The articles below appeared in the August 2010 issue of Technology Transfer Tactics. Click here to subscribe.

Amid the daily hustle and bustle of a busy TTO, tracking and checking the accuracy of royalty payments is one activity that frequently is shunted aside or, at best, performed on an ad hoc basis. That’s a mistake, says Sidney P. Rattner, CPA, a partner in the Schaumburg, IL, office of the certified public accounting firm McGladrey & Pullen, LLP. Decades of auditing royalty streams associated with license agreements have taught Rattner that 70% to 80% of audits produce “not only a report for our client, but also a check.”

Michael F. Moore, manager of strategic accounts and compliance in the Office for Tech Commercialization at the University of Minnesota (UMinn), agrees that audit results usually work in favor of the licensor and are, at worst, cost-neutral.

“We do royalty audits, but we do them on a limited basis,” Moore says, adding that the audits typically focus on licensees with the largest royalty streams. “The difficulty for us is the cash outlay.” Some TTOs respond to the challenge of optimizing royalty audits with homegrown solutions. The Wisconsin Alumni Research Foundation (WARF) conducts royalty audits using customized checklists “derived from the specifics of the particular license and the type of technology,” explains Andrew Cohn, director of government and association relations. “We look for anomalies like wide variation in reported income for medium-size licensees, which might trigger an audit, but that has not happened for a while. For our most valuable licensees, we audit around every five to seven years.”

Checklist guides audit choices

To help make the best use of limited resources, Rattner, who oversees his firm’s royalty audit process, has developed a checklist TTOs can use as a “diagnostic tool” to determine whether and how often to audit license agreements. The simple scoring tool helps users to assess the “risk profile” of each license and identifies factors that signal an audit may be warranted.

The checklist examines factors such as the timeliness of royalty payments, supporting documentation, and complexity of the royalty calculation as well as the TTO’s level of understanding of the licensed technology, its distribution channels, and commercial uses. Responses are scored on a point system, with the total indicating the agreement’s potential exposure. (Click here for the complete checklist.)

IP managers sometimes need help deciding which licenses to monitor closely, which to place on autopilot, and which to send for outside review, according to Rattner. Most TTOs are so caught up with processing paperwork that they don’t recognize a problem with a license until months after a mistake has occurred, when “bells and whistles start going off,” he says. The checklist provides TTO staff with systematic, concrete documentation to better guide their audit decision-making.

The checklist also may help to confirm or refute your suspicions that the royalty stream associated with a certain license doesn’t seem quite right. Seventy percent of Rattner’s clients are university TTOs, and he’s seen countless variations on the same theme: fuzzy math that does not match the agreement’s terms. For example, he’s seen situations where sales subject to royalties were reduced by inappropriate subtractions from gross sales, and others where high-dollar sales to end-users were recorded as lower-dollar sales to distributors for royalty reporting purposes. In other cases, sales of products in countries outside the US, where no patent coverage existed, were not reported for royalty purposes even though, in many of these cases, the licensed product was manufactured in the U.S. and subject to royalties. These “mistakes” can cost TTOs millions of dollars in lost revenues.

Budget and prioritize royalty audits

Iowa State University uses the questions on Rattner’s checklist but applies its own scoring system, according to Nita Lovejoy, associate director of the Office of Intellectual Property and Technology Transfer for the Iowa State University Research Foundation. “The checklist sets out all of the red flags,” Lovejoy says, “but we know how to prioritize our audits.”

ISU conducts royalty audits every year, but the number of audits varies according to the amount the office can budget in a given year. “Generally, we have a list of licensees that we want to audit,” Lovejoy says — mainly those with a large potential financial impact or inconsistencies in royalty reporting. “But audits do take a lot of time,” she concedes. “You have to collect information and sometimes you have to make visits to go over the license agreement. You have to take all of those resources into account.”

Rather than focusing only on large licensees, audit licenses “that are not returning what you expected them to return,” Moore suggests. Lovejoy agrees, noting that ISU audited a small licensee several years ago when the inventor expressed concern about possible under-reporting. The audit generated a small recovery for the institution just as the patent and license were about to expire.

In general, keep inventors informed as an audit progresses, Lovejoy advises. When royalty structures are especially complicated, ISU consults the inventors beforehand to gain insights that might help the audit team. Researchers often know more than auditors about a technology’s potential applications in the marketplace, she points out.

Don’t wait more than a year or two after payments begin to flow before auditing a license with a complex royalty stream, she adds. “Not only does that help you get the royalty that’s due, but it also helps the licensee to get processes in place so they’re complying with the terms of the agreement.”

That being said, audits don’t always generate returns for the TTO. In fact, the first audit of one of Moore’s largest licensees identified an overpayment that UMinn was forced to refund. The second audit, however, uncovered a large underpayment that resulted in significant reimbursement to the university. Moore expects the third audit, now underway, to be at least cost-neutral.

Moore and Rattner have discussed implementing a formal royalty audit program at UMinn rather than “pinging the portfolio” and auditing on a selective but random basis. “You want to ensure that you hit a number of different kinds of licenses and, over time, audit as many as you can,” Moore says.

Conducting regular royalty audits offers other advantages, Rattner maintains. Often, the prospect of facing an external audit will prompt a licensee to self-audit, which may in turn generate a voluntary disclosure of under-reporting. Often, these mistakes are unintentional. For example, a company’s R&D department may use a licensed technology to develop a new product but neglect to submit the proper paperwork internally. Consequently, the licensee’s accounting department will shortchange the TTO when the product launches commercially.

“If somebody underpaid us drastically, I’d want to know the reason why,” Moore says. “Was it a strict accounting determination? Were they under-reporting sales? The bullet points under the dollar figure that explain what caused the discrepancy are important.” If a licensee’s audit revealed questionable accounting or reporting tactics, “we would factor that in to consider auditing them more often in the future — especially if it was a big royalty earner,” Moore says.

ISU also accelerates its audit schedule when the “gut instinct” suggested in Rattner’s checklist raises doubts about a licensee’s internal accounting processes. If the TTO’s outside auditor finds a large royalty underpayment, Lovejoy may repeat the audit the following year. She’s also sensitive to major changes in a licensee’s management, product stream, or target market. “We’re doing four audits this year, and two of them are repeats,” she tells TTT.

Address audits in contract

Write your contracts to provide for the ability to audit on an ad hoc basis and make the terms as friendly to the university as you can, sources suggest. For example, seek to extend as far as possible the number of years you can reach back to recoup underpayments and the amount of interest you can charge on them. Although ISU generally uses an outside auditor, its contracts allow audits by internal staff. “We haven’t had our licensees complain about a request to audit,” Lovejoy says, crediting the “fairly broad” language in its licensing agreements.

In fact, ISU staff conduct informal audits of licensees in its germplasm program when the licensing associate and researcher make annual visits to these companies. “We attach a royalty report to each license, so it’s pretty clear how to do the calculations,” Lovejoy says. During the visits, “we go over the royalty reports and the process of completing these reports so we know they’re reporting accurately.”

Licensees also should bear the cost of the audit if an underpayment to the licensor exceeds a certain threshold — for example, 5% to as little as 2%, Moore suggests. License agreements should set expectations at the front end, Lovejoy agrees, noting that licensees “pay us the lesser of 5% or a fixed dollar amount” when significant royalty errors are found.

Rattner stresses that the audit checklist is most beneficial when used consistently. Decide up front what thresholds you will set to manage audits internally and when to send a license for external review. Prepare to act when a licensee’s risk score suggests that oversight is needed.

Even when a score is low, “that is not to say that a license doesn’t deserve an audit,” Rattner says. The very process of monitoring your licenses on a regular basis will help attune your staff to certain peculiarities in the licensee’s behavior that may suggest the need for a review.

Failing to audit a licensee altogether is never a smart move. In 20 years of working with licensees, for instance, Lovejoy says only one company has contacted the university proactively to admit to a mistake in its royalty payments.

“Every entity has a responsibility — in the case of a university, to the inventors, the lab, the institution itself, and the state in which the university resides — to use good business practices,” Rattner emphasizes. Even when the checks arrive on time and the reports are submitted properly, “if you’ve had a license for 10 years that you’ve never audited, it still behooves you to conduct an audit.”

The relationships surrounding some license agreements are more sensitive than others, “and you may not want to rattle the chain of the licensee,” Rattner concedes. “But the licensee world has become educated. Just like income tax audits by the IRS, licensees — especially big pharmas and biotechs — recognize that royalty audits are going to take place.”

Contact Cohn at 608-263-2821 or cohn@warf.org; Lovejoy at 515-294-4740 or nlovejoy@iastate.edu; Moore at 612-624-9531 or moore045@umn.edu; and Rattner at 847-413-6217 or sid.rattner@mcgladrey.com.