and licensing IP is the legal cost. By tokenizing certain IP rights, the need for negotiated agreements can be eliminated. The result is less friction in the system of IP exploitation. Of course, on the other hand, the terms offered are take-it or leave-it terms, which may result in fewer completed transactions.
Additionally, the unique legal requirements of IP transfers must be considered in creating viable NFTs. For example, exclusive licenses and assignments of copyrights must bear the actual signature of the assignor and must be in writing. That means copyright tokenization of anything other than nonexclusive licenses must have a written signature. This currently presents an obstacle to implementation of copyright transfers through a smart contract. Similar limitations will also apply to patent transfers. These signature requirements add a layer of inefficiency to the typical NFT.
Trademarks present even thornier issues, as the sale of a trademark usually requires the sale of the goodwill associated with the use of the trademark. Further, licensing trademarks may trigger both state and federal franchise laws.
With these limitations, finding the right IP to tokenize can allow for efficient transactions, including repetitive nonexclusive transactions. In situations where there is a market for repeated transactions, most of the transaction costs will be in minting the first token. Each subsequent token could simply follow the path created by the first smart contract. That is a huge opportunity to eliminate transaction costs for repetitively licensed IP rights.
Tokenization Could Grow the IP Marketplace
While some of the problems with tokenized IP rights can undermine efficiency, the take-it-or-leave-it nature of tokenized rights can increase the market for IP rights. By offering these nonnegotiable terms, owners can advertise their IP broadly without the concern of experiencing expensive marketing or legal costs for unqualified purchasers. Such a system of take-it-or-leave-it IP rights may generate a marketplace.
Today, many IP rights are broadly distributed. OpenSea, the largest U.S. NFT marketplace, is proof that an NFT marketplace can be viable. OpenSea allows individual users to mint (create) NFTs and to buy or sell NFTs either at a set price or through an auction system, and to embed smart contracts in those NFTs.
A similar system might allow those seeking IP rights to engage in one-stop shopping through a single marketplace where various NFTs associated with IP rights and their embedded terms would compete with one another. One-stop shopping makes it easier for less sophisticated buyers to participate in the marketplace and could well broaden the scope of potential licensees.
Imagine a marketplace that enables nonexclusive patent licensing without the need for every single deal to be negotiated or sold and that allows smaller businesses to license patents on transparent terms and prices. Such a marketplace could also be a way forward for some franchise models with every territory marketed by an NFT. In this instance, whoever owned the NFT would have a right to operate a franchise in that market pursuant to the terms of the smart contract. For franchising, this is probably a better fit where the franchise success is based on business know-how as opposed to exacting brand standards. In theory, the market would determine which franchise models best fit into such a tokenized marketplace.
No matter the IP rights offered, increasing the number of buyers and licensees will increase the value of IP rights and benefit the creators. In this way, IP tokenization can be a blue water model for creating whole new markets.
Tokenization Could Create More Flexibility for Small Businesses
Most small businesses fail. This complicates licensing to small businesses both from the licensor and the licensee sides. From the licensor's perspective, that a small business will likely fail means that fewer royalties can be expected. From the licensee's perspective, it means the risk in licensing expensive IP rights is great, because the business is not likely to generate a significant return on the investment. Some of this risk is just what it means to start a business. But NFTs and smart contracts can mitigate some of that risk.
The value of NFTs is, to a degree, determined by how easily traded they are. This may allow licensees to pay a higher amount for tokenized IP rights, if the terms allow for resale in the event that the new venture fails. Smart contracts may incentivize allowing for the transfer of tokenized rights because a built-in resale royalty can be included in the self-executing smart contract.
For instance, such a system could give purchasers the ability to buy, sell or trade franchise rights with a smart contract that has a redistribution royalty rate baked in. That could increase the value of the initial sale and ensure that any subsequent sale would generate at least some payment to the IP's ultimate owner.
The more flexibility that can be created in sales and licenses means more participation in the marketplace and more opportunities to monetize various forms of IP.
The Importance of Tokenization to Companies
In today's economy, assertion of IP rights is a major source of income for some industries. This is true of both practicing and nonpracticing entities. Assertion of IP is just the enforcement of IP owners' rights. The U.S. regulatory system provides for broad exclusive rights in most IP, but it is incumbent upon the owner to bear the cost of bringing a lawsuit or other administrative agency enforcement action.
For assertion, proof of ownership is the very first step to any action. Tokenization of IP rights ultimately may provide definitive proof of ownership. If blockchain registries become the best evidence of ownership, tokenization may be incredibly important to those looking to enforce their rights.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
