Royalty Audit and Contract Compliance: It’s More than Just the Money

Your brands and trademarks are extremely valuable.

After all, you have expended considerable time, effort and money to build them and, when managed correctly, they can generate significant royalty income, and provide valuable market data leading to a competitive advantage.  We believe that because of this significant value brands and trademarks should be proactively protected; and in what follows, we provide actionable steps designed for licensors to take that will help them execute this important process or component of a licensing program.

There are three distinct ways licensors approach the concept of a Royalty Compliance program. Each has its own characteristics and risks. Let’s take a look at all three.

 PASSIVE COMPLIANCE.The characteristics of this (all too common) approach include:

• Failure to audit licensees or the infrequent performance of a small number of audits
• Failure to consider audit windows and allowing periods to close without auditing
• No audit plan or budget to conduct audits
• Failure to include sufficient audit language in the license

The risks associated with a passive compliance program encompass: lost revenue; absence of timely, accurate business intelligence; devaluation of brand; negative effects on relationships with 3rd party rights holders and licensees; vulnerability to litigation; non-adherence to Sarbanes-Oxley or fiduciary obligations, especially if your licensed properties are owned by 3rd parties; and undefined business growth opportunities.

REACTIVE COMPLIANCE.  Here we see a number of features that are problematic.

• Basing an audit only on perceived problems, or the sudden need for additional revenue
• Adopting a punitive approach as opposed to a cooperative one
• Lacking structure that impairs effectiveness
• Not budgeted. At a critical time funds may not be available to address a suspected issue

The risks of a reactive compliance program include: incorrectly choosing the licensee based on bad data or due to a knee jerk reaction; damaging relationships with a licensee who feels targeted; no or minimal findings while out-of-pocket audit costs are incurred; difficulty obtaining compliance with no history of compliance in the past.

 PROACTIVE COMPLIANCE. Here we see characteristics that can lead to successful outcomes with limited risks.

• A structured audit plan is in place, with staff assigned to the process
• The compliance program is budgeted, funded and actively managed
• Contractual provisions are well written and built-in to support the audit process
• Open, candid and frequent lines of communications are maintained with licensees

With a proactive program the costs and time required for staff and resources (and the possibility that audits are not necessarily self-funding) are far outweighed by the benefits both monetary and non-monetary. Clearly, we believe a proactive approach is the proper approach. So, from a licensor’s perspective, what are some of the steps that can be taken in devising an audit plan that delivers results?

First, establish your goals. These should include ensuring general compliance with the license agreement and disseminating your expectations under the agreement.  They should also take into consideration maximizing licensing income; protecting the brand; gaining better insight into licensee practices and how they exploit your brand properly.

Goals are important but there are some practical requirements that need to be put in place at the outset, including: allocating dedicated resources, including  the proper people  in the process, ensuring sufficient funding, effectively using licensing software systems with reporting capabilities; maintaining internal coordination among legal, finance and sales. Once these elements are in place, licensors can systematically approach the more strategic issues about which licensee audits to undertake. Some of the criteria you should consider:

• Timing and quality of the licensee’s  reporting and payments
• Recoupment of advances and minimum guarantees
• Volume of royalties reported and the significance of such royalty stream to your business
• Number of licenses executed with the licensee
• Nature of rights granted
• Licensee’s reputation and the industry in which they operate
• 3rd party rights holder obligations

A concern that often goes unaddressed is that of managing licensees’ expectation – and, frankly, allaying their fears. The advice we provide our licensor clients is to communicate early and often with your licensees. We suggest an advisory letter be sent to all your licensees providing a head-up that you have a royalty audit plan in place and that they (as part of a group and not being singled out) may be  contacted. We find that such an advisory reduces surprise and can result in a degree of self-auditing  leading to adjustments and increased royalties going forward.

All of this inevitably leads to a pre-audit period where licensors should communicate with their internal management, sales team and their licensees, and, of course, select their auditor. Naturally, we’d invite licensors to consider EisnerAmper as their royalty auditor, but there are factors to weigh before making a final determination including: reputation, experience in your industry, capacity (e.g. multiple licensees/international requirements), location, full service/boutique and cost. 

The Royalty Audit and Contract Compliance professionals at EisnerAmper are prepared to discuss any of these issues with you at no cost. The monetary and non-monetary value of patent, brand and trademark protection can be maximized through the use of qualified and experienced royalty audit service providers and we invite you to get in touch with us to learn more and to get started.