Intellectual Property licensing is big business, and is getting bigger. But most licensors do not earn as much as they should because they fail to perform royalty audits allowed under their license agreements. The remedy is obvious, but is often not done for fear of the audit’s cost or concern over disrupting the licensee relationship. With the proper help, getting more money can be fairly painless.
Licensees make mistakes. The sales department may not timely communicate newly licensed product to the accounting department responsible for reporting royalties to you. Some agreements allow licensees to make judgments about deductible expenses allowed under the agreement. Others simply rationalize not paying what is due. All of this results in substantial royalty underreporting. Our experience is that license underreporting occurs more than 80% of the time.
By following the steps below, with a portfolio of licenses, you are virtually guaranteed of improving your financial results. The more licenses you have, the greater the probability that you are not getting all that is rightfully owed.
Step 1 – Include Provisions that Facilitate Audits
Even though the majority of licensors never invoke them, most “standard” license agreements contain audit provisions. Nevertheless, when drafting agreements, you should pay close attention to this area and insist on the following:
- A broad right to audit the licensee’s books and records (both paper and electronic form) with no restrictions placed on the scope of the investigation;
- Reporting in a specific format that includes information about the licensee’s specific results as follows:
- Product numbers
- Units sold
- Sales Dollars
- Country and currency translation used, if any
- Details of any returns that do not receive royalties
- Details of any promotional units that do not receive royalties
- Details of amounts manufactured but not yet sold (and therefore no royalties are yet submitted)
- If costs are deductible, details of the specific items
- Royalty rate calculations based on the above;
- Reporting and related cash payment at least quarterly;
- A provision that the licensee pay for the full cost of any audit should an underreporting above a specified amount occur. Five percent is a typical allowable margin of error.
- Interest charged on late or underpaid royalties.
- The right to review at least the last three years of reporting.
Step 2 – Commit to Perform an Audit
Surprisingly, this step is usually the greatest obstacle.
The only way to know if your licensees are underpaying royalties is to hire a competent auditor who goes to your licensee’s offices, looks at the original records, and talks with personnel responsible for the relevant records. “Reasons” for not doing the audit often include:
- “The person with whom I talk on the phone is so nice. I don’t want to upset them by performing an audit.”
- “We always get approximately the same amount of money, so everything looks reasonable.”
- “We are on budget for the year in that category. I need to focus on other problems.”
If you are worried about the cost of the audit, most license agreements provide that the licensee pay the cost if findings exceed a specified percentage of underreporting. When the reported royalties are small, it is even easier for audit findings to exceed the threshold. Licensees end up being responsible for the cost of over half the audits we perform.
Alternatively, you can employ an auditor on a contingent fee. Our firm consists of capable and experienced auditors who will accept contingent fee projects after learning more about your situation. An auditor on a contingent fee receives a premium if the audit findings are large, but this should not concern a licensor that was not planning to perform an audit without such an arrangement. If the auditor does not find anything, then you get peace of mind for free!
Step 3 – Select the Right Firm
The auditor you select should meet all of the following characteristics:
- Is a specialist in this type of work, with a solid record of accomplishment– Some firms that perform royalty audits are financial statement auditors trying to keep busy in the “off-season”. These people are usually a poor choice because they do not have a proper focus on the differences between a financial statement audit and a royalty audit. For example:
- Financial statement auditors usually focus on a materiality threshold based on the overall financial statements. In a royalty audit, we are identifying real money that you should be receiving. Materiality is more properly focused on the cost to calculate the adjustment and convince the licensee to pay it;
- Financial statement auditors rarely test extensively for revenues being underreported, yet that is the primary concern in a royalty audit.
While these distinctions may seem simple, many clients are frustrated with staff personnel that require additional supervision and rework to perform properly focused work. Your selected auditor should be able to provide references of satisfied clients that have obtained large recoveries.
- Have excellent computer skills – Many firms continue to perform work manually that could better be done electronically. Electronic downloads of information will lower the cost and will minimize disruption to the licensee. However, this requires computer expertise that many firms do not have.
- Be a savvy negotiator – Some auditors are simply too timid to obtain everything needed to prove what is owed. When disputes arise, your auditor should be able work towards an amicable resolution.
- Have solid litigation skills – Sometimes disputes cannot be negotiated. You should plan for that possibility by employing a firm that has taken numerous cases to trial…and won!
You should not make a selection