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