By Kevin Howley and Alex Montgomery
What is one’s intellectual property (IP) worth? That’s an important question for a business or individual who holds a patent, trademark or copyright. Of equal interest is how to guarantee that the owner of the IP is adequately and fully compensated for its use by licensees. That is where an audit provision can provide essential protection.
IP is an asset that can be turned into cash in the form of licensing income or royalties. Licensing your IP can help turn your ideas into commercially successful products and services. Licensing a patent, trademark or copyright can lead to a steady stream of income while retaining ownership and control of the IP.
Monetizing IP generally involves a licensing agreement that is tied to some form of license fees or royalties paid by the licensee (along with various other legal provisions to protect the licensor). Similar, but with a different range of agreements, are franchised businesses which can generate royalties for the franchisor. This revenue stream can grow by increasing license fees or through growth of the revenue generated by a licensee.
Licensing of IP can be exclusive, with a single licensee paying for the sole right to use the IP; or non-exclusive, which permits the licensor to license the IP to multiple licensees. Licenses can also be allocated in various ways, such as granting territorial rights, industry exclusive rights, or by medium exclusivity (such as online vs. print use).
“Trust but verify.”
Licensing your IP is a great way to generate revenue. But maintaining the revenue stream depends on the vigilance of the IP holder. That’s why every licensing agreement should include an audit provision. That provision typically gives you (or your representative) the ability to examine financial statements and other financial documentation to determine whether or not the licensee is meeting their commitments. Verification of license fees or royalty payments helps to preserve the revenue stream from your licensed IP.
Not all licensees make their license fees or royalty payments on time, and some fail to make payment in full. Honest mistakes are sometimes made. But some licensees may try to game the system by submitting false results and financial documents. Unless you have the ability – and willingness – to examine a licensee’s financial statements and other documents, it’s difficult to determine whether or not the license fees or royalty payments are in compliance with the license agreement.
There are red flags that may alert you that a licensee is not fully living up to their obligations. Late payments, level or diminished payments from a licensee whose business is expanding, or slowly growing royalty payments from a licensee in an industry that is otherwise generating strong financial growth are all signs that something may be amiss.
What is an audit?
An audit is a thorough, independent examination of a licensee’s use or resale of the licensor’s IP. The audit is an in-depth look at the actual numbers of users or sales revenue generated by a licensed product. The audit should be conducted by an independent third party in order to obtain unbiased results.
In addition to verifying that license fees or royalties have been properly calculated and remitted in accordance with the terms of the license agreement, audits examine compliance with other provisions of the license agreement, such as verifying that sales of the licensed products have only been made to customers within the territories specified in the license agreement, that exclusivity provisions are being followed, and that the licensee is otherwise complying with any restrictions on use of the IP (such as the number of authorized users).
The examination should include a review of customer purchase orders. This is to help ensure that the licensee is selling the licensed products if they are specified by a downstream customer, and not substituting generic equivalents.
How often should you audit?
Licensors of IP should monitor license and royalty income on an ongoing basis, and continually evaluate license revenue analytics. This is an important component of risk analysis which can help determine which licensees should be audited, and how often.
Depending on the nature of your IP, you may want to conduct an audit on an annual basis, or more frequently if there have been problems with a licensee in the past. But it is important to have an examination done at least every other year. Signs of any of the “red flags” indicated above is cause for an immediate audit. These terms should be clearly expressed in the license agreement.
Some licensing agreements include audit provisions that incentivize compliance by obligating the licensee to pay for the cost of the audit if the audit reveals underpayments of more than a certain percentage. But even if you pay for the audit yourself, the assurance that your revenue stream from licensing is flowing as strongly and frequently as it should is worth the investment. Uncovering a license fee or royalty payment shortage or other non-compliant activity provides valuable protection.
Kevin F. Howley is a Partner in the firm of Gray, Gray & Gray, LLP in Canton, MA, and a certified public accountant with more than 25 years of auditing experience, including royalty audits. He can be contacted at khowley@gggcpas.com or (781) 407-0300.
Alexander P. Montgomery is a copyright and trademark associate with Hinckley, Allen & Snyder LLP in Boston, MA. He can be contacted at amontgomery@hinckleyallen.com or (617) 378-4366.