As well as improving brand awareness and creating additional consumer touchpoints, product licensing agreements can also generate significant royalty revenue; but, there are risks, especially where the terms of an agreement are disputable. Akin Ogboye explains how clear language can minimise the risk of disputes following a royalty audit.
In 2019, licensed merchandise and services generated over USD293 billion in retail sales, demonstrating how lucrative licensing agreements can be. However, to paraphrase Thomas Reid, there is no greater impediment to the advancement of agreements than the ambiguity of words. This includes product licensing agreements.
Licensors can minimise disputes, reduce risk and facilitate a smooth working relationship with licensees by ensuring that clear and concise language is used consistently throughout their agreements. This simple consideration is a highly effective addition to royalty audit procedures that avoids unnecessarily strained relations.
There are several areas where clear, concise and comprehensive language, especially in definitions, are particularly important.
Product licensing agreements: defining the terms
A proper definition of ‘net sales’ in a product licensing agreement is crucial. Net sales can have a variety of meanings, so it is important to go beyond simply defining it as ‘gross sales less returns, discounts and allowances.' Every aspect of ‘net sales’ needs to have its own definition.
For example, is 'gross sales' based on invoiced amounts or cash received? This becomes particularly important in a post-COVID-19 era where retailers and distributors are tightly squeezed.
It is important to clarify whether ‘gross sales’ is ‘at source’. When considering sales to a related party or sub-distributor, it is necessary to define the point at which sales value will be recognised. Is a related distributor allowed to take a margin off end-user sales value before ‘gross sales’ is calculated by the licensee? At what stage and on what basis or price are these sales subject to royalties?
It is important to consider the rates that apply to FOB (Free on Board) and non-FOB sales and define them clearly.
Are direct-to-customer sales to be treated differently when they involve royalties? Are consignment sales permitted in determining the point at which royalties become due?
One of the more frequent areas of dispute between licensor and licensee is allowable deductions. In order to arrive at net sales, a number of items may be allowed as deductions which will clearly impact royalties payable.
Some areas of ambiguity to avoid are:
Do discounts include customary trade, quantity and cash discounts? Are volume discounts (for larger customers) allowed?
Are bad debts deductible?
Which costs can be deducted, e.g. can marketing and advertising costs be deducted? Can freight and insurance be deducted?
Which taxes are allowable - withholding taxes, other specific local levies and taxes? Some of these may be irrecoverable by the licensor
Another contentious area is returns. The product license agreement should state clearly which types of returns are deductible; for example:
Are returns for defective products only?
Are they actual returns or estimates?
The agreement should also clarify whether there is a returns limit. This is usually expressed as a percentage of total sale
Other areas of risk in royalty audits
Incorrect royalty rates
There are valid commercial reasons for royalty rates to vary across sales types: direct-to-customer vs wholesale; FOB vs non-FOB sales; new product vs legacy products; related party sales etc. Extra care should be taken to ensure that these are clearly defined and applicable royalty rates are clearly spelt out.
The rates should be easily identifiable in agreements and written in concise language to minimise the likelihood of licensee error related to multiple royalty percentages. Where possible, a summary table of such royalty rates should be provided.
Unauthorised or unlicensed sales can potentially damage the brand.
It is important that agreements clearly state the penalty for unlicensed sales, whether these are sales of unlicensed products, sales outside of the license period, or sales in unlicensed territories.
Monetary penalties associated with unlicensed sales would serve as a good deterrent.
Late payments and penalties
Late payments and late reporting are typical findings from royalty audits. It is important that license agreements state the expected timeframes in terms of royalty reporting and payment, as well as the consequences of falling outside those timeframes.
The interest rate chargeable on late payments should be clearly stated, and any upper limits on interest chargeable (such as any maximum business-to-business interest rates) should be considered. This may vary between different territories.
Although a number of territories require licensees to receive invoices before international remittance can be made, the onus remains on the licensee to ensure that payments are made promptly and in accordance with contractual terms.
Access to licensee records
Licensors should ensure that there is a penalty should the licensee fail to provide complete and auditable books and records and access to relevant personnel. Include an error threshold beyond which audit costs may be recharged to the licensee.
To learn more about how we can support you with your royalty audits and help you develop a robust license-monitoring programme, contact Akin Ogboye.