“While fraud may be an obvious assumption when licensors feel their royalty agreements haven’t been followed, there are other common reasons for the underreporting of royalties.”
Forensic royalty audits can identify issues and correct royalty underpayments and IP valuations, but there are many aspects, not just financial, to consider.
Beyond the costs and benefits associated with conducting a royalty audit, it’s also important to understand why and how licensees underreport and underpay royalties, and the key terms to scrutinize in your licensing agreement.
Is a Forensic Royalty Audit Worth It?
There are internal direct costs, external costs and opportunity costs associated with a royalty audit that should be considered.
Internal direct costs are internal to the organization that the licensor can fully attribute to conducting the royalty audit.
External costs include hiring qualified forensic accountants, consultants, and lawyers. These costs may be covered by the licensee if underreporting of a royalty exceeds a certain threshold, typically 5%.
Then there’s the opportunity cost: What the licensor stands to lose if they don’t conduct an audit. Typically, this is the difference between the current royalty payment received and the payment the licensor believes they should receive. The licensor must decide whether the difference is enough to justify the costs for conducting an audit to quantify the underpayments.
These benefits to conducting a royalty audit can be both tangible and intangible, and short- and long-term.
The tangible benefits are the short-term increase in profits from retroactive royalty payments and future, long-term increase in revenue from a correct royalty payment calculation.
Intangible benefits can be short- and long-term as well. Royalty audits can identify historical issues that can improve future compliance and establish consistency in enforcement for all of an IP rightsholder’s licensees. Correcting royalty payment amounts also add to a company’s value and may motivate other licensees to comply with their agreements.
How and Why Royalties are Underreported
When deciding whether to conduct a royalty audit, it’s important for intellectual property holders to understand the common reasons and red flags for licensing agreement underpayments.
While fraud may be an obvious assumption when licensors feel their royalty agreements haven’t been followed, there are other common reasons for the underreporting of royalties.
A 20-year empirical study on royalty errors prepared by InvotexIP Audit Statistics broke down the frequency of underreporting by error type. InvotexIP found that 60% of all examined licensing agreements contained underreported sales.
In most of the instances of underreported sales, according to the study, the licensee missed a second generation or updated product. Even something as benign as a color change could lead to a new product number being created, thus derailing the royalty reporting chain. Another source of errors: new products incorporating the licensed technology that were left off royalty reports.
The next most common error was questionable license interpretations, which were found in 30% of the licensing agreements examined.
“Often the people who negotiated and wrote the license agreement are not the people put into the position to interpret it,” the study’s authors wrote. “Worse yet, sometimes the people reporting royalties under the terms of a license agreement have never even seen the agreement.”
The other sources of errors from the InvotexIP study were disallowed deductions (26%), math errors (13%), misapplied royalty rates (11%), transfer prices (5%), unreported sublicenses (5%), and unreported benchmarks and milestones (5%).
Is your licensee at risk for one or more of these reporting errors? Consider these red flags:
- Have your licensees recently changed royalty reporting and accounting staff?
- Do they have poor financial reporting and/or inventory controls?
- Have they reported sales lower than industry trends, or declining sales trends?
- Do they have significant financial problems?
- Are they performing worse than other licensees over the same reporting period?
Pay Attention to Detail in the License Agreement
A well-written license agreement may be the best way to keep parties in accord and forensic royalty auditors at bay. The license agreement should embody every detail of the deal with the key terms clearly and concisely spelled out.
Here are some of the key terms to scrutinize in your licensing agreement:
- Licensor grants the licensee the right or license to use, create, or sell IP. The licensor receives royalties, license fees, and other payments from the licensee.
- Licensee receives the right or license to use patents, trademarks, copyrights, trade secrets, or other IP. The licensee sells licensed products in accordance with the provisions of the license agreement. Licensee agrees to make royalties and other payments to the licensor.
- Licensed Product Definitions: This is the eventual product made using the licensed technology. This is especially important regarding complex products, which may contain multiple pieces of IP. As much as you can, define up front which products will contain the licensed IP. Furthermore, it can also assist with keeping tabs on the licensee’s new products to make sure they are reported properly if they contain licensed IP.
- Intellectual Property Definition (Patent, Trade Secret, Trademark, and Copyright): This is the subject matter of the license agreement. This will typically include the U.S. and foreign registration patent, copyright, and trademark numbers and application numbers and description of trade secrets. The license agreement may also include discussion of improvements to ongoing research and development.
- Royalties: Payments made for the ongoing use of the license by the licensee to the licensor for use of the IP. The terms of the royalty structured payments are defined in the license agreement. Royalties can take on a variety of measurements: lump sum or fixed value; per unit or usage; percentage of gross revenue; percentage of net revenue; percentage of costs; percentage based on cost savings; percentage of gross profit, operating profit or net profit; escalation clauses, stair step; and other combinations.
- Royalty Base (Units or Dollars): The base amount upon which the royalty rate is calculated. This is defined in the license agreement. The definition of a royalty base may be complex in the context of a multi-component device, such as an iPhone. The royalty base can be limited to the component or the value of the end-use product.
- Royalty Rate refers to the payment per unit or percentage of dollars paid in consideration for the right or license to use, create, or sell IP. Many factors influence the royalty rates, including upfront payments to the licensor by the licensee, standard rates, stage of development of the IP, market potential, relative bargaining negotiating strength of licensee and licensor, profitability, and available non-infringing substitutes. Guideline royalty rates can be used for the valuation of IP.
- Units: Standard of measurement often defined in the license agreement. A license agreement may have minimum unit sales requirements or maximum units upon which a royalty is paid.
- Initial Payments: License fee payments required at the onset of the licensee agreement. This is the minimum amount of money that licensees must pay to the licensor regardless of sales.
- Term (length or time period) and Termination Clause: The license’s duration and circumstances in which the license agreement may be terminated by either party. The license agreement should include the terms that will end the license agreement.
- Minimum Performance: Requirements that must be fulfilled by the licensee or the agreement may be terminated often involving a minimum sales quota.
- Territory: The territory rights in which the licensee will be able to use the IP rights granted during the term of the license agreement, such as geographical limitation(s).
- Exclusivity vs Nonexclusivity: Consider the nature of the parties. If exclusive rights were granted to the licensee, the licensor may add minimum performance standards. Some licensees have been known to enter into exclusive license agreements and not commercialize the product.
- Application / Product Limitations: Copyrights may be granted for only print books, e-books, or audiobooks, for example. Or patents may be granted for research and development but not commercial purposes.
- Royalty reporting generally requires a written report provided by the licensee detailing the royalty calculations, including quantity sold, description, price per unit, gross sales, deductions taken, net sales, and royalty rate(s).
- Payment Terms (in U.S. dollars or other currency), timing and frequency of payments, including what happens if the licensee does not make the scheduled payment owed to the licensor.
- Representations and Warranties from the licensor that owns the IP that the licensed IP is valid and that the licensor owns the IP.
- Audit Clause, including source of payments for audit and penalties for inaccurate reporting: A common clause in IP agreements will require the licensee to pay legal and forensic accounting fees if their royalty payments are in error by more than 5% or 10%.
- Financial and/or Accounting Definitions: Net sales, for example, can be calculated using different accounting practices. Consider the licensee’s in-house accounting practices vs. generally accepted accounting practices and establish specific ground rules for accounting definitions.
- Deductions, items that reduce the amount of a royalty base, including pricing discounts, returns and allowances from customers, and operating expenses deducted in profit measurements.
- Apportionment is especially important to define on complex products that contain multiple pieces of licensed IP and when the licensed IP is a major component of the product.
- Special Terms, such as quality control requirements of licensee, confidentiality, choice of law, arbitration requirements, and renewal rules.
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