Licensing Agreements And Forensic Royalty Audits

Licensing is one of the most common ways of monetizing Intellectual Property. It entails a temporary transfer of the rights of the patent owner to a third party for the use of the product/invention. This is done in exchange for a fee or royalty or both. The avenue of profit provided by licensing makes it a valuable proposition for the owner.  

Unlike the selling of IP, where a one-time transfer of payment occurs, an IP licensing agreement is an ongoing transaction for the contractual time period. This makes it important to keep a tab on the royalty sum received and ensure that the licensing agreements are not being undervalued. Below we understand how royalties may go underreported, framing fool-proof IP licensing agreements, and the circumstances that necessitate forensic royalty audits.  

Drafting Clear Licensing Agreements for Intellectual Property 

Most of the problems related to underreporting of royalties emerge from varying interpretations of the license agreement. This necessitates scrutinizing all details to ensure things are clear and concise. Below are some key terms that must be thoroughly analyzed in licensing agreements for Intellectual Property: 

• Licensor – Refers to the individual/business who grants the right or license to use, create, or sell IP to the third party in exchange for royalties, license fees, and other payments. 
• Licensee – The licensee is the receiver of the right or license to use patents, trademarks, copyrights, trade secrets, or other IPs. The licensee is legally bound to sell the licensed product and pay royalties to the licensor in accordance with the terms of the agreement.  
• Licensed Product Definitions – The final product made using the licensed technology becomes the licensed product. It is essential to clearly define the products that will contain the IP to avoid any confusion later. It is also recommended to keep an eye on the licensees’ new products to ensure they do not contain licensed IP without previous authorization. 

• Definition of IP – Depending on whether the IP is a Patent, Trade Secret, Trademark, or Copyright, the license deal will include the registered patent, copyright, and trademark numbers, as well as application numbers and a description of trade secrets from the United States and other countries. The subject matter may extend to the inclusion of any ongoing research or proposed improvements to the patent. 
• Royalties – The legally binding payments that are made by the licensee for the continued usage of the licensor’s product are called royalties. The amount to be paid in royalty may be set in different ways depending on the product and usage. For example, royalties for books may be based on the number of units sold, for oil/gas it may be decided by the revenue earned, and for franchises, it is usually set as a fixed or variable percentage of gross sales.  
• Royalty Base – Royalty base can either be the number of units produced or sold by the licensee or the sales value. In cases where the sales value is the royalty base, it becomes imperative to clearly define whether gross or net sales constitute ‘sales value’. Calculating royalty base is easier in single products as compared to complex multi-component devices.  
• Royalty Rate – The payment per unit or percentage of dollars paid to use the IP is called the royalty rate. Factors such as the stage of development of the IP standard rates, market potential, relative negotiating strength of licensee and licensor, available non-infringing substitutes etc., influence the setting of the royalty rates. 
• Units – It is the standard of measure that is used in the IP licensing agreement and remains consistent throughout. Royalties may be set at minimum or maximum sales requirements.  
• Initial Payments– The amount that a licensee is required to pay to bring the agreement into effect is known as initial payment. It is paid regardless of sales or any future consequences.  
• Term & Termination Clause – This defines the duration of the agreement as well as the conditions under which it may be terminated before or on completion of the term.  
• Performance Clause – A performance clause enlists the minimum requirements/sales that the licensee must meet to keep the agreement valid. Establishing such a benchmark is important to ensure that the licensor is able to monetize their IP effectively.  
• Nature of Licensing – A license may be exclusive or non-exclusive in nature depending on which other terms may be decided. For example, a performance clause is almost always included in exclusive agreements so that the licensee commercializes the product.  
• Application – The agreement may contain limitations on the manner in which the product is used. Patents may be granted for research only and not commercial use, copyrights might be limited to printing books excluding audiobooks etc.  
• Accounting Definitions – The accounting practices, especially for the calculation of net sales, vary from company to company. Take note of the practices followed by the licensee before drafting an agreement. 
• Deductions – Any amount which reduces the royalty base is referred to as a deduction.  Customer returns, discounts, operating expenses etc., fall under deductions.

Assessing The Need For Forensic Audits 

1. Identification and rectification of issues in present IP licensing agreements serve as a road map for drawing future contracts. 
2. Motivates other licensees to comply with the license agreements and adds to the company’s value. 
3. Increase in revenue from retroactive royalty payments as well as correct calculation of future payments.  
4. Periodic audits help build a trusted relationship and keep the lines of communication open between the licensor and licensee. 
5. Prevent unauthorized use of Intellectual Property.