Intellectual property owners are entitled to financial compensation in exchange for granting rights to licensees. As licensing deals grow, it is important to develop monitoring or audit programs to hold licensees accountable.

What is merchandise licensing?

Licensing exists in almost every product category that you see in retail stores. The intellectual property (IP) / Copyright owners and/or distributors (e.g., studios, creators, or brand owners, collectively “IP Owner” or “Licensors”) license out their rights for licensees to use in a wide range of merchandise categories. Well-known entertainment properties such as the Marvel superhero characters are often licensed in typical markets, such as toys, apparel and video games, but can also be found in a variety of other markets, such as food, household and stationary products. Due to the expanding range of product categories and property types, global licensing revenues have reached $262.9 billion in 2016, according to the latest survey published by the Licensing Industry Merchandisers' Association.

Are you owed licensing royalties?

As an IP Owner, you are entitled to financial compensation – also known as minimum guarantees and/or royalty payments – in exchange for granting the rights. These royalty payments are generally calculated based on a percentage of gross or net receipts generated by the sales of the licensed products. Based on our experience, royalty rates could range from 3 to 17 percent in a gross royalty deal (i.e., royalties are earned on gross receipts). The royalty rates could be higher in a net royalty deal (10-50 percent); however, several additional deductions are allowable in the net royalty calculation, which could lead to more errors in licensee reporting.

So, are the royalties you received coming close to your expectation? Maybe not. We often get asked questions such as:

“Are licensees hiding revenues? Are they deliberately miscalculating royalties?”

In our experience, most underpayment of royalties is a result of limited resources and experience at the licensee level. Many small to medium licensees do not have an automated royalty system, and the manual process is prone to errors. In other cases, licensees may have certain royalty systems or software, but such systems are not sophisticated enough to reflect the complicated royalty calculation or unable to adapt to the new distribution models. Potentially due to lack of experience and/or intent, licensees may improperly interpret the licensing agreement to the detriment of the IP owner.

Additionally, as more and more licensing deals are done with foreign licensees, there are additional risks in royalty reporting due to cultural, linguistic and business differences between territories, such as issues in translation and interpretation of the agreement from one language to another.

Potential Findings Related to Merchandising Licensing Audits

Below are some examples of the royalty issues that we at GHJ have encountered when performing licensing audits:

• Anomalies in Data Analysis

Missing certain products, sales channels or territories

Miscoded or duplicated expenses

Excessive revenue reserves or expense allowances

Incorrect exchange rates (in sales and return processing)

Incorrect prices or unusually low prices reported by certain customers

• Contractual Issues:

Royalty rates not correctly applied to different categories of sales (e.g., direct distribution vs. sales by agents)

Unallowable expenses

Expenses charged in excess of the contractual cap, or the cap is being charged even though actual expenses are less

Incorrect or excessive charges of fees but no actual distribution effort is spent

Double deduction of expenses or fees in multiple royalty calculations

Late statements and payments

Application of advances or minimum guarantee payments

Verification of proper rights, products, distribution platforms and markets

• Other Risk Areas:

Statement formula errors

Reconciling variances in revenues or expenses

Inappropriate estimates applied in manufacturing costs, freight costs, etc.

Deduction of royalty payments to third parties

Related party sales and deductions

Allocation in bundle products

Unreported manufacturer rebates or credits

Application of unearned minimum guarantees

Application of tier-based royalty rates

Audit Consideration

Given the above possible issues with the licensees, it is important for the Licensors to develop monitoring and audit programs. Verifying royalty reporting not only helps Licensors recover unpaid royalties and hold licensees accountable, but also gives Licensors more visibility into licensees’ sales and operations. Therefore, owners of successful IP’s often choose to audit their major licensees at least once in a contract term.

In evaluating whether an audit is warranted, you may consider things such as the earnings pattern, recent changes in licensee reporting or corporate structure, whether royalties are paid in a timely manner and/or whether your account is recouped or near recoupment, to name a few. Also, remember to check your license agreement to see if it contains an audit fee reimbursement clause that obligates the licensee to pay for the audit costs when findings exceed a certain error rate, such as 5 percent for example. If you need help with developing your own monitoring program or evaluating whether an audit is warranted, the GHJ’ Entertainment Practice is experienced in handling these types of issues. Contact us.