Licensing Agreements And Forensic Royalty Audits

March 17, 2023
- Patent Portfolio Commercialization
- Patent Portfolio Management

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.

Reasons For Underpayment Of Royalties

There can be several reasons for royalties to go unreported. Per a recent study, almost 89% of licensees underreport royalties. An understanding of these reasons is crucial if one wants to take precautionary measures and ensure a steady flow of income. While fraud is the first logical assumption in such cases, there are several other ways in which licensees knowingly or unknowingly underpay royalties, these are:

Inaccurate interpretation of agreement: Everyone wants to interpret things in ways that are favorable to them and an IP license agreement is no exception. Given that agreements are not drafted by either the licensee or licensor, it leaves room for interpretation. Even if the agreements are written in the most crystal clear ways, the language used by lawyers requires interpretation of clauses that may be done erroneously by the accounting staff. The sole way of avoiding this is to remain alert and dig deep into the accounting system of the licensee in areas pertaining to the royalty agreement.
Calculation of gross to net sales: IP Licensing agreements always carry a definition of ‘net sales’ which lists the specific deductions offered. But there are times when the licensee may use vague language in a contract and stretch these definitions. Therefore, one must always ask for the precise details of the calculations, from gross to net sales, for the purpose of calculating royalties. If any suspicious deductions are spotted, they must immediately be discussed with the licensee.
Calculation Errors: While we may be living in a world of meticulous spreadsheets and other tech tools that promote accuracy, there is still room for errors. These errors might not be present in the main audit data but in the supporting documents which the licensor might not have access to. Therefore, it is advisable to ask for copies of the spreadsheets so you can check the formulas and methodologies and prevent any errors.
Royalty Rate Errors: In some cases, the licensing agreement extends to several different products with varying royalty rates. In such a scenario it may be possible that incorrect rates are assigned to products where the sales volumes are very high and cross-checking becomes difficult. The best way to avoid this is to keep the royalty rates simple and easy to apply. Grouping rates by type or price range makes it more convenient and error-proof.

Transfer Prices, Unreported Sub-Licenses, and unreported benchmarks and milestones are some other sources of errors when it comes to calculating the correct royalty rates.

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

Forensic royalty audits are conducted to uncover the reasons for underreported or undervalued license agreements. IP License agreements sometimes contain a clause that gives a licensor the right to determine if royalties are being correctly paid. If a discrepancy is found post a royalty audit, then the licensee bears the audit fee.

While audits may unearth gaps and increase revenue, it is important to consider the internal indirect costs, external costs, as well as the opportunity cost of performing it. The internal as well as external costs include hiring forensic scientists, consultants, legal teams, etc. These may be recovered from the licensee if the underreporting exceeds a threshold of 5%.

This brings us to the opportunity cost i.e., what the licensor is foregoing if the audit is not conducted. In most cases, this would be the difference between the expected royalties v/s those currently being received. Therefore, the time-consuming exercise of performing an audit must be undertaken only if this difference is perceived to be substantial.

Benefits of A Royalty Audit

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

Conclusion

It is vital to have a well-structured management model in place to regulate licenses. A set of clearly defined policies and meticulous record maintenance is fruitful for both parties and averts future conflicts. Big companies with several licensing agreements perform better with regular royalty audits that aid compliance. But smaller businesses with one or two licensees also need to implement a system that manages and monitors the licensing relationships. The key to successful licensing is to build a solid structure with clear expectations that reduce ambiguity and promote understanding.

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