I can be such a nerd sometimes… really nerdy things get me all excited. Case in point: licensing intellectual properties. Sure, your average person on the street doesn’t even know what that means, but I think there’s something entirely cool about developing technologies or intellectual properties (i.e., creating something valuable) and having other companies sell it in some shape or form and pay you a percentage of the proceeds. Several of my clients and past employers have exclusively used this business model to generate revenues. Cool, no?

(OK, I told you I can be a nerd.)

Today I found myself sitting at a presentation by Sidney Blum, an expert in the field of royalty auditing. Royalty auditing requires your licensees to open up their books and operations for a third party accounting audit in order to determine whether or not they have been paying your royalties properly.

According to Blum, licensees routinely underpay the licensors by 20-30%. Some licensees, by way of policy, underpay until they get caught, at which point they pay pennies on the dollar owed. Hello! That’s a good chunk of money if royalties are your main source of revenues. How much does a typical company spend on product development or sales and marketing to increase revenues by 20-30%?

Common reasons for the underpayment of royalties range from fraud to oversight, to misinterpretation of the terms of the contract such as: the “sales price” (what happens to discounts, freebees, barters, etc), inventory accounting (does anyone really have a good handle on their inventory?), sub-licensing, foreign exchange conversion rates, and many other factors.

I know, when you’re working on that licensing agreement, everyone is ready to pop the champagne bottles, and details fall by the wayside. It’s particularly exciting when you are with a smaller company licensing IP to a larger company (been there, done that). But you want to make sure to get paid for your hard work. So here are some things to consider for a licensing deal:

Engage a royalty auditor in the early stages of contract negotiation. Everyone associates contract administrators and attorneys with licensing agreements. But I highly recommend (my clients know what this means – “you must”) you also engage a royalty auditor in the early stages of a licensing contract negotiation. They will know what can go wrong and try to prevent it from happening.

Include a detailed audit clause in the contract. Discuss the details with your royalty auditor.

Include penalties and back interest in the contract. Not everyone does.

Don’t be afraid to perform royalty audits. Seems a bit nerve wracking, but get used to performing this regularly. According to Blum, licensees don’t walk away from a good deal because they were audited. Think about it, if they have nothing to hide, the audit shouldn’t bother them (except it’s probably a pain in the neck, but that should be part of the contract – not the pain in the neck, the audit).

Expect some underpayment beforehand. I know someone who owns a bunch of bars who factors cash-stealing by employees into his business model. You can apply the same principle to your business. Increase your minimum annual royalties, or simply raise your royalties to cover for the loss.

Enforce the contract. Once the contract is signed, make sure your finance department understands it in detail so they can charge your licensees properly. Make sure all the negotiated clauses are enforced.

Keep your licensees. Sure, they all underpay, but they’re still paying! Don’t lose your licensees over underpayment issues. Have a good contract in place, enforce it, and make the licensee pay penalties for misbehaving. Then get back to business.

At the end of the day, conducting a royalty audit is a business decision. More often than not, the audit more than pays for itself. The question becomes how often you will conduct them, and how you’ll collect your royalties once the underpayments are discovered. That’ll be up to you and your licensees.

Disclaimer I: under no circumstances, any IP attorney or audit CPA I have ever known or will ever come to know will be considered a nerd. Count on them being way cool. You heard it here first.

Disclaimer II: Disclaimer I was not written by an attorney.

  • Alister & Paine

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  • Polprav

    Hello from Russia!
    Can I quote a post in your article with the link to you?

  • CustomDesign

    One more thing… is there a “Royalty Auditing for Dummies” or similar book you suggest (I can’t seem to find the right book on Amazon… they all seem to be tailored for companies preparing to be audited). Thanks.

  • CustomDesign

    @Sidney: After reading this article we decided to consult a royalty auditing firm and we’re put off by the fees. The two companies I spoke with wanted a retainer and would be paid a great deal of money whether or not the audit resulted in any recovered earnings for us. Is this customary in Royalty Auditing?

  • First!

    Thanks Sidney – hadn’t considered going about it in criminal court… since monetary awards are typically paid out in civil court. In your experience can you recover punitive damages in criminal court or do these cases typically end up in settlements? (We’re not anywhere near $100k in collectables with any one licensee – but it’s good to know).

  • Sidney Blum

    PS: If you have more questions, you can write to me at sblum@ghjadvisors.com.

  • Sidney Blum

    REPLY TO FIRST: I’m the expert referred to in the article. Litigation is bad for businesss and extremely expensive, even if you can recover lawyer fees, so unless your out for hundreds of thousands of dollars, I don’t recommend it. Tactfully nudging non-payers ..hard to do. From what I see, it is best to write a letter notifying them of noncompliance and reminding them of termination as identified in your agreement, if they fail to remedy the situation. If that doesn’t work, I suggest termination. Either they are going to pay your or they won’t, so having audited over $8 billion dollars of royalties, I can tell you will have to stick to your guns…nicely of course. After you terminate, if they continue to use your IP, and it is more than $100,000, I recommend using a lawyer that specializes in pursing the money under a criminal complaint and not a civil complaint. It gets the money at a lower cost and is a lot more forceful. Not to many people are aware of the criminal route and they default to the more costly civil route.

  • GucciGirl79

    We’ve been dealing with this problem since I joined my company (sports licensing)… sometimes it’s impossible to even find out who’s manufacturing the goods (t-shirts, posters, dvd’s etc.)
    @FIRST! If you know who the non-payers are I’d mention that you need to receive payment asap – a good reason is the upcoming end-of-year – use the EOY audit as a reason to gently nudge them… I’ve always found you attract more bees with honey than lawyers.

  • First!

    FIRST!

    I was just talking about IP Law the other day with our GC… it’s getting harder and harder to get clients to comply and lawsuits are bad for business. Suggestions on tactfully nudging non-payers???