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Use this royalty audit checklist to identify “red flag” licensees

This article appeared in the June 2014 issue of Technology Transfer Tactics. Click here for a free sample issue or click here to subscribe.

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Don’t let concerns about how a licensee will respond if you initiate a royalty audit keep you from doing so. True, an individual license can represent a significant revenue stream, and technology transfer offices are wise to proceed with caution when the future profitability of any arrangement is at stake. But, as Nate Ruey, CPA, director of Royalty Contract Review Services at McGladrey LLP, points out, the days of licensees breaking off relations in a huff over an initiated audit are long gone.

“We’ve seen that change over time,” he tells Technology Transfer Tactics. “When our firm first started to do royalty audits, there weren’t as many reviews being done. Now, the truth is companies get audited all the time. The mindset in the past was, ‘I can’t believe you’re auditing me.’ Now it’s, ‘You can’t do it this week because someone else is coming in to audit me.’”

Chicago-based McGladrey is the fifth largest provider of accounting, tax and consulting services in the United States, and Ruey’s group is focused on royalty audits. The firm has produced a checklist TTOs can use to determine when a formal audit may be appropriate. “It’s not so much that a TTO has done anything wrong that leads up to the need for an audit,” Ruey explains. “It’s the nature of those organizations and the staffing challenges they face where licensing officers often work on deals — and then manage them post-execution, too. Often, they don’t have time to work closely with licensees post-execution, and when that happens, things may slip through the cracks and potential licensee issues are not identified as quickly as they could be.”

Usually that involves money not coming in or coming in late, he notes. “We’re typically brought in for audit reviews when there’s been a problem,” he adds, “because most TTOs are reactive in nature. Proactive TTOs can use the checklist as a tool to detect red flags.”

Include reporting template in deal

The checklist (click here) is designed to walk TTOs through an analysis of how the royalty-related aspects of their licensing arrangements actually play out; another document from the firm offers sample language to include in those documents. For example, one checklist question bluntly asks if the licensee under review actually pays on time; TTO responses ranging from “all the time” to a simple “no” are weighted such that the total of all the checklist responses guides them toward an informed judgment call on whether to initiate an audit.

Why is there even a question about licensees paying on time — or at all? Why don’t TTOs nail that down right away every time? For one thing, different TTOs are structured differently, notes Ruey’s colleague Elizabeth Watts, a manager at McGladrey. In some, she says, the licensing officer manages the agreement post-execution, while in others a compliance function is set up; that alone can affect how carefully royalties are tracked. In addition, she notes, start-ups are frequently delinquent, which can affect the mindset of license managers; it may be a matter of not tracking non-start-ups as closely as a result.

Another question on the checklist looks at whether licensees include supporting schedules with their royalty payments, and what details those schedules include. Those are obviously helpful, but they’re not free.

“Licenses are a negotiation,” Ruey notes. “A TTO needs to look at its objectives in licensing the technology and commercializing the product and weigh the costs and benefits of getting the deal done versus including or excluding certain provisions or a detailed royalty report template.” Typically in a license agreement, he explains, the licensee will negotiate certain key reporting provisions, like net sales, that discuss how royalties will be calculated. There are often variations based on the technology, the industry and other factors.

“But what we don’t see consistently are royalty report templates,” he adds. “Those are critical documents. They capture a lot of useful information, and if they’re not in the agreement, the licensee has the flexibility to provide any type of reporting it chooses, and the licensor won’t have as much to stand on if it does not think the reporting is adequate.”

He adds: “We’ve seen instances where a royalty report template is not included, and the licensee provides just the dollar amount. At the other extreme, some licensees submit a 20-page report.” Neither extreme is particularly helpful, he adds, when the goal is to understand what’s going on with product sales — the where and the why — and use that information to sketch out historical trends.

Watts does note than less-than-illuminating royalty reports may be acceptable when the licensed product is still in the research phase and parties know there won’t be measurable sales for several years. In those cases, the licensee and licensor can agree on supporting documents later.

Suggested audit-related provisions

In its suggested license language document, McGladrey recommends royalty reports be formatted as attachments to license agreements; at a minimum, it says, the following information should be included, detailed by country of sales origin:

  • product number;
  • units sold;
  • unit price;
  • extended sales dollars;
  • royalty rate;
  • extended royalty dollars due; and
  • foreign currency conversion rate, if applicable.

The document also suggests only allowing royalty stacking when two or more royalties must be paid on the sale of the same licensed products. And, McGladrey recommends that late or underpaid royalties bear interest — and that the TTO determine whether the interest computation should be simple or compound. Further, agreements should state that “if the underpayment is 5% or greater for any royalty reporting period included in the royalty examination, the licensee shall bear the cost of the audit.”

Defining royalties due

In terms of how to report royalties, simple is generally better, but, as in most areas of tech transfer, “it depends on the technology,” Ruey notes. “If you’re talking about a technology in agriculture, for example, that’s different from pharma, medical devices, engineering or semiconductors. The industry of the product to be commercialized typically dictates how royalties are calculated and tracked; whether it’s high-volume, low-dollar or high-dollar, low-volume, it’s up to the TTO to go through due diligence and understand the market and how similar technology royalties are being presented.”

The important thing, he emphasizes, is “clearly defining how the royalties will be paid and what kinds of products and services are subject to royalties.” Complicated royalty calculations may be unavoidable when the licensed product is only a small part of the product being sold on the market — say, chip technology.

McGladrey suggests defining “net sales” as the gross amount invoiced less certain deductions which may vary by industry. In addition, the document warns TTOs against using the words “in accordance with Generally Accepted Accounting Principles (GAAP)” in the definition of net sales. “In certain situations — i.e., sales of products, which include software, service, warranty, etc. — GAAP mandates that, in certain cases, revenue recognition be deferred. The licensor should receive its royalty payment based on that definition of net sales without any reference to GAAP.”

Market knowledge affects audit decision

Another question on the audit checklist discusses the TTO’s “understanding of the market.” That’s an important perspective, Ruey emphasizes, because “the inventor may have some ideas on the market,” including “an idea of current products on the market that could be used with their technology.”

Indeed, subjective judgments can play an important role in determining the need for a royalty audit, Ruey points out. A question on the checklist, for example, asks about the TTO’s perception of its relationship with a licensee. What does “good” mean? What does “contentious” mean? Is a rocky relationship a dependable marker for inaccurate royalty payments? “It’s a judgment call,” Ruey says, “but it’s based on history and the TTO’s relationships with other licensees, so you can use that as a benchmark.” A good relationship involves “good communications and free-flowing ideas,” he adds, while a rocky one is a pretty dependable red flag for future discord.

Of course, royalty determinations shouldn’t become a “he said, she said” situation — unless they have to. “TTOs should have communications with their licensees,” Ruey emphasizes. “Their perceptions of the marketplace represent an integral part of a successful relationship.” Many licensees are publicly traded companies, he adds, so TTOs should check out the details available to them.

The news won’t always be good. “There are instances where additional products include the technology but aren’t being included in the royalty reports,” he notes, “so what the licensee is paying isn’t reflective of the market.” In some non-exclusive license agreements, the TTO might be licensing to multiple third parties and two of the three may have significant growth — but one is flat. The “why is that?” should be part of the communications the TTO is having with the licensee. Ruey recommends license agreements demand specific research and development spending requirements and marketing spend requirements. “That’s helps achieve the growth the TTO feels the technology should exhibit,” he says.

Insist on transparency

In crafting royalty audit language, he adds, it’s important to make sure you get as much transparency as possible. “Within the audit clause should be details on how long books and records should be maintained,” for example, he advises,” plus interest provisions regarding late payments or underreported royalties.” A provision should also exist to transfer the cost of the audit if under reported royalties over a certain threshold are identified. Ruey states, “The licensee enters into license agreements because they want the technology. The onus should be on them to accurately pay all royalties that are due.”

The firm also recommends reserving the right to audit at least annually, and it warns TTOs that “since royalty audits take place typically at least three years after the royalty information has been submitted, many companies do not save the original data files, and they attempt to recreate the data at the time of the audit, which, on many occasions, produces a different royalty liability.” In addition, the language recommends extending the right-to-audit umbrella over these key areas:

  • invoice registers and original invoices;
  • product sales analysis reports;
  • accounting general ledgers;
  • sub-license and distributor agreements;
  • price lists, product catalogs and marketing materials;
  • audited financial statements and/or income tax returns;
  • sales tax returns;
  • inventory and production records; and
  • shipping documents.

Checklist helps prioritize audits

McGladrey devised the checklist from its experience hammering out royalty documents and conducting royalty audits. Each response was weighted subjectively, Ruey explains, “based on history in conducting our reviews. Our group has seen a lot of technologies and performed a lot of different reviews in the last 20 years-plus.” The objective of the checklist, he adds, is to give TTOs a tool to help determine if a licensee is hitting its requirements.

“The more common types of errors we’ve seen lead to greater weight in the checklist,” he says. “In general, there’s not one area to focus on more than others. When licensors use the tool, they take a holistic approach to everything going on with the licensee and how royalties are being reported. This guide provides a framework.”

He adds: “All licensees should be audited, but many TTOs do not have an unlimited budget. If there are enough red flags, the licensee should go through an inspection at some point. The checklist, in other words, helps with prioritization.”

The common errors Ruey refers to include not monitoring licensees closely enough and not conducting audits enough; indeed, he urges TTOs to “understand the importance of the technology and the fiduciary responsibility they have to the stakeholders — whether it be the inventors or the universities.”

Contact Ruey at 312-634-3328 or nathaniel.ruey@mcgladrey.com; contact Watts at 312-634-4754 or elizabeth.watts@mcgladrey.com.


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