Maximizing Revenue through Royalty Compliance Audits
By Frank Rudewicz, J.D., CPP, CAMS
Companies are constantly striving to increase efficiency and gain a competitive advantage. While the current economic environment has elevated this quest to lower costs as a necessity for survival, companies typically do not save their way to success. A company’s overall success usually depends primarily on its revenue growth. One major source of revenue, particularly for not for profit and academic research entities, is revenue from royalty payments for the use of intellectual property.
The licensing of intellectual property to a third party is commonly recognized as one of the most cost effective processes that yields results in the shortest time. Licensing allows a licensor to extract value in the form of information and presence, maintain a revenue stream, and at the same time identify lost revenue opportunities.
In the last several years, various companies have spent significant amounts of money in creating and protecting their intellectual property. The last several years have also brought a significant increase in licensing activities, in which companies have been trying to monetize intellectual property that they do not commercialize internally. Yet, once the license is created, many licensors fail on the required follow up. In order to realize the full benefit of licensing their intellectual property, companies must ensure that their intellectual property is being utilized to its full potential by third parties. The licensor should actively monitor the adherence by the licensee to the licensing agreement, and review the receipt of all royalty payments.
All licensing agreements should have an explicit audit right clause for this very purpose. The most obvious reason to perform a royalty audit is to verify that the licensor is receiving all royalties entitled by the licensing agreement; however, the ability to audit can provide other important benefits as well. By performing the royalty compliance audit, the licensor is demonstrating its interest in the licensee’s commercialization of the intellectual property. Regular audits or reviews remind licensees of a licensor’s willingness to monitor proactively and help to manage internal controls where Intellectual Property is identified as a strategic asset.
Licensors often struggle with the decision to spend money to review a license that has produced positive cash flows over the years without any intercession. This decision may fail to take into account a provision often seen in licensing agreements. Such provision usually provides that the licensee will be responsible for the costs of the royalty audit, if the audit identifies underreported and underpaid royalties of a certain threshold (usually ranging from to five to ten percent).
Many royalty audits uncover underreporting and underpayment, the source of which is often human error and not necessarily malicious intent. Common errors stem from a lack of understanding of the licensing agreement, poor tracking systems and finally, deliberate omissions. Generally, the calculation and the payments of the royalties are performed in the accounting and finance departments. The employees from these departments are often not included in the licensing negotiations and may have a different understanding of the terms in the agreements. Additionally, while many companies have well functioning internal accounting software systems, royalty calculations tend to be prepared manually on individual spreadsheets, which often lead to numerical errors.
- Incorrect Royalty Base, and Missed Products – The largest area related to the underreporting of royalties is usually associated with the determination of the total sales of royalty-bearing products. Common omissions of royalty bearing products include:
- Products of new generations;
- Products with new or different product numbers;
- Pass-through revenue;
- Revenue from sublicenses;
- Unreported distribution channels;
- Unaccounted production; and
- Purposely underreported sales.
- Incorrect Royalty Base, and Incorrect Value – Even if the total products are reported correctly, the value of the revenues from these products may be misstated for a variety of purposes, including:
- Transfer Pricing Miscalculations – Sales to subsidiaries and related parties are often reported in prices that reflect intercompany transfer pricing and are not consistent with the terms of the licensing agreements;
- Excessive Price Discounts – Customer discounts may be at odds with the agreement; and
- Misapplied Conversion/Exchange Rates – The exchange rate used to convert the international sales is inconsistent and different from the exchange rates stated in the licensing agreement.
- Incorrect Royalty Rate
- Misunderstanding of the license agreement
- Non-escalation of royalty rates
- Inappropriate Deductions – Quite often a difference of opinion exists as to what discounts and allowances should be included in the calculation of the royalties due. As a result, inappropriate deductions are made.
- Late Payments – Royalties are often paid late; however, the late fee, as stated in the licensing agreement, is not often paid.
The Benefits of a Royalty Compliance Audit
By performing the royalty compliance audit, parties can clear up any misunderstanding and ensure future compliance. Additionally, royalty audits will encourage communication between licensor and licensee, which often leads to additional cooperation between licensor and licensee and potentially new licensing agreements between both parties. If conducted with sensitivity and efficiency, the compliance audit will maintain a good business relationship between the parties and help to ensure strengthened intellectual property and a long future of continued royalty payments.
Mr. Rudewicz thanks Martina Rozumberkova for assistance with this article.