How Royalty Audits Strengthen Your Bottom Line and Business Relationships
Article

How Royalty Audits Strengthen Your Bottom Line and Business Relationships

by Kevin Guy, Amber OMalley
October 07, 2021

Leaving money on the table is never a good thing. Yet companies often do just that by not enforcing royalty agreements because they place too much trust in their licensees or think that questioning them will hurt the business relationship.

You should never assume that your licensees are reporting the right numbers. They could be under-reporting due to human error, ethical lapses, diverse business practices, misunderstandings of contract language or any number of other reasons. The good news is that there are ways you can enforce your license agreements without losing customers.

Here’s how a royalty audit can help you identify and collect additional royalty payments owed to you while strengthening your relationships with licensees.

What Is a Royalty Audit?

A royalty audit, also known as a licensing audit, is when you examine your third-party licensee(s) to determine whether you are collecting all the royalty income you are contractually owed from the licensing of your brand, patent or intellectual property (IP).

For example, say you license your brand, likeness or logo to a third party, and they owe you a royalty every time they produce and sell the licensed merchandise. How do you really know the licensee is paying you for every item, every time or that the investment in your IP is being protected by your licensees?

Royalty audits can even span outside of the direct revenue stream. For instance, they can help you determine whether sales are within licensed territories, that only authorized products and/or services are being sold, that no new products and/or services are being added and other requirements determined by the licensing agreement.

Benefits of a Royalty Audit

By examining the fine details of your agreements, not only can you recover what would have been lost revenue, you can also put procedures in place to ensure ongoing compliance. The benefits of this include:

  • Additional revenues added to your bottom line from audit findings (our experience shows that more than 75% of the time, licensees underreport royalties to licensors)
  • Stronger compliance processes and reporting accuracy in the future
  • Improved contract language that provides clarity and transparency regarding the licensing requirements, especially when there are language barriers
  • Improved relationship and trust between licensor and licensee due to clear, regular communication (which helps sales staff retain and preserve customer relationships)

Why Some Companies Still Don’t Perform Royalty Audits

One of the main reasons companies don’t perform royalty audits is purely emotional — they don’t want to offend their licensees or other business partners. However, royalty audits are simply a way to ensure accurate tracking procedures are in place, benefiting both parties.

Audits are an anticipated and common business practice and don’t have to “rock the boat.” In fact, many agreements are set up with a clause permitting audits. Having this sort of language in contracts will help with any hesitation to have the audit performed. Ideally, a regular cadence of royalty audits will be established upfront as part of procedure for the ongoing business relationship.

Why You Shouldn’t Delay Contract Enforcement

If you wait too long to audit and enforce royalty agreements, you could lose significant revenue and place otherwise good customer relationships at risk by pursuing interest and other penalties on products (possibly shipped years ago).

In addition, many royalty agreements have audit clauses that permit audits to be performed only within a set period following the statement issuance. If you do not announce the intention to audit within that period, you may miss the opportunity to identify losses and rectify underlying issues.

Warning Signs of Reporting Issues

The first step toward better enforcement of your license agreements can be as simple as identifying where or how errors are likely to occur when licensees self-report royalties owed. Common errors associated with licensees include:

  • Sales of unauthorized products
  • Improper bundling of licensed products with unlicensed products
  • Alteration of the licensed product to circumvent the contract terms
  • Underreported sales by a sublicensee
  • Incorrect royalty volume calculations
  • Applying inappropriate exchange rates to sales or expenses reported
  • Misapplied conversion rates
  • Clerical errors, which can lead to reporting issues

In many cases, these errors will manifest themselves in ways a licensor can identify, such as:

  • A third party that does not report timely or is late to make required royalty amounts due
  • Payments not in compliance with the license agreement based on sales channels
  • Payments inconsistent with market expectations
  • Payments inconsistent with previous payment history or sales trends

Although these are just a few of the key warning signs, there are many more signals of misreporting that a royalty audit will help uncover.

Royalty Audit Costs and ROI

The costs associated with royalty audits can vary based on scope and geography. But, more often than not, an audit will reveal underreported revenues that more than cover your audit fees and boost your bottom line.

There are also costs driven by in-house legal review, accounting and IT staff to support reporting and compliance efforts. Consider modifying your contracts to specify that licensees pay audit fees in the event of under-reporting.

Case studies

Here are two brief case studies that illustrate the added revenue and savings a royalty audit can uncover and enforce:

A Silicon Valley company engaged Armanino to do a royalty audit of a multinational billion-dollar licensee with sophisticated reporting systems. We discovered the licensee had simply been entering the improper parameters when capturing sales data, omitting certain channels of distribution and geographies. The company recovered $268,000 in additional legitimate royalty payments. They also recovered their full audit fee because of contract language specifying that their clients pay audit fees.

In another recovery, because of a significant language barrier, the customer/licensee misunderstood the term “end-user” as defined in the agreement and incorrectly believed they were only responsible for reporting units sold to end-users rather than units sold to original equipment manufacturers. Using remote conferencing tools that enabled us to conduct a thorough audit without costly travel to Asia, we recovered $82,000 for the client. In addition, the full audit fees were paid by the licensee.

Best Practices for Enforcing Royalty Agreements

Drafting a license agreement that includes the best language possible can be tricky, and enforcing it can be even more daunting, especially if the enforcers of the agreement aren’t the originators. Here are some suggestions for strengthening enforcement of your royalty agreements:

Make sure contracts contain penalty clauses. This includes interest and payment of audit fees. Be sure to understand the terms of your agreements and periodically review them to eliminate ambiguities in language (terms like pay “promptly” or in a “reasonable” amount of time should be replaced with a cited number of days).

Develop a more robust database of licensees. Create a risk profile for all licensees and customers based on key characteristics like geography and size. Identify and focus on high-risk licensees with more frequent and in-depth audits of reported figures.

Be sure you can identify and understand non-compliant customers. See what your organization can do to increase compliance reporting by licensees and/or pursue enforcement through regulatory channels for suspected non-licensees.

Continually update licensees on their reporting obligations and definitions of what is applicable under license agreements. For instance, maintain a SharePoint site or a portal where your customers can view contractual agreements. Send your licensees regular email reminders to view these agreements for compliance and to annually reconfirm terms and conditions of contracts. Also provide examples of licensee violations to clarify what is acceptable under agreements, such as examples of what qualifies for reduced royalty rates.

Engage an outside consultant that has experience auditing licensees and identifying issues. A professional third party can support your effort by performing royalty audits, reviewing contracts for potential issues and providing recommendations. Placing a third-party expert between you and your customers also helps you preserve your relationships with them.

Adopt a program of continuous improvement around licensing. Apply continuous improvement methods to communicate, capture and audit royalties due under agreements.

Keep Your Bottom Line Healthy

Whether you are negotiating new contracts or monitoring existing ones, it’s vitally important to protect your brand, patent or IP. By auditing your licensees and strengthening enforcement of your agreements, you can recover underreported revenue, reduce the amounts you pay your third parties and improve your business relationships.

To learn more about how a royalty audit can help you get full value from your licensing agreements, contact our experts.

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Authors
Kevin Guy - Risk Assurance & Advisory
Managing Director
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