Congrats!

Your deal memo has been approved, the contracts have been routed through your legal department, and the creative compliance team has been approving products – even before the ink on the agreement has dried.

Now the real work begins.

Licensors and their licensees need to translate the terms of the contract into the real world of financial compliance to navigate a multiplicity of legal interpretations and brand management issues.

In this whitepaper, we will outline some of the key points that all parties must mutually accept and understand, such as:

• Gross versus net sales
• Primary contract issues, including penalties, interest charges, audits, and guarantees
• Royalty reporting details
• Other financial decisions

Let’s dive in.

GROSS VERSUS NET SALES

The term “gross sales” describe the total amount paid or owed to the licensee and licensee’s affiliates from the sales of licensed articles. The most common definition of gross sales is tied to list prices in each territory and based on invoiced amounts before discounts and allowances are applied.

When looking at invoices, watch for hidden discounts such as products shipped gratis in lieu of discounts. Gross sales typically exclude:

• Finance charges
• Taxes on sales
• Reasonable shipping and handling fees, which are separately identified on the invoice for a sale.

To clarify the definition of gross sales, all parties in an agreement must answer the following questions:

• What is the basis of gross sales: the amounts paid, or the amounts owed?
• What constitutes an affiliate of a licensee?
• Are gross sales tied to retail sales or wholesale (the amount sold to a distributor)?
• Is the price of each product sold based on invoiced amounts before or after discounts and allowances?
• How about products shipped gratis, such as for promotional use?

Net sales are defined as gross sales minus credits for returns (actually made or allowed) and assessed charges for personalization.

Deductions from gross sales — e.g., cash or early payment discounts; advertising or mark‐down allowances; costs incurred in manufacturing, packaging, selling, advertising, promoting, importing, or distributing licensed articles; freight costs; bad debt — are typically not allowed.

It should be very clear within your contract what to do with returns received. Are they allocated back into inventory for future sales or sold again as a different sales type (e.g., as electronic sales through off‐price channels)? Is there a cap on deductions for returns?

For clarification within your contract, it is better to list out what is deductible, rather than what is not deductible. You can also cap deductible amounts of any type, as a percentage of gross sales versus net sales.

PRIMARY CONTRACT CLAUSES

A contract clause addresses a specific aspect of the agreement in order to provide clarification or additional stipulations, such as penalties.

Penalties:

The penalties for non‐compliance must be clear and enforceable. The risk of paying on time, for the licensee, is that they overpay royalties. For instance, say that they meet a retailer’s request to get products on shelves for a movie, but the movie does not come out on schedule or does not resonate with consumers.

Therefore, the branded products sell much less than what was expected. Consistent measurements of royalty payments over time allow the brand owner to analyze which products are likely to be returned, giving both parties valuable information.

The alternative is for a licensee to ride out the license to face an end‐of‐term audit settlement and negotiate excessive returns. “Penalty” is a particularly challenging term in Europe since most contracts in the EU cannot legally curtail competition across borders.

If you do fine licensees that sell outside of the territory granted in their license agreement, it will not necessarily prevent them from selling indirectly into excluded territories.

For example, if you impose a 200% penalty for sales to another territory of products tied to an 8% royalty, the situation is analogous to granting the licensee the rights to that territory at 16% of net sales. It may not prevent the licensee from selling in excluded territories, by EU rules.

Interest Charges:

Interest on late payments encourages licensees to pay on time, but only if it is enforced each period and not just at the end of the contract. If the licensor’s administrators capture royalties on current net sales, they will catch late payments before the next royalty statement.

If they wait until the end of the agreement, the late payments become a bargaining chip and the amount owed is often reduced during the negotiation process.

Audits:

Strong language is critical to protect the licensor’s interest throughout different points of the agreement. Audits are effective only if they are use, and early interventions help audit provisions – allowing the auditors to correct errors, look after licensor’s best interests, and clear up any misunderstandings with licensees.

In terms of who pays fee‐reimbursement thresholds (which require the licensee to pay for the audit if a certain amount is owed) help prevent under reporting, since the licensee does not want to be responsible for third‐party auditor fees.

FOB Sales:

Free on Board (FOB) pricing is usually applied to sales occurring at the port of origin in any agreement where retailers take large shipments directly. Since the FOB prices are usually much lower than retail or wholesale prices, royalty rates tend to be 20% or more than the standard rates applied to other sales types.

If FOB sales are not called out and adjusted in the licensing agreement, the licensor’s royalty revenues will be much lower than they should be.

Guarantees:

Minimum guarantees have historically been calculated as 50% of the licensee’s sales forecast over the term of the contract, but they have declined since the worldwide recession. Licensees see the timing of guarantee payments as crucial – as they need to recoup their upfront costs in marketing, testing, and developing each product.

Annual guarantees that step up over the term of the license may be a good solution for licensees who have large upfront costs to bring their branded products to market.

ROYALTY REPORTING DETAILS

Royalty reports are a compilation with details regarding the number of sales and aggregate selling prices within a set period of time – typically a business quarter. Therefore, it is important that licensors clarify the exact information that must be included in the royalty reports so they are receiving an accurate picture of net sales for their licensed products.

Retailer‐Reported Information:

Brand owners and agents are increasingly using retailer‐reported sales information to pitch collections of products on behalf of several licensees across product categories, to specific accounts. Many retailers also require direct shipments to each store or each region.

It is therefore beneficial to ask licensees for a breakdown of sales per retailer, especially if they mostly sell to national accounts.

This requirement is not critical for licensees who sell to a large pool of independent retailers, since compiling the information is more time‐consuming and costly. Tracking many minor retailers does bring a lot of benefit in terms of promoting the brand.

SKU Reporting Versus Product/Category:

Licensees ship product directly to each retailer or store using a unique, identifiable product number or SKU. Unlike when they rely on product or category‐level information, licensors can use these unique item numbers to validate approved products and ensure that the correct royalty rates apply.

SKU reporting allows the generation of reports detailing where and how revenue has been created, which is useful for strategy‐planning purposes.

Some licensors wait until the end of an audit to validate unapproved products, while others validate SKUs each reporting period. In the case of assortments combining multiple branded products, it is important that licensees break out individual SKUs.

Invoice‐Level Detail:

Many large licensors are requiring invoice‐level detail to help establish gross and net sales more carefully and to monitor selling prices and sales margins. Licensees that are not properly automated face a huge burden in complying with this level of detail in their royalty reports.

Territory Reporting:

Some licensors require different royalty rates for different territories. Even when that requirement is a simple breakdown of one rate for all foreign sales and another for all domestic sales, the contract must carefully define what constitutes a domestic sale.

For instance, Puerto Rico, Guam, and foreign military bases can be defined as a part of the domestic U.S. territory. But, how will guarantees that accrue before any products have been sold be allocated when licensees sell into more than one territory?

Once royalties are reported, brand owner revenue can be appropriately allocated to different territories. Territory allocation can be especially complicated with TV‐based deals that have a lot of stakeholders in different countries, with different allocations payable for different territories on sales of branded merchandise.

Now, things get a bit more complicated when it comes to franchisees in Europe.

According to the Treaty of Rome in the EU, it’s illegal to prohibit or penalize unsolicited sales across the different territories within the union. Therefore, with cross‐border sales in the EU, you need to know if each sale was unsolicited or intentionally marketed by the licensee, and the contract must be carefully worded with regards to out‐of‐territory sales.

Managing licensed product sales across European territories becomes a very strategic exercise. The expectation of an ongoing successful relationship for both parties is the best bargaining chip to ensure compliance in territory sales.

OTHER FINANCIAL CONSIDERATIONS

Invoicing:

Invoicing international licensees can also be tricky, so you must be quite clear and thorough in your expectations for invoicing reports. For instance, does the invoicing need to be stated in that country’s or territory’s currency?

Be sure to consider the local legislation requirements as well, In many territories, such as Germany and Australia, brand owners need to invoice foreign licensees with proper tax forms in order to get paid.

Agents as Collectors:

Licensors using licensing agents should make sure the latter are prompt in collecting revenue from licensees and in paying the licensor. Some licensors prefer to collect the money from the licensees themselves to minimize the risk and boost cash flow.

For instance, in some territories, such as Russia or South Africa, this can be difficult due to legal or cultural constraints. It is typically best to agree upon a money transfer provider for all financial exchanges.

Most international transfers will incur a fee, so keep this in mind when setting a payment schedule.

“Other” Royalties:

Historically, some brand owners have included a contract term demanding an additional royalty as reimbursement for advertising or other activities to support the overall brand.

These requirements, which include Common Marketing Funds (CMF), Joint Marketing Funds (JMP), Anti‐Piracy Funds, and General Marketing Commitments, are becoming less common in deals today.

Sublicensing:

Sublicensing represents a challenge in many foreign licensing deals. Some licensors require the same royalty rate for sublicensed products as for direct‐licensed products.

This is especially common in global publishing deals — where a licensee in one territory typically holds wide geographic rights and sublicenses publishers in territories where it doesn’t have offices.

Since the licensee shares in the revenues from sublicensees, the licensor ends up with less revenue. Licensors need to ask for a higher rate on sublicensed merchandise to compensate for the revenue‐sharing.

If it is tough to reach agreement on sublicensing rates, consider alternative deal structures, such as a distribution deal with a third party.

Divorce:

A number of contract terms deal with ending a licensing deal under various circumstances. A contract must define what constitutes a breach of a license (e.g., failure to report royalties, late payments, or unapproved use of IP).

It also must outline the sell‐off period for any remaining stock, whether that means working with the licensee to facilitate sensible disposal or buying back existing stock and selling it directly or indirectly to the new licensee.

The ultimate breakup challenge is the bankruptcy of a licensee or a major retailer.

When Woolworth went insolvent in the U.K. in 2012, many licensees also closed up shop due to uncollectible debts. Bankruptcy regulations can also vary vastly by territory. Be sure that any restrictions or clauses regarding bankruptcy are in accordance with that country’s legislation.

KEY TAKEAWAYS

• Negotiation and accurate translation of licensing contracts (particularly with international licensees) can possess complexities. It is critical to interpret contractual obligations and terms of a contract and clarify the financial relationship between the licensee and the brand licensing company.
• It is important to delineate the differences between gross and net sales and illustrate exceptions and exclusions.
• Be sure to include the necessary contract clauses for additional interpretation on specific circumstances. This includes penalties, interest charges, audits, FOB sales, and guarantees.
• Clarify what information should be included in royalty reports and how sales for SKU versus product categories should be stated.
• Licensees are required to ensure compliance while selling across different territories, as royalty rates vary, and cross border laws and currency rates Must be taken into consideration.
• Licensors and agents need to address other financial considerations within your contract regarding invoicing, other royalties, sublicensing, and termination of a contract.

SUMMARY

Formalizing contract terms and establishing diligent internal compliance practices will help licensors and licensees come through the royalty audit process with a minimum of pain and cost. Implementing better practices will also help on a strategic level, turning licensing administrators into analysts.

In order to ensure your contract covers the full gamut of all financial legal situations, you should consider not only hiring an attorney – but also utilizing licensing management software that focuses primarily on license and royalty management.

Such software solution enhances licensing processes through automating manual tasks in the licensing operation, allowing both licensors and licensees access to all legal, financial, creative, sales and marketing information at any time.

If you have any further questions about brand licensing management software, give us a call at +1 877-289-8431, +1 424-213-6663 (International) and +44 203 882 3370 (UK) or email us sales@dependablesolutions.com.