In this paper we study the relationship between capacity constraints and licensing strategies. To do so, we focus on the licensing strategy of an outside patentee who licenses a process innovation to the downstream sector of a vertical Cournot oligopoly. Downstream firms source their input requirements from an upstream sector in which a subset of firms is capacity constrained. It is shown that (1) the patentee licenses large innovations via per-unit
royalty contracts and small innovations via fixed-fee contracts; (2) an increase in the number of capacity constrained upstream firms makes it more likely that the patentee opts for a per-unit royalty contract; (3) depending on the number of capacity constrained upstream firms, privately optimal per-unit royalty contracts may maximise economic welfare.

