The Licensing Executive Society (LES) Iowa Chapter met on Monday April 29th in Coralville, Iowa, and took a deep dive into issues with auditing Intellectual Property (IP) license agreements. Other issues of IP valuation were also discussed by two accounting experts from Sikich. The discussions brought to the forefront issues commonly associated with IP license agreements – namely, what happens after you sign on the dotted line? When should you consider auditing a licensee under the terms of your license?
To get to an executed license agreement you have invested resources, time, and money. Any type of IP asset could be the basis of commercial activity to monetize your products or services. So, what happens next? If you are the licensor you expect the royalty checks to start flowing, so to speak. Whatever the structure of the license agreement, there are many reasons why you should consider inspecting what you expect once the agreement is signed. This is one of my favorite phrases – “inspect what you expect.” Although I am sure I did not coin the phrase, I like to say it quite often to clients.
So, when should you consider auditing a licensee? Well, perhaps you noticed a licensee is underperforming compared to your expectations or sales trends in the industry, or you may have identified calculation errors in royalty reports, or became aware that a licensee had poor inventory controls. These are just a few red flags that might suggest an audit is warranted. Even if there are no red flags, as time passes there may be a new team of people involved in sales and reporting of royalties compared to the initial team that negotiated and entered into the license. Change in personnel could cause misunderstanding of obligations under a license.
There is also a strong argument to routinely audit a licensee early in the relationship to send a clear message that you are closely reviewing things and intend to hold the licensee accountable to the specifics of your license. This can provide significant tangible and intangible benefits to your relationship. The primary intent would be to have improved financial performance under the license. If a licensee knows you are inspecting what you are expecting, behaviors tend to improve. This is supported by nationwide data showing improved future compliance following royalty audits.
If you need more motivation to consider an audit, a 2018 Annual Royalty Study conducted by Invotex IP Audit Statistics concluded that only 14% of licensees properly reported royalties (full report available at www.invotexip.com/statistics). That means 86% of licensees underreported royalties, representing a lot of money left on the table! What was most alarming to me is that over 20% of licensees underreported royalty obligations by over 100%. Of these errors, the greatest amount (60%) resulted from unreported sales, followed by (30%) errors caused by license interpretation. An alarming 13% of underreported royalties were simply due to math errors.
In addition to these recent statistics supporting the position to “inspect what you expect”, they also demonstrate a need to put into your agreements clear auditing provisions. For example, the terms of your agreement should identify who is responsible for the costs of an audit, consequences of the outcome of the audit, and the materiality threshold for such consequences. Clear definitions for all terms used in calculating royalties are critical. Common terms include units, deductions, net versus gross revenues, profits, etc. In addition to defined terms, it is a good idea to have an exemplary calculation of royalty obligations and payments in the license. An equally good idea is to include what is required to be produced by a licensee in an audit.
Terms of the agreement are important as this is used as the basis for assessing compliance in an audit. License terms control – not GAAP (Generally Accepted Accounting Principles) unless they are specifically called for in the agreement. Having well drafted license agreements provides a better starting point for an audit. From there, the accountant or auditor can take a deeper dive, for example, into the licensee’s sales data, public records, interviewing management, and the like.
If it has been years since you signed the dotted line of your license or if you have concerns over licensee’s royalty payments, it may be time to look back at those terms and ensure royalties are accurately reported and paid. It may even be time to consider auditing the licensee.