Licensing agreements are common amongst intellectual property (IP) owners that wish to commercialize their IP, namely patents, copyrights, and trademarks. In their simplest form, agreements set forth conditions of how a party (the licensee) may use the IP and financial obligations due to the IP owner (the licensor) under the agreement. Most often a royalty arrangement is agreed to by the parties. Royalties can be viewed like rental payments. Some licensing agreements are royalty-free but others may contain important restrictions on the licensee.
When dealing with licensing agreements, the devil is in the details. Rights granted could be exclusive or non-exclusive, limited by territory or for use in particular applications or products. For example, an author may grant rights in their copyright for print books and e-books but not audio books. Just as a patent owner may grant patent rights for research and development but not commercial purposes. It is important at the outset to understand the intentions of both parties when drafting licensing agreements to ensure that the agreement reflects all potential uses meant to be covered. Disputes may arise when there is ambiguity over what was actually granted, and a licensee is perceived to be using the IP outside the scope of the license agreement. This can lead to breach of contract as well as infringement claims.
In addition to controversies surrounding the specific IP granted in a license agreement, disputes can arise over the calculation of royalties. Clear, unambiguous language with defined terms is paramount in this area. Royalty payments may be based on net sales, units, revenue, or lump sum payments. The calculation of royalties often allows for the deduction of certain items such as freight, duties, customary government fees, and trade discounts.
Royalty calculations may be straightforward—for example, $3 per unit sold.
However, most agreements call for a much more complex calculation of royalties. For purposes of discussion, consider this hypothetical royalty clause, which will illustrate some questions it poses based on actual disputes we have seen.
On an annual basis, royalties shall be calculated as 10% of revenue less discounts and normal trade allowances up to 10,000 units on normal domestic sales, 12.5% of net sales on units to between 10,001 to 15,000 and 15% on net sales thereafter. The rate for foreign sales shall be half the domestic rate. If Licensee reaches 15,000 units, the highest rate shall be retroactive until inception. Royalties shall be calculated after the deduction of duties and government fees, trade discounts. Trade discounts are not to exceed 10%. Royalties shall be paid quarterly.
Sales and revenue are often used interchangeably to calculate royalties, but there are differences. The intention of most licensors is that a royalty is generated at the time of sale. Revenue may be calculated differently depending on the accounting standards adopted by the licensee. For example, if a royalty is based on revenue and the licensee changes from U.S. Generally Accepted Accounting Principles to International Financial Reporting Standards, how does that affect the royalty base? This very issue came up when a licensor received an adjustment on their royalty statement because the licensee changed their accounting method. Issues may also arise as a result of the licensee’s accounting system. For example, a licensee may not generate royalty payments until revenue is properly recognized (i.e., software sales with ongoing obligations in which revenue is recorded over the life of the customer agreement although payment is made upfront). These issues could lead to later disputes over calculation of royalties.
Escalation or tiering clauses are common in licensing agreements. Not only do they provide fertile ground for mistakes in calculating royalties, they can also lead to problems if not drafted well. In the above royalty clause example, it is unclear exactly what type of sales will trigger the escalated royalty rate. Is it all sales or only domestic? Does the licensing agreement specify other sales channels for which sales should count toward higher tiers? What if there is a delay in reporting sales in the appropriate time period such that the licensee does not report sales at the agreed-on escalated royalty rate? How would the Licensor even be aware of such a problem? Experience shows that escalation clauses are virtually never implemented with 100 percent accuracy.
Another common area for disagreement among parties is discounts. In the above royalty clause example, it is unclear if the maximum discount applies to individual transactions or in the aggregate. And if in the aggregate, over what time period? In one royalty dispute between parties involving this issue, the licensee sold the licensed products to big box retailers and at the end of each quarter gave a credit to its customers based on sales volume. The licensee did not link discounts to particular product sales but did give discounts on the licensed products as part of a bundle of total sales. The licensee took the clause to mean that so long as they did not deduct more than the allowable deduction in a particular reporting period, they were operating within the scope of the license agreement. Over the course of a year, the licensee gave customer discounts that averaged 10 percent. However, on a quarterly basis there were individual discounts less than 10 percent and greater than 10 percent. The licensor’s position was that deductions needed to be considered certain on a quarterly reporting basis such that if a deduction was 5 percent to a particular customer, that was the allowable deduction and if the deduction was more than 10 percent, the deduction had to be capped at 10 percent.
Keeping in mind the above potential pitfalls in licensing agreements will help avoid problems in drafting agreements, and help litigators to identify potential areas of dispute when advising clients that have an existing licensing arrangement.
