Businesses that enter into agreements to license their intellectual property often do so with the goal of maximizing their potential revenues. However, in many cases, they fail to realize that it is profits instead of revenues that should be optimized for, and to optimize profits, they need to minimize the costs associated with monitoring their licensing revenue streams. Optimizing for profits can be achieved, in part, by focusing on two primary issues when negotiating a licensing agreement:

• How to ensure that the licensee will report royalty payments accurately
• How to ensure that, if audited, the licensee will provide the information necessary to prove compliance both efficiently and without ambiguity

Novice and seasoned licensors often overlook the importance of using contract language to instruct their licensees on how to calculate the royalties and preserve the documentation that supports those calculations. In the absence of a trained accountant’s or royalty expert’s involvement, those drafting the contract may fail to appreciate the nuances inherent to royalty reporting and the negative outcomes that can result from differing interpretations of vague contract language.

Licensees that are required and incentivized to calculate royalties correctly and maintain complete, organized, and readily producible records will usually make more accurate royalty payments. They will also reduce the licensors’ desire to conduct potentially costly, time-consuming royalty audits in attempts to uncover underpayments.

In our comprehensive Royalty Audit Guide, we explain the royalty auditing process and the red flags that licensors should continuously monitor, and we provide an in-depth analysis of the various contract provisions that can have outsized impacts on licensors’ ability to conduct and complete thorough audits of their licensee relationships. 

In this article, we address contract provisions that can help to both mitigate those red flags and facilitate future royalty audits. Specifically, we will discuss the contract terms that concern:

• The royalty calculation methodology
• Requirements of the licensee to maintain adequate documentation 
• Other periodic reporting by the licensee

The Royalty Calculation Methodology

Typically, this section of the license agreement is among the most scrutinized and heavily negotiated. In practice, devising a royalty calculation mechanism is highly dependent upon what exactly is licensed and for what purpose. An author licensing her book to a publisher will likely have a royalty calculation that differs drastically from that of a public company that licenses a patent portfolio to a chip manufacturer. There are and should be questions of whether the royalty is calculated and paid based on quantities of sales or sales dollars, invoiced price or MSRP, and sales orders or actual deliveries. The licensor and licensee should consider nuances specific to the licensed property and how the licensee intends to or could otherwise exploit it.

An alternative to the tailored approach is using one side’s template contract and making minor modifications. Negotiations may be prone to this route when one side, typically the licensee, possesses outsized bargaining power, as often occurs when the licensor is an individual (e.g., patent owner, author, etc.). If the licensor lacks the ability to affect the royalty calculation mechanism, it is important that they ensure the contract contains a comprehensive section which affords the right to perform regular audits of the licensee’s royalty reporting.

Assuming the parties agree to negotiate the royalty’s mechanics, each should ensure that it considers and balances two key criteria: sufficient specificity and the licensee’s ability to produce the applicable supporting data when requested.

Specificity: A well-defined royalty calculation minimizes room for interpretation. This is important for several reasons, not the least of which is that various stakeholders – not simply those drafting the contract – will ultimately be responsible for determining what the parties meant when they executed it. This includes the licensor’s accounts receivable and internal audit personnel, the licensees’ accounting personnel and auditors, legal counsel, potential royalty auditors, and, in instances where a dispute arises, arbitrators and judges.

Drafters should take care to define key terms (e.g., “net sales”), and where possible, ensure that those definitions align with industry-standard definitions. For example, we have analyzed numerous license agreements that define gross sales as sales after deductions for discounts, returns, and taxes; however, accounting professionals consider “gross revenue” to reflect revenue before any such deductions.

Further, when royalties are calculated based on sales, the drafters should endeavor to define all of the parameters around what constitutes a sale. For example, whether a sale is constituted by a sales order, invoice, delivery, or payment. To the extent royalties are calculated on some form of net sales (i.e., after certain defined deductions), the contract should define parameters for any deductions, ideally in a way that aligns with the parameters used for the sales. For example, if the royalty for a pharmaceutical product is calculated based on delivered goods, it adds significant complexity to the calculation if deductions like chargebacks or rebates are calculated on an accrual basis.

Additionally, a well-written agreement should cover all potential allowable uses of the licensed products, as well as any restrictions. If the agreement contemplates multiple types of usage, the reader should be able to clearly identify the applicable royalty calculation. Consider, for example, the seemingly simple area of free goods. Many agreements are either silent on this topic or lack specificity regarding how or to what extent the licensee is required to track these units. Even in instances where the contract places limits on these products, the term “free good” may not be sufficiently defined. The lack of both limits and a definition of free goods can incentivize licensees to provide the free goods to a customer in exchange for promised higher purchases of non-licensed goods or other favors that result in reduced royalty payments. Similar consideration should be given to other potential bundling arrangements, as well as sales (or transfers) the licensee might make to subsidiary or affiliate companies.

The following are examples of the types of language a licensee might consider including in the agreement to thwart any potential circumvention of royalties:

• “Unaccounted for, free, internally used and other property dispositions not included in sales shall bear a royalty based on the highest net selling price for the licensed property.”
• “In the event Licensee elects to sell the Licensed products as part of a bundled offering (with or without non-Licensed products), the total bundled selling price shall be fully allocated to the Licensed products for the purpose of calculating the Licensor’s royalty payment.”
• “The Gross Sales price shall represent the invoiced price, and will not reflect the results of discounts or other deductions.”
• “Product returns shall not be subtracted from gross revenues,” or “For the purpose of calculating Licensor’s royalties, the impact of Product returns on Gross Sales shall not exceed 5% of Gross Sales for the calendar quarter.”
• “If Licensee sells a Licensed product as a subcomponent of a larger (e.g., end) product, Licensor’s royalty will be calculated based on the sales price of the corresponding larger (e.g., end) product.”
• “Licensee shall only include deductions to the extent they are readily identifiable on the corresponding invoice and are clearly allocated and related to the sale of the Licensed Product.”

In our experience, we find that complex royalty mechanisms, when lacking adequate specificity, can increase the potential for misreporting and, in turn, lead to higher monitoring costs. Consider engaging an experienced royalty auditor to assist during the drafting process to identify areas that lack clarity, do not align with industry standards, or could be exploited as loopholes by the licensee.

Support: When establishing the calculation mechanism, both parties – and particularly the licensee – should consider its ability to generate and produce documentation that supports its calculations. This step is crucial to limiting future monitoring costs. The licensee’s supporting documentation can be classified in two primary categories:

• Information provided to the licensee: License agreements typically require that the licensee provide some form of supporting documentation alongside its regular royalty statements. The type of information can vary and is often non-specific. However, the licensee’s goal should be to provide documentation adequate to show the licensee its calculation mechanics so that the licensor can independently confirm that both it and the licensee understand how royalties are meant to be calculated. Friction in the relationship can result in instances where, over the course of an agreement, the licensee appears to adjust its calculation methodology, provides differing types or amounts of supporting documentation, or fails to provide adequate detail. This friction leads to time and cost on the part of the licensee as well as the decision to seek a royalty audit. Drafting the agreement should be treated as an opportunity to avoid this potential friction by agreeing to clear parameters around the documentation to be regularly provided by the licensee. In many cases, the agreement includes a template royalty statement and identifies data appendices to be included.
• Information to be provided to a future royalty auditor: During a royalty audit, the licensor should expect to provide substantially more information to a third-party auditor. Through the execution of a non-disclosure agreement, the licensee can be assured that the licensee will not have access to the licensee’s proprietary, confidential, or competitive information. However, because it is often the duty of the royalty auditor to use the licensee’s data to recalculate the royalties, the licensee should be prepared to provide complete sales and inventory data, which includes more than just the licensed products, and which can then be reconciled to higher level documentation (e.g., financial statements, bank statements, tax returns, etc.). Providing upfront awareness to the licensee during the drafting process gives the licensee the opportunity to maintain its supporting documentation in a format that will substantially increase future audits’ efficiency while limiting both parties’ compliance costs.

Requiring the Licensee to Maintain Adequate Documentation

Licensees commonly fail to maintain proper records to support their royalty calculations. Instead, the royalty auditor often finds that the licensee needs to spend an inordinate amount of time compiling and reviewing documentation, thereby slowing the audit and increasing the associated costs. This is because the licensee’s internal record retention requirements often are not tailored to the needs of the licensor or auditor. Further, even in instances where the license agreement requires some form of record retention, there is rarely a penalty should the licensee fail to retain the records. In the initial license agreement, and annually thereafter, consideration should be given to reminding the licensee in writing of its obligation to maintain financial records to support the royalty statements. In some instances, it may be reasonable to include a clause for liquidated damages if the licensor is deemed to have failed to maintain the necessary documentation.

Other Periodic Reporting by the Licensee

As a best practice, the licensor should consider constantly monitoring different aspects of the licensee’s operations to identify red flags of concern that could result in underreported royalties or otherwise diminish the value of the licensed property. One way to assist in this process is to require that the licensee provide a customized, signed checklist concerning the licensee’s operations at certain stages of the relationship. This checklist could concern the licensee’s product offerings, customer relationships, sales territories, pricing, and vendor/supplier relationships. It could also be used to identify hirings or employee turnover that impacts the licensee’s royalty reporting process.

Establishing a License-Monitoring Program

As a best practice, licensors should establish licensee monitoring programs to assess on a continual basis whether the licensee is properly self-reporting royalties and complying with other key contract terms and conditions.

Many licensors rely far too heavily on their licensees’ own willingness and ability to provide accurate self-reporting or to adhere with various other contract provisions. By effectively relinquishing contract oversight to the licensee, licensors often are unaware when licensees experience turnover of key employees, reduce the number of staff responsible for overseeing license compliance, or turn over responsibility to less experienced team members. Licensors generally do not monitor licensee operational changes. Cutting internal monitoring capabilities may prove especially risky in situations when licensees have international operations and the licensor lacks the resources to monitor worldwide sales.

Due to the complex nature of licensing contracts and the prevailing reliance on licensees to report and pay royalties accurately without substantiating backup documentation, the best way for licensors to assess that royalties are correct and can ensure contract compliance is to establish a proactive licensee compliance program. In instances where the potential additional revenue from uncovering underreported royalties and license fees is greater than program costs, leading companies implement a systematic program with three primary goals: (1) increase the licensee’s awareness of its obligations; (2) assess licensee compliance with those obligations; and (3) inform the licensee of leading practices.

These three goals are accomplished by two methods: regular internal monitoring, and external monitoring through the application of royalty audits. Internal monitoring is generally limited in scope and relies on an analytical review of the royalty statements, focusing on red flags that indicate potential underreporting.

Royalty Audits

Royalty audits are an effective deterrent to licensee abuses, and those conducting the audits can perform important roles. For example, while often overlooked, skilled royalty auditors can help to preserve and enhance the licensor/licensee relationship. They will also provide valuable insights and advise on how to reduce future contract violations.

The royalty auditor’s background and approach is critical. Ambiguous contracts are subject to varying degrees of interpretation, and underreported royalties are often difficult to uncover and harder to present with reasonable certainty. Even the most sophisticated companies may underreport royalty income because of contract ambiguities or efforts of inexperienced or overzealous personnel to meet predetermined operating goals. While an experienced royalty auditor typically will not independently interpret the agreement, they will provide the licensor with helpful insights regarding contract language and future negotiations with its licensees.

A dedicated royalty auditor will be alert to these and other problems and will look beyond collections and revenue recovery issues to identify reporting problems. The auditor also can help put controls in place at both the licensor and the licensee that address the root causes of the reporting issues without damaging or undermining valuable business relationships.