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Fulcrum Inquiry

Intellectual Property licensing is big business, and is getting bigger. But most licensors do not earn as much as they should because they fail to perform royalty audits allowed under their license agreements. The remedy is obvious, but is often not done for fear of the audit's cost or concern over disrupting the licensee relationship. With the proper help, getting more money can be fairly painless.

Licensees make mistakes. The sales department may not timely communicate newly licensed product to the accounting department responsible for reporting royalties to you. Some agreements allow licensees to make judgments about deductible expenses allowed under the agreement. Others simply rationalize not paying what is due. All of this results in substantial royalty underreporting. Our experience is that license underreporting occurs more than 80% of the time.

By following the steps below, with a portfolio of licenses, you are virtually guaranteed of improving your financial results. The more licenses you have, the greater the probability that you are not getting all that is rightfully owed.

Step 1 - Include Provisions that Facilitate Audits

Even though the majority of licensors never invoke them, most "standard" license agreements contain audit provisions. Nevertheless, when drafting agreements, you should pay close attention to this area and insist on the following:

  1. A broad right to audit the licensee's books and records (both paper and electronic form) with no restrictions placed on the scope of the investigation;
  2. Reporting in a specific format that includes information about the licensee's specific results as follows:
    • Product numbers
    • Units sold
    • Sales Dollars
    • Country and currency translation used, if any
    • Details of any returns that do not receive royalties
    • Details of any promotional units that do not receive royalties
    • Details of amounts manufactured but not yet sold (and therefore no royalties are yet submitted)
    • If costs are deductible, details of the specific items
    • Royalty rate calculations based on the above;
  3. Reporting and related cash payment at least quarterly;
  4. A provision that the licensee pay for the full cost of any audit should an underreporting above a specified amount occur. Five percent is a typical allowable margin of error.
  5. Interest charged on late or underpaid royalties.
  6. The right to review at least the last three years of reporting.

Step 2 - Commit to Perform an Audit

Surprisingly, this step is usually the greatest obstacle.

The only way to know if your licensees are underpaying royalties is to hire a competent auditor who goes to your licensee's offices, looks at the original records, and talks with personnel responsible for the relevant records. "Reasons" for not doing the audit often include:

  1. "The person with whom I talk on the phone is so nice. I don't want to upset them by performing an audit."
  2. "We always get approximately the same amount of money, so everything looks reasonable."
  3. "We are on budget for the year in that category. I need to focus on other problems."

If you are worried about the cost of the audit, most license agreements provide that the licensee pay the cost if findings exceed a specified percentage of underreporting. When the reported royalties are small, it is even easier for audit findings to exceed the threshold. Licensees end up being responsible for the cost of over half the audits we perform.

Alternatively, you can employ an auditor on a contingent fee. Our firm consists of capable and experienced auditors who will accept contingent fee projects after learning more about your situation. An auditor on a contingent fee receives a premium if the audit findings are large, but this should not concern a licensor that was not planning to perform an audit without such an arrangement. If the auditor does not find anything, then you get peace of mind for free!

Step 3 - Select the Right Firm

The auditor you select should meet all of the following characteristics:

  1. Is a specialist in this type of work, with a solid record of accomplishment - Some firms that perform royalty audits are financial statement auditors trying to keep busy in the "off-season". These people are usually a poor choice because they do not have a proper focus on the differences between a financial statement audit and a royalty audit. For example:
    • Financial statement auditors usually focus on a materiality threshold based on the overall financial statements. In a royalty audit, we are identifying real money that you should be receiving. Materiality is more properly focused on the cost to calculate the adjustment and convince the licensee to pay it;
    • Financial statement auditors rarely test extensively for revenues being underreported, yet that is the primary concern in a royalty audit.

    While these distinctions may seem simple, many clients are frustrated with staff personnel that require additional supervision and rework to perform properly focused work. Your selected auditor should be able to provide references of satisfied clients that have obtained large recoveries.

  2. Have excellent computer skills - Many firms continue to perform work manually that could better be done electronically. Electronic downloads of information will lower the cost and will minimize disruption to the licensee. However, this requires computer expertise that many firms do not have.
  3. Be a savvy negotiator - Some auditors are simply too timid to obtain everything needed to prove what is owed. When disputes arise, your auditor should be able work towards an amicable resolution.
  4. Have solid litigation skills - Sometimes disputes cannot be negotiated. You should plan for that possibility by employing a firm that has taken numerous cases to trial...and won!

You should not make a selection based primarily on cost. If you pay a small fee and the auditor does not find anything, have you really saved any money? A small hourly rate and few hours should be a warning that the person is planning a surface-level review. The scope of work should be sufficient to give you peace of mind that you are receiving the royalties that are rightfully owed. The rates should be sufficient to pay for highly skilled professionals supported by facilities that provide responsive service.

Step 4 - Plan for Success

The audit should be performed on the licensee's business premises and include discussions with accounting personnel that are responsible for keeping the daily records. Do not attempt to save money by accepting copies of records, or short cut the employee interviews.

The licensee should not approve, or even know, the reason for specific requests or questions. Providing this type of information beforehand biases the investigation, and may even allow records to be manufactured.

You should obtain the licensee's electronic records before the start of fieldwork. Data produced electronically is fast and inexpensive, yet provides massive amounts of information. When done in this fashion, a skilled auditor can perform data analysis before interviews and on-site inspections occur.

You and your auditor should work together to identify the areas of greatest concern. We find that the following areas usually have the greatest payoff:

  1. Unreported sales, perhaps from (i) related product lines that use the licensed technology, trademarks, etc. or (ii) foreign territories;
  2. Not following contractual requirements, such as maximum amounts for deductions, or minimum guarantees for sales;
  3. Transactions with related parties that are not conducted on an arms-length basis.
  4. Cost allocations that unfairly burden the licensed product;
  5. Evidence of underreporting that is not apparent by looking at what has been reported. For example, to find unreported revenues, the auditor should inspect records that show relevant cost information that might be inconsistent with the reported revenues.

The Fulcrum Advantage

Fulcrum Inquiry performs its work as recommended in this article. We have the following advantages:

  1. We have a solid record of accomplishment - We typically identify monetary recoveries that exceed the cost of our work. This is particularly true when there is a group of audits that occur at the same time. In most cases, the cost of our work exceeds the threshold established for the licensee to pay for the cost of the audit, in which case our audit costs you nothing.
  2. We are experienced royalty auditors. We do not make mistakes that are common with other providers. Specifically:
    • We focus on those items that will get you money.
    • We do not ignore "immaterial" items. We are aware that we are obtaining real money for you, not reviewing the overall fairness of a financial statement
  3. We have better computer capabilities We prefer to work with a direct data download from the licensee's computer system. This allows us to work more efficiently, with significantly more information.
  4. We are more persistent. We insist on getting the records necessary to do our job.
  5. We are skilled in litigated disputes. Our personnel have presented hundreds of cases in trial, mediation and arbitration. Having persuasive communication skills will improve your chances for recovery.

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David Nolte is a principal at Fulcrum Financial Inquiry LLP with over 30 years experience performing forensic accounting, auditing, business appraisals, and related financial consulting. He regularly serves as an expert witness.

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