Effective Licensee Monitoring
Businesses that include proper contract language instructing a licensee how to calculate a royalty, the specific documents to retain and that have a proactive licensee monitoring program are best positioned to achieve higher royalty revenues at reduced monitoring costs without damaging business relationships.
Both novice and seasoned licensors make the same critical mistake by not adequately instructing the licensee on how to calculate the royalty and preserve supporting records. The emphasis to close the deal and rely on the honesty of the self-reporting licensee to report royalties properly and to maintain documents usually costs the licensor significant income. Experience shows that the typical licensee underreports revenues sufficient to trigger the cost recovery provision of the licensee agreement. Licensees with better record keeping and royalty accounting practices make more accurate and higher royalty payments, reducing the need for royalty audits and the inevitable negotiations to recover underpaid royalties and audit costs.
Prior to executing a license agreement, the following questions should be considered:
• How will I make certain the licensee understands their responsibility to self-report the royalty income properly?
• How will I be comfortable that the licensee has complied with the license agreement?
There are four important royalty reporting items to be communicated to the licensee prior to executing a license agreement:
• Method of calculating royalties on the disposition of all licensed product(s).
• The licensee’s responsibility to maintain internal records that support the creation and disposition of licensed product(s) (ie, inventory and sales records).
• Information to be provided in royalty statements.
• Information to be provided in periodic reports regarding the status of the licensee’s operations.
Calculating Royalties on the Disposition of all Licensed Product(s)
Authors of license agreements generally do not have financial experience and are, therefore, unable to identify properly the very specific financial records that should be considered for retention. They are also unable to contemplate how a licensee might interpret seemingly simple royalty calculations in various ways that inevitably lead to underreported royalties. For example, many licensees consider gross revenues to be calculated after discounts, returns and taxes while they actually should be an accounting consideration before any deductions. Therefore, many licensees’ under-report revenues when these deductions are limited. Seasoned intellectual property attorneys may also miss the detail required in the license agreement that instructs both the licensee’s entry level accounting clerk as well as management on how exactly to calculate the royalty for all licensed product dispositions.
Most license agreements tend only to address the payment of royalties from net sales, generally defined as the gross of invoiced sales minus certain deductions and any product returns. Also, these agreements do not often cover other non-sale dispositions of licensed property such as free goods, missing goods and intellectual property used internally by the licensee for things like research and development or personal consumption.
A well written agreement must cover all potential uses of licensed products and define restrictions on each prospective disposition and its associated royalty, if any, to be paid to the licensor. Consider the seemingly simple area of free goods. Many agreements are either silent on the topic or when limits are placed on them, the term free good is not defined. The lack of both these limits and a definition of free goods commonly results in licensees providing 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.
The following are commonly missed instructions to licensees for calculating 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.
• Consideration should be given to not allowing free goods (unless there are strong restrictions).
• Licensed products are not to be sold bundled with non-licensed product. If they are, the total bundled selling price shall be fully allocated to the licensed product.
• The gross sales price shall be the invoiced price before any deductions.
• Product returns shall not be subtracted from gross revenues or shall be limited to a small percentage of gross revenues.
• A licensed subcomponent shall have the royalty paid based on the sales price of the total working end product.
• All deductions must be specifically defined by the agreement. For example, taxes must be specifically listed on the invoice and identified by category, e.g. value added or sales etc.
A leading practice is to have the licensor’s royalty auditor review the license agreement prior to signing to identify loopholes that may allow the licensee to miscalculate the royalty.
Maintenance Procedures for Licensee’s Internal Records
Licensees rarely maintain the proper records to support their royalty calculations. Usually, the licensee’s internal record retention requirements do not consider the needs of the licensor or auditor. Even when records are required to be maintained by the license agreement, there is rarely a penalty should the licensee not 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.
If records are not retained, the licensor should give consideration to requiring that the licensee pay liquidated damages, generally defined with a minimum and maximum range, e.g., between 20% and 100% of the royalties owed or damages to be calculated by the royalty auditor that are not subject to challenge. And such liquidated damages should be considered to be further defined as not less than a specific dollar amount or at the minimum guarantee. In the end, the lowest amount is usually claimed.
Information to Be Provided in Royalty Statements
Licensees tend to provide minimal information in royalty statements. From their perspective, the more information provided to the licensor, the more opportunity the licensor has to identify potential under-reporting. The initial license agreement should also consider inclusion of an appendix with the royalty statement the licensee must complete.
Information to Be Provided in Periodic Reports
The licensor should consider constantly monitoring the licensee’s operations to identify red flags of concern that could diminish the value of the licensed property. A customized, signed checklist should be submitted with each royalty statement that provides the licensor with an update of the licensee’s operations. Certain responses provided by the licensee may trigger a detailed assessment of the licensee’s contract compliance.
Establishing a License Monitoring Program
A licensor must establish a licensee monitoring program to assess on a continual basis whether the licensee is properly self-reporting royalties and complying with other key contract terms and conditions.
Licensors have relied far too heavily on their licensees’ own ability to provide accurate self-reporting or to adhere with various other contract provisions. In relinquishing contract oversight to the licensee, licensors fail to see that licensees have been reducing the number of staff responsible for overseeing license compliance or have been giving this responsibility to less experienced workers.
More troubling, as awareness of staff cutbacks spread, so does the risk rise that licensees will purposely under-report royalties knowing the chances of getting caught are low. Licensors generally are not monitoring licensee operational changes. Cutting internal monitoring capabilities may prove especially risky in situations where licensees have international operations and the licensor lacks the resources to monitor worldwide sales.
It is important to understand that underreporting royalties is more of the norm than the exception. Over my 20 plus years of royalty auditing, an overwhelming majority of royalty compliance audits, perhaps more than 95%, have resulted in tangible recoveries. This often results in a no-cost project to the licensor if the license agreement has a cost recovery provision (for example, passing on the cost to the licensee should the underreporting in any one period exceed the lesser of 3% of reported royalties or $5,000)
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 only way licensors can assess that royalties are correct and can ensure contract compliance is to establish a proactive licensee compliance program. Because the potential additional revenue from uncovering underreported royalties and license fees is greater than program costs, leading companies implement a systematic program with three major goals: (1) increase licensee awareness of their obligations; (2) assess licensee compliance with their obligations; and (3) inform the licensee of leading practices.
These three goals are accomplished by two methods: internal monitoring and external monitoring through royalty audits. Internal monitoring is generally very limited in scope and relies on an analytical review of the royalty statements that search for predetermined risk warning red flags that indicate licensee underreporting of royalties. Generally, a red flag warning will dictate the need for a royalty audit.
Royalty audits can be an effective deterrent to licensee abuses and those conducting the audits can perform several important roles: they can help to preserve, and even enhance, the licensor/licensee relationship; they know how to secure the greatest recoveries at the lowest cost; they provide valuable insights and advise on how to reduce future contract violations; and they often discover underreported royalties that are many times greater than that of auditors lacking this particular expertise.
Take the case of a leading company that initially assigned its internal audit team to perform three biannual audits of its licensees. The work findings from the internal auditors yielded about US$20,000. After hiring external advisers to conduct the next biannual royalty audit, the findings ranged from approximately US$200,000 to US$500,000 per licensee. In addition to recouping these funds, the process helped the licensee and licensor strengthen their internal controls and clarify their reporting requirements through rewritten license agreements. In another case, top 25 university received US$15,000 in royalties from its licensee, but an external royalty audit found US$23 million more was due because the technology had been sublicensed for $75 million and never reported.
The importance of the royalty auditor’s background and approach cannot be overemphasized. Ambiguous contracts are subject to varying degrees of interpretation and under-reported royalties are often so well hidden that only a very experienced royalty auditor can find the funds and successfully present the claim. Even the most sophisticated companies may under-report royalty income as a result of contract ambiguities or the efforts of inexperienced or overzealous personnel to meet pre-determined operating goals. While the auditor does not interpret the agreement, they can point out weakness in language for licensor/licensee discussion.
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.
Unfortunately, too many licensors fear upsetting the relationship and therefore do not execute their rights to audit. This is a real risk if using a non-dedicated auditor to perform the royalty audit. Financial statement and internal auditors may not understand the business relationships that go beyond and often exceed the importance of monetary findings.
There are several important steps to consider when developing strategies to monitor intellectual property. The first step is to identify which licensees present the highest risk based on their internal monitoring capabilities and then, if necessary, conduct a royalty audit. But it is equally important for the royalty auditor to review:
• Processes and controls to offer improvement ideas to both licensees and licensor.
• Existing agreements to ensure compliance and reporting requirements.
• Agreement structures to reduce underpayments by licensees.
• Contract-administration processes to benchmark against best-in-class standards.
By Sidney P. Blum, CPA CFE, CPEA, CFFABOUT THE AUTHOR: Sidney P. Blum
Royalty Audit Expert Witness
Royalty Audit Expert Witness
Sidney Blum is a financial damages and royalty audit expert witness
Copyright Sidney P. Blum, CPA CFE, CPEA, CFF
Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer.For specific technical or legal advice on the information provided and related topics, please contact the author.