March 01, 2015

As a licensor monetizing your intellectual property (“IP”) through licensing royalties based on future sales, have you ever wondered whether your licensee is paying the royalty according to the negotiated terms, who is the right person to contact when questions arise regarding royalty related issues, or what is the best way to confront your licensee regarding potential royalty underpayments without jeopardizing the relationship? A post-license monitoring program is a useful tool that addresses these questions and helps maximize your licensing revenue. This article discusses some of the key elements to consider when structuring a post-license monitoring program.

When a licensor and a licensee enter into a license agreement, both parties commit to a long-term relationship that is mutually beneficial. For example, the licensee needs the granted IP rights to legally make, use, and/or sell the licensed products and/or services while the licensor benefits from the licensee’s commercialization of the IP through some form(s) of payments. For licenses, due to the technology, market, and types of products, including payment terms that involve ongoing royalties based on future sales of the licensed products, it is important for the licensor to institute a systematic method for monitoring the reported royalties to confirm that the reporting and payment of the royalties are in compliance with the terms of the license agreement.

A well devised post-license monitoring program not only ensures proper royalty reporting and payment, but also enhances the relationship and elevates it to a partnership. The following are some key elements to consider when setting up such a program.

Communications

Constant and consistent communication with your licensee is one of the key elements for a successful post-license monitoring program. Such communication helps maintain a healthy relationship based on mutual respect and understanding. Communications with the licensee need to be at multiple levels, including the licensee’s legal, negotiation, and technical teams. In addition, a communication window with the individual in charge of royalty reporting within the company should be established. The benefits of constant and consistent communications at multiple levels with your licensees are numerous:

  1. Knowing whom to contact when questions arise
  2. Building trust and minimizing surprises, which are rarely pleasant in such a relationship unless it relates to a scientific or commercial breakthrough
  3. Conveying a consistent message regarding the desire to ensure the compliance of all terms and conditions, including the proper reporting and payment of ongoing royalties
  4. Gaining an understanding of the method and source of information relied on by the licensee personnel to prepare the royalty reports
  5. Enhancing the opportunity for future collaboration and technology licensing

Active monitoring and feedback

Active monitoring of the royalty reports and licensee activities will provide you with clues regarding the question of whether or not your licensee is paying the royalty according to the negotiated terms. It is often the case that a license agreement has terms that seemed explicit and unambiguous to you at the time of negotiation and execution, but in practice has resulted in ambiguity and misinterpretation. Our experience indicates that the number one culprit for royalty underreporting is misinterpretation of the license terms. Claiming disallowed deductions, unreported sublicenses, and use of the wrong royalty rate are other frequent causes for royalty underreporting. Even in the case where the parties are on the same page regarding the terms of the agreement, underreporting could occur when licensed products expand and/ or are modified from the original negotiation and the licensee fails to include the new products in the royalty report. Besides checking for mathematical errors and missing milestone payments, active monitoring should include other steps that help identify potential areas of vulnerability or red flags for misreporting. Examples of such steps include, but are certainly not limited to, the following:

  1. Tracking the sales trend of the royalty reports to monitor the relative increases and decreases over time
  2. Comparing the reported sales trend to the licensee’s public statements
  3. Comparing the reported sales trend to industry benchmarks such as competitor products and market share
  4. Noting changes such as the categories within the royalty reports, the person responsible for the reports, or the exclusion of certain schedules
  5. Monitoring new product launches or the expansion into new markets/territories of existing licensed products

Material deviations or unexplained changes observed through any of the aforementioned and other monitoring steps should be communicated to the licensee in an effort to elicit feedback. In some cases, a friendly in-person visit with the licensee, particularly in the early stage of the license period, may be warranted. This helps you get acquainted with the person in charge of royalty reporting as well as ironing out any kinks in the royalty reporting based on your initial observation. In all cases, active monitoring allows you to identify issues early before they become too big and complicated and, therefore, increases the likelihood of resolving the issues quickly without jeopardizing the relationship.

Timely Royalty Audit

While certain issues can be identified and resolved through active monitoring, other issues may require an onsite royalty audit. Royalty audits can be either proactive or reactive and both have their place in cultivating the relationship with your licensee. A proactive audit puts the licensee on notice that the terms of the license agreement will be enforced and adhered to from the outset of the relationship. Communication at the beginning of the relationship of your intent to audit the licensee on a regular basis over the life of the agreement will go a long way in avoiding the appearance of accusing the licensee of a violation. Furthermore, a consistent practice of proactively auditing all of your licensees convincingly demonstrates your willingness to protect your rights under the agreement. Finally, a proactive audit may reveal ambiguities or weaknesses not previously identified in the terms of the agreement, thus allowing the parties to clarify and repair those issues.

A reactive audit, generally performed in response to a specific incident that may call into question the practices of the licensee, intentional or otherwise, can also help to cultivate the relationship with your licensee if performed at the appropriate time. Justifying the need for a reactive royalty audit through analytical or objective reasoning, such as the items discussed previously in the active monitoring section, can alleviate some of the common feelings of perceived persecution by a licensee.

Whether a proactive or reactive audit, the key is to perform the audit on a timely basis. One of the worst things that a licensor can do to jeopardize the relationship with the licensee is to wait until the issues become too big and complicated to fix quickly and amicably. Cash flow and budget are very important in running a business operation smoothly and successfully. For a smaller private company, the accumulated underreported royalty amount may cause a significant squeeze to the company’s cash flow and put a strain on its operations. For a publicly traded company, the implication of a sudden large, unbudgeted royalty payment goes far beyond the cash flow. For example, it is difficult for the unexpected expenses to be absorbed into the company’s financial reporting without causing unwanted attention and careful explanation. In some extreme cases, we have seen the licensor wait too long to address an issue and allowed time for the licensee to simply close down its domestic business and transfer all of its assets overseas to avoid the royalty payment all together.

Unless you are willing to accept whatever is reported and paid, a timely audit can help recover underreported royalties while avoiding straining the relationship with your licensee.

Selecting the Right Auditor

Assuming you have made the decision to audit your licensee, selecting the right auditor to perform that audit is paramount in maintaining a healthy relationship with your licensee. The right auditor should be experienced and knowledgeable in the industry in which they are auditing. The auditor should avoid any appearance of a conflict of interest. Furthermore, the auditor should be sensitive to the fact that the relationship with the licensee is a partnership and should know how to perform a thorough investigation while maintaining a positive relationship with the licensee. Finding an auditor who is persistent, knows what questions to ask, and shows respect to the employees of the licensee while strictly adhering to the audit procedures will help to ensure a successful audit.

In conclusion, there are four primary stages in the IP monetization life cycle, namely identification, valuation, licensing, and postlicense monitoring. Many organizations spend a tremendous amount of effort in and through the licensing of the IP. Post-license monitoring is often the least discussed because of the desire to maintain a good relationship with the licensee and, therefore, an unwillingness to rock the boat. However, as discussed, a wellplanned post-license monitoring program that entails constant and consistent communication, active monitoring, and timely auditing by a qualified auditor can enable a licensor to cultivate the relationship with the licensees without leaving money on the table.

Editor’s Note: This article was originally published in the Licensing Executives Society, Inc. (LES) Insights on November 17, 2014.