A patent and license portfolio can provide a consistent and reliable revenue stream. However, many companies have technology, trademarks, and merchandising opportunities that are not fully exploited. Even if fully licensed, there is often considerable upside available via vigilant enforcement of audit provisions to ensure all amounts due are paid. Unlike almost any other business transaction, additional royalties drop to the company’s bottom line, so greater attention here often yields disproportionate results.
Once a license is obtained, many companies tend to sit back and watch the checks roll in. Often, little analysis is performed to assess whether those checks reflect accurate reporting of contractual obligations. Comparisons with supporting documents provided in order to support the checks are unlikely to provide insight into what is not being reported. Without examination of the underlying records from which the information is derived, there will always be a question of completeness. Depending on the basis for the royalty formula, investigations of additional costs and allocations are likely appropriate. Such examinations of the licensee’s private data are often only contractually allowed by third party auditors.
Common Licensee Errors
Many instances of underreporting with reputable business partners are unintentional, often times the result of automated processes that fail to recognize covered products. However, for those with more nefarious intentions, there are many creative ways to intentionally misstate results and aggressively interpret contract provisions in ways that are inconsistent with the parties’ intentions. This requires an experienced auditor who is not wedded to a narrow list of preconceived notions of what could be wrong. In difficult economic times, the combination of reduced licensee accounting resources and the temptation to “save” money by artificially reducing royalty payments generally leads to greater levels of underreporting.
Here is a partial list of the errors that we frequently see:
- Purposeful, otherwise unexplained underreporting of what is owing (i.e., the licensee lied).
- A “misunderstanding” occurs regarding what is covered by the technology being licensed. New products/SKUs that should be royalty bearing are not reported.
- Product numbers/SKUs get altered. Those preparing the royalty reports in a mechanical manner do not report all products that are royalty bearing.
- Sublicense revenue is not reported.
- Accounting reports (which are often generated for purposes other than compliance with a specific contract) are relied upon to prepare the royalty reports, but the computer algorithm that generates the report fails to add all relevant transactions.
- The licensee over-relies on manual processes and/or spreadsheets for royalty reporting, which allows clerical errors to occur.
- Royalty-bearing products are bundled with non-royalty products. Sometimes the bundle is not reported at all. In other cases, the allocation of revenues and/or costs is more favorable to the licensee than what the underlying value and economics are.
- Transactions (usually with related parties) are reported at prices or terms that do not reflect market conditions.
- Promotional uses, samples, employee theft, and other transactions that do not generate revenue are not reported at all, even though the underlying definition(s) contained in the license agreement provides for compensation to the licensor for all uses of the technology.
- For international sales, incorrect exchange rates are used.
- Unreported transactions occur at international or subsidiary locations because (i) the remote units do not report transactions in the same way as the parent or primary entity, and (ii) the accounting personnel preparing royalty reports do not address such discrepancies.
- Use of “standard”, “convenience”, “average” or other revenue rates that differ from actual transaction values. A licensee’s desire to streamline the reporting process is rarely allowable under the license agreement.
- Differences in opinion exist regarding terms contained in the licensing agreement.
- Licensee-favorable interpretations as to what can be deducted from the royalty base for various “allowances”.
- On agreements that allow certain costs to be deducted from the royalty base, the licensee uses unfair cost allocations that lower the royalty base.
- On agreements that allow certain costs to be deducted from the royalty base, the licensee applies a more lenient view of what direct costs are included in the calculation.
- The licensee fails to incorporate agreement-based limitations to deductions (not-to-exceed amounts or percentages) in the royalty calculation.
Most licensee reporting contains errors in these (or numerous other) categories. Finding these errors requires specialized audit experience and related data processing skills. For more advice, see Best Practices in Royalty Audits.
Importantly, most license agreements provide that if the audit identifies additional royalties (usually with a threshold of around two to five percent of what was initially reported), the licensee pays for the audit’s cost. Such cost-shifting provisions mean that there is often no ultimate cost associated with finding these additional profits.
While first time audits usually have the largest findings, the expectation of regular audits is a strong incentive for future ongoing compliance. A licensee is less likely to underreport if the licensor engages in a regular audit program. If problems continue, a licensor may want to modify or terminate the existing licensing agreement. Past material noncompliance with the existing agreement is often necessary for any such termination.