1 bullet-proof your license agreements: prevent post-license disputes and shed dead-weight licensees...

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Bullet-Proof Your License Agreements:Prevent Post-License Disputes andShed Dead-Weight Licensees

Technology Transfer TacticsJuly 29, 2010

Daniel Burns, M.Phil., [email protected]

Knowing is Better

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Key Take-Aways about Royalty Audits

Most organizations lack effective licensing compliance function Many licensees underreport royalties Licensors concerns about royalty audit are often misplaced Royalty audits have a very favorable cost-benefit ratio

Recoup past income and increase future income at relatively low cost Do not end relationships “Leverage” your compliance efforts to other licensees

Copyright 2010, Daniel Burns & Associates, Inc.

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Concerns for Licensors and Licensees regarding Royalty Audits

• Licensor– Audit candidate selection– Consensus building to

support audit– Impact on relationship with

licensee– Cost– Licensee may say they

overpaid or no longer use the licensed technology

• Licensee– Scheduling– Burden to staff– Confidentiality– Independence of auditor– (Licensees rarely offended at

prospect of audit)


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How should audit candidates be selected?

Selection of candidates is only as good as your ability to assess risk, therefore, develop cost-effective selection criteria

NIH published criterion are similar to many U’s and RF’s1) Annual earned royalties > $100K 2) Late, variable, or rapidly changing payments3) Reporting contradicted by other evidence

We suggest three approaches to streamline audit candidate selection1) Scoring Chart or Red Flag Checklist 2) Independent Research 3) Approach licensees directly


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Approach #1: Red Flag Checklist (do for all licensees)

Red Flag to check for Points1. Gut instinct, research, or inventor evidence suggest underpayment 32. Royalty calculation very complex or royalty reporting is poor or variable 33. Sublicenses exist that have not been reported to you 34. Licensed product is one component of larger assembly 35. Licensed products made overseas; sold overseas through affiliates 26. Licensee under scrutiny from regulatory bodies such as SEC or FTC 27. Turnover at CFO, General Counsel, IP counsel, or Controller level 28. Licensee is in distressed financial condition; stated it has a “design around” 29. Poor communication between licensee’s legal, accounting, and bus dev groups 110. Licensee uses invention in multiple product lines or processes 111. Licensee pays minimum year after year but no royalty bearing sales 112. More than five years have passed since the last royalty audit 1

If you can check-off any three 3-point items, or where the total of checked off red flags is at least 12 points, a royalty audit may be warranted.


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Approach #2: Independent Research and analysis

Key resources: Royalty reports (Quarterly)

Sequential analysis of licensee’s own results Compare against competitors, industry averages, or other

non-exclusive licensees, if any. Licensee: Press releases, website review (Periodically) Public companies: analyst reports, market research, Factiva, etc. Private companies: Hoovers and other specialized services Markets / technologies: analyst reports, trade associations, etc.


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Approach #3: The direct approach

Ask questions and demand responses First commercial sale: Call the licensee and say “Congratulations!

By the way, how do you calculate the royalty?” Have the licensee send you documents to illustrate the calculation.

Consider a Questionnaire Can be for one, some, or all licensees May commit licensee to positions that benefit you later May cause licensee to undertake “self-audit”

(useful, but not a complete answer) Can incorporate hypotheticals: what royalty would result if

certain conditions are true?


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Timing, Cost, and Licensor Role in the Royalty Audit Process

Generally 4-6 weeks from notification to site visit

Typical fees range is $15K - $35K for all prep work, field work, and written report. Most common fees are ~ $20K - $25K. Many variables outside royalty auditor’s control, though.

Inventor can address uncertain definition of licensed products

Audit notification letter from licensing office to licensee

Confidentiality: licensee usually wants us to enter NDA -- this is not usually a problem provided we can fully disclose our findings to you

After the audit, follow up promptly with the licensee to resolve underpayments and other issues


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SOME of the core tests done in a typical royalty audit

RECONCILIATIONSRecorded sales were reported in financials and royalty reports

VALUE & CLASSIFICATION

Sales that were valued correctly and classified properly as RB or NRB

UNITS MADE & SOLD Sales that occurred

were actually recorded in the financial

statements

Reconcile royalty report detail to sales journal

Test royalty bearing invoice detail for price, quantity and deductions

Opening inventory at start of audit period

Reconcile sales journal to product line or line of business income statement

Test non-royalty bearing invoices to confirm no royalty bearing product

Plus quantity manufactured

Reconcile product line income statements to…

Less quantity sold

Consolidated income statements…

+/- other adjustments, such as returns or scrap

Do for each year Equals ending inventory at close of audit period

COMPLETE TESTING POPULATION

PROPER VALUATION OF SALES DISPOSITIONS ACCOUNTED FOR

NOTE: ALL TESTS MAY NOT BE NECESSARY. IN SOME CASES, OTHER TESTS MAY BE APPROPRIATE.

Copyright 2010, Daniel Burns & Associates, Inc.9

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Frequent reasons for underpayment of royalties

Underpayment on licensee’s own sales: key issues are definition of Licensed Product, the number of units sold, the sales price, and deductions taken Units

Newly developed products not treated as royalty bearing Royalty calculated on only part of a composition Licensed product defined as an “option” of larger apparatus “Allocation” of value between licensor’s IP and licensee’s “contribution” Territories where product made or sold are not patent protected

Pricing Proxy price established for royalty accounting Royalty based on sell-in price to Affiliate

Deductions Impact of Sarbanes-Oxley: external accountants requiring larger reserves Order of deductions or offsets can impact calculation

Sublicenses and sublicensing income Agreements not reported or characterized as other types of agreements Multiple elements of agreement cloud value of IP transferred This is a large and growing problem Key point: There is a “Structural Bias” is toward royalty underreporting


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Time; in this case, several years

Royalty bearing sales on quarterly royalty reports

Newly developed licensed products not included on royalty report

Sales in new territories not included on royalty reportsUnreported sublicensee issue fee and royalties

“Allocate” royalties to licensee & 3rd party patents

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The Structural Bias Toward Royalty Underreporting

License signed

First Commercial

Sale

First of several subsequent events that should affect royalties

Copyright 2010, Daniel Burns & Associates, Inc.11

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Resolution

Have an effective collection letter with clear time frame for payment or response and consider carefully whom to negotiate with Present reasons for underpayment Gain understanding of any licensee objections to overcome

Be prepared to negotiate on interest and audit costs Often involves credible threat of termination or adversarial

proceeding Understand alternatives available to them and to you Impact on relationship going forward Lengthy delays hurt your negotiating position


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Avoid problems before they start: Audit rights

State your audit rights clearly in License Agreement Licensee to use your standard royalty reporting format Audit clause should provide for access to documents relevant to

manufacture, sale and use of licensed products, such as: Sales records, invoice/shipping records, financial statements, product line

income statements, manufacturing and inventory records, price lists, catalogs, chart of accounts, cash receipts journal, transfer pricing records, distributor agreements, sublicense agreements and royalty reports, tax returns (esp. if private company), and, crucially, ability to have reports generated from licensee’s MIS or accounting system

Right to interview selected staff and to copy relevant documents Right to select investigator Licensee pays if discrepancy too high ( +/- 5%) in any period Licensee to retain records for five years

IRS require records be maintained six years from date of filing for returns with material underpayments

Damages claim for infringement can reach back six years from date suit filed Audit right should exist for at least one year beyond termination Licensee to get same rights from sublicensees


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Avoid problems before they start:Keep royalty calculation simple and verifiable

Use an easily measured royalty base Confirm that you and licensee define “Licensed Product” the same way Number of units sold or total unit sales in dollars Avoid like the plague:

Royalties on allocated cost of royalty bearing portion of product Royalty based on a percent of any “profit” measure

Use a straightforward royalty rate; % of sales or $/unit are best Contact licensee after first commercial sale is reported

Discuss methodology used to calculate earned royalty Discuss internal controls in place to ensure future products are treated as

royalty bearing


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Avoid problems before they start:Defining net sales

Accounting terms should be recognized terms of art. If in doubt, ask your CPAs

Try to avoid characterizing net sales as being determined “in accordance with GAAP”

Sales to Affiliates should be valued at sell-through price to third party Allowable deductions, other than returns, should be defined clearly and

should be those that are actually incurred and billed separately to the licensee


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Avoid problems before they start: Other provisions

Late payments Interest rate usually tied to prime or prime-plus Seek compounded interest

Royalty stacking; combination products “MedImmune provision”

Higher royalty rate or other consequence of validity challenge? Post-expiration payments may be unenforceable

To ease cash flow, licensees may seek to spread payments over time at a lower rate Such arrangements may be unenforceable (Scheiber v. Dolby, 7th Cir., 2002)

Best efforts & minimum royalties Some courts (in at least the 3rd, 6th, and 7th Circuits) have refused to imply a best

efforts obligation where an exclusive license calls for minimum annual royalties or advance royalties


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Avoid problems before they start: Sublicensing issues

“Creative” sublicensing practices we are seeing “Teaming agreements” (a sublicense by any other name) containing upfront

payments and earned royalty provisions are not reported to the licensor Licensor’s IP is licensed jointly with licensee’s and sublicense royalties are

apportioned to the licensor Agreements that contain sublicense rights as part of a bundle of assets, where too

little value is accorded to the sublicensed IP Recommendations

Require copy of any agreement involving your IP Licensor, not just the licensee, should be able to initiate audit of sublicensee Be as expansive as possible in covering forms of compensation you are entitled to

participate in: don’t limit yourself to one type of compensation Some compensation (R&D payments, FMV of cross-license) typically excluded Require that your IP must not be bundled with other assets in a sublicense; if it is,

consider requiring a Purchase Price Allocation to show the fair market value of the sublicensed IP rights


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The concepts and theories addressed herein are for discussion purposes only and are not intended to be all-inclusive on the topic of

licensing investigations, or royalty audits. The concepts discussed are illustrative only and do not necessarily represent the approaches that

the author or his firm would recommend in any particular matter.

No part of this document should be construed to constitute legal advice.

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