When a licensor and a licensee agree to work together, it can be the perfect match. The owner of an intellectual property or “IP” asset is referred to as the licensor, and the party that pays to use the IP asset is referred to as the licensee. However, arriving at this position often requires delicate negotiations before the parties are able to enter into a license agreement.
Creating a license agreement that benefits both the licensor and licensee is a balancing act. Like any contract, the parties must agree to each of the terms and clauses to produce a mutually beneficial arrangement. In most cases, the royalty payment is the primary focus of the license agreement. It also can be the primary focus of a disagreement. If one party — usually the licensor — suspects that the amount of the royalty payment is inaccurate, a forensic royalty audit can ensue.
A well-written license agreement may be the best way to keep the parties in accord and keep the forensic royalty auditors at bay. The license agreement should embody every detail of the deal with the key terms clearly and concisely spelled out. A few key terms of interest in a well written license agreement include the product and IP definitions, types of royalties, territories, rights (exclusive/non-exclusive), and audit clauses. In some instances, the inclusion of representative calculations may avoid future interpretation issues and conflicts.
Product Definition
The parties must define the product that is the subject of the license agreement. Is it the IP asset itself? Is it the characteristics that the product embodies? When other products are grouped together, does it meet the definition in the agreement? The licensor and licensee must fully understand the licensed product as defined to successfully move forward.
Types of Royalties
An all-important step in a license agreement is to determine the type of royalty payment that works for the industry and product involved. Common types of royalty payments are lump sum fixed, minimum royalty, and variable amounts.
• Lump sum fixed. This payment from the licensee is a large dollar amount paid all at once to the licensor. The payment can be made upfront only, annually, or at any interval. The parties also can agree to a lump sum fixed amount with a variable amount, meaning there’s an upfront fixed dollar amount plus a fluctuating amount paid periodically based on units sold or a percentage of revenue or profits. The lump sum fixed and variable amounts must be unambiguously defined in the license agreement.
• Minimum royalty. This payment requires that the licensee pay to the licensor a set dollar amount whether or not a particular threshold is met. Then, if the threshold is exceeded, a variable amount also applies. For example, the agreement may require that the licensee pay $50,000 for all sales up to 10,000 units. If the licensee sells 5,000 units, the licensee pays $50,000. If the licensee sells 12,000 units, the licensee pays $50,000 for the 10,000 units plus the agreed-upon variable amount for the additional 2,000 units sold. The measure of the threshold and how the variable amount is calculated must be detailed in straightforward language in the agreement.
• Variable. This payment can be structured in many different forms including:
‐ Per unit sold. This structure includes a royalty payment for the sale of every unit of product. The agreement must clearly define “per unit sold.”
‐ Dollars per time period. This payment is a flat dollar amount paid at specified intervals, similar to a lump sum fixed amount or minimum royalty amount.
‐ Percentage basis. A royalty payment based on percentages adds complexity to the calculation. This payment can be based on gross revenue (all income received from sales), net revenue (gross revenue minus any allowances), or gross profit (all profit minus deductions). The agreement must be specific about how the percentage basis is calculated.
Territory
The license agreement must establish the geographical territory where the licensee wants to use the IP asset and the licensor wants to grant the rights. Each party should ask: What country, region, or radius is included in the territory? How do online sales work within the agreement? Are the rights exclusive within the territory? The license agreement must define the boundaries in precise terms to prevent future conflict.
Audit Clause
When one party questions the accuracy of a royalty payment, the party can hire a forensic royalty auditor to conduct a forensic royalty audit. If the auditor finds that the amount is incorrect, the audit clause may be triggered. Most audit clauses state that the licensee will pay the external costs of an audit, including the costs of forensic accountants, consultants, and attorneys, if the underreporting of the royalty exceeds a certain percentage, typically 5%.
Conclusion
Creating a license agreement that properly benefits both parties for the risks being taken by the licensor and licensee can be a complex negotiation. A well-written agreement with the key terms clearly and concisely spelled out from the beginning can keep the licensor and licensee working in harmony to reduce potential conflict over the amount of royalties paid and the need for a forensic royalty audit at a later date.
