One of the questions I receive most about licensing is, “But how will I know my licensee is paying me enough?” It’s a valid question. Good partnerships are built on trust, and licensing is really about finding the right partner to help you bring your product idea to market. But you don’t want to be taken advantage of, either. If you suspect a discrepancy, you need recourse. And that’s where audit clauses come in.
Say you license your product concept to a large company. Soon enough, the product begins selling in major retailers. As a result, you begin collecting royalties, which are typically paid out per unit sold. If the company licenses another idea from you, if your product expands into a line, if different sizes end up being made — totaling what you’re owed can get complicated. At some point, you may wonder if your royalty checks are accurate. Is your licensee capable of making a mistake? Yes of course. It’s possible their right hand doesn’t know what their left hand is doing. For that reason, it’s smart to monitor your licensee.
What’s one of the easiest ways of monitoring your licensee? Paying attention. For example, the first concept I licensed was an indoor NERF basketball game to Ohio Art. Amazingly, the Michael Jordan Wall-Ball sold for more than a decade. Ohio Art released versions with images of Penny Hardaway and Grant Hill on the backboard, but I never game them much thought — until I began thinking about cereal boxes. Cereal boxes often included little giveaways. So when I came across a cereal with Michael Jordan’s image on it, I bought it. And sure enough, when I opened it, out came a miniature Michael Jordan Wall-Ball. I loved it! It was cute and clever. Ohio Art wasn’t paying me a royalty on it, though. I started to wonder how many cereal boxes with mini Wall-Balls had been sold.
Like most companies in the toy industry were and are, Ohio Art was truly supportive of inventors. They depended on inventors. In fact I thought Ohio Art had treated me exceptionally well. So I picked up the phone. I told my contact I’d seen the promotion and was wondering if I should be collecting royalties on the mini Wall-Balls as well. He told me they needed to check and would get back to me. When he did, he apologized: They had made a mistake and were going to rectify it. It was that simple.
Will it always be that simple? No. My point is, your attitude is everything. I could have emotionally reacted, concluded the worst was happening, gotten angry and upset. There’s always more than one way to approach a situation. Don’t assume the worst.
Over the years, I’ve seen all sorts of audit clauses negotiating on behalf of my students. They’re important to include, particularly when dealing with big companies. (Please note, rarely has a student actually asked for an audit to take place.) Typically they work something like this. The licensor is required to give his licensee at least one week’s notice. The licensor pays for the audit, unless a significant enough (usually around 10 percent) discrepancy is found, in which case the licensee agrees to correct the difference, plus interest, and also cover the cost of the audit itself.
To gain more of an audit and contract compliance perspective, I interviewed Peter Betts, a big four accounting advisory services senior associate based out of New York City. Betts is well versed in audit clauses, albeit primarily for much larger licenses: The more than 30 agreements he has audited represent at least five billion dollars in revenue. (When he worked on the licensor side of things, he was responsible for more than two thousand licensing agreements.) In his experience, many entrepreneurs misunderstand how license reviews are actually performed as well as how to implement one.
When misreporting happens, it’s often due to licensee employee overturn, Betts said. Responsibilities change hands. Companies fail to allocate adequate resources to monitor their contracts, which can lead to underreported royalties and profits owed. “Every license is unique. Underreported profits and non-compliance to the agreement could be due to multiple factors.” During negotiations, the audit clause itself is often overlooked. His advice? Don’t rely on general legalese. Review the audit clause carefully. Consider having your contract specify your right to audit exists for the entire length of the license — rather than leaving the clause unaddressed or open-ended — Betts advised.
In his opinion, it’s also important to include general language that emphasizes any documentation considered reasonable to prove amounts reported be subject to the audit. “The licensee might try to negotiate exactly which documents or materials can be reviewed during an audit, which could potentially limit an auditor’s ability to fully perform the examination.”
If you decide to audit your licensee, approach with caution. “Inventors need to be careful about who they hire to perform the audit.” An adversarial review could damage your relationship. When Betts is tasked with pursuing an audit, he takes a non-confrontational approach. “My goal is to make sure the licensee is complying, but also that the relationship continues. Licensees and also inventors who have never been through the examination process often look at an audit with fear, however it has become standard practice for many entrepreneurs.”
Setting the right tone in that first call is crucial. When you notify your licensee you will be performing an audit, be as transparent as possible, Betts encouraged.
What else can do you to ensure you’re being paid fairly? Take it upon yourself to get to know the salespeople. If you befriend them, they’ll tell you how much is selling and to whom. They’re proud! You could also visit retail stores selling your product in person to introduce yourself to managers. Ask them, “How well the product is selling?” This is an opportunity to put your creative skills to use. There’s always more than one way to get the information you need.
Originally published on Inc.com May 13th 2016.
