When reviewing a proposed license agreement that has been submitted by a potential licensor, Be On The Lookout for provisions that can artificially or inadvertently act to, in effect, increase the royalty rate. Some examples:
- Gross Sales based on the wholesale or list prices rather than the actual invoice price. Is the top line on your invoice always list?
- Unreasonably low caps on deductions permitted in calculating Net Sales. Some caps can be defensible but, if your historical rate of “discounts, allowances and returns” is higher than the cap …
- Quarterly caps on deductions. Some quarters will have disproportionately higher shipments and the others will have disproportionately higher returns. Any cap should be based on annual sales and deductions.
- Quarterly payments of earned royalty in excess of the quarterly minimums. If, as is common, minimum royalties will be paid quarterly in advance and if earned royalties are calculated and paid quarterly as well, the quarterly payments of earned royalty should be computed on the basis of Net Sales during the entire year through the end of the most recently completed quarter, with a credit for all minimum royalties and earned royalty previously paid for that year. (For belt and suspenders aficionados: While the formula accurately reflects the customary agreement of the parties, to avoid all possible confusion, some licensee lawyers will also request a provision to the effect that, at the end of the day, the aggregate royalty due for each year will be the higher of (a) the minimum royalty for the year and (b) the earned royalty that accrues on Net Sales during the year.)
- A chargeback is not an allowance (and, therefore, even though the license agreement may permit deductions for allowances in calculating Net Sales, a chargeback would not be deductible unless the license agreement says it is). The lesson is that a licensee must make sure that it understands all aspects of the definition of Net Sales and that the agreement allows it to deduct all items that it would expect to be deductible. Historically, auditors claiming significant underpayments of royalties are more likely to point to improper deductions than to underreported sales.
Credit: Jonathan R. Tillem
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