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“While fraud may be an obvious assumption when licensors feel their royalty agreements haven’t been followed, there are other common reasons for the underreporting of royalties.”
Companies that license intellectual property may not realize they are leaving money on the table in royalty underpayments and calculation errors made by their licensees.
Forensic royalty audits can identify issues and correct royalty underpayments and IP valuations, but there are many aspects, not just financial, to consider.
Beyond the costs and benefits associated with conducting a royalty audit, it’s also important to understand why and how licensees underreport and underpay royalties, and the key terms to scrutinize in your licensing agreement.
There are internal direct costs, external costs and opportunity costs associated with a royalty audit that should be considered.
Internal direct costs are internal to the organization that the licensor can fully attribute to conducting the royalty audit.
External costs include hiring qualified forensic accountants, consultants, and lawyers. These costs may be covered by the licensee if underreporting of a royalty exceeds a certain threshold, typically 5%.
Then there’s the opportunity cost: What the licensor stands to lose if they don’t conduct an audit. Typically, this is the difference between the current royalty payment received and the payment the licensor believes they should receive. The licensor must decide whether the difference is enough to justify the costs for conducting an audit to quantify the underpayments.
These benefits to conducting a royalty audit can be both tangible and intangible, and short- and long-term.
The tangible benefits are the short-term increase in profits from retroactive royalty payments and future, long-term increase in revenue from a correct royalty payment calculation.
Intangible benefits can be short- and long-term as well. Royalty audits can identify historical issues that can improve future compliance and establish consistency in enforcement for all of an IP rightsholder’s licensees. Correcting royalty payment amounts also add to a company’s value and may motivate other licensees to comply with their agreements.
When deciding whether to conduct a royalty audit, it’s important for intellectual property holders to understand the common reasons and red flags for licensing agreement underpayments.
While fraud may be an obvious assumption when licensors feel their royalty agreements haven’t been followed, there are other common reasons for the underreporting of royalties.
A 20-year empirical study on royalty errors prepared by InvotexIP Audit Statistics broke down the frequency of underreporting by error type. InvotexIP found that 60% of all examined licensing agreements contained underreported sales.
In most of the instances of underreported sales, according to the study, the licensee missed a second generation or updated product. Even something as benign as a color change could lead to a new product number being created, thus derailing the royalty reporting chain. Another source of errors: new products incorporating the licensed technology that were left off royalty reports.
The next most common error was questionable license interpretations, which were found in 30% of the licensing agreements examined.
“Often the people who negotiated and wrote the license agreement are not the people put into the position to interpret it,” the study’s authors wrote. “Worse yet, sometimes the people reporting royalties under the terms of a license agreement have never even seen the agreement.”
The other sources of errors from the InvotexIP study were disallowed deductions (26%), math errors (13%), misapplied royalty rates (11%), transfer prices (5%), unreported sublicenses (5%), and unreported benchmarks and milestones (5%).
Is your licensee at risk for one or more of these reporting errors? Consider these red flags:
A well-written license agreement may be the best way to keep parties in accord and forensic royalty auditors at bay. The license agreement should embody every detail of the deal with the key terms clearly and concisely spelled out.
Here are some of the key terms to scrutinize in your licensing agreement:
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