Once upon a time, the audit clause in licensing contracts was rarely brought into play.
On the rare occasion that it was, it was typically only towards the end of an agreement in cases where the licensor suspected that royalties were underreported. The licensor’s action often severely damaged its relationship with the licensee, whether the audit uncovered anomalies.
As the licensing market has matured, many more brand owners and agents are auditing their licensees as part of best practices. Audits have caused the licensee to recognize the need to have good processes in place across its business, since an auditor looks at more than just the financial aspects of the contract.
It makes good sense to audit a licensee in the middle of a contract term, rather than just at the end. A mid-term review can be of great benefit to both sides.
If there are misinterpretations of contract clauses, it is far better to pick that up and remedy it one year in, rather than discover costly mistakes at the end of the term, when the licensee must foot a larger bill.
Licensees should be aware of the vast number of issues that can come up during an audit so they can be prepared.
In this article, we will discuss:
- Aspects that auditors will investigate.
- How licensees and licensors can be best prepared for unexpected audits
- Tips for licensees to implement systems to prevent any issues with audits.
What’s the Deal?
An audit will examine the licensee’s interpretation of all the terms of the contract and the compliance expected across all areas. This includes:
- Distribution channels
- Product approvals
- Final samples
- Safety certificates
- Third-party manufacturer agreements
- Ethical policies (when they exist)
- Sales thresholds
- Allowable discounts
Consistency of contract interpretation and execution throughout the business can be difficult to achieve using manual systems, particularly when managing a burgeoning portfolio of licenses, each with different terms and conditions attached.
A serious breach of any of these aspects could cause the termination of a contract.
Do not despair! With a brand licensing management software in place, quick access to all contractual obligations is made easy. Licensees easily refer to their licensing contracts and confirm that all deductions, allowances and net sales rates are allowed.
Who’s Driving the Deal?
In many licensee companies, the contract negotiator is not the same person who processes product sales, calculates royalties, manages the sales team activities, or submits approvals.
The accounting department of the licensee’s company may have a different interpretation of net sales, for example, but does it have the same meaning as that of the licensor? Is the licensee being more generous in their interpretation of what discounts and costs can be deducted than was intended in the contract?
Remember that the audit trail is a vital part of the licensing process. Licensees need clear evidence of contract amendments and their execution when an auditor questions a royalty rate that differs from the initial contract.
Brand owners contracts work diligently to form crystal clear explanations of all exceptions and limitations. Licensees similarly digest all contract legal definitions, addendums, clauses, and submit statements according to their interpretations of the agreement.
The reliance on Excel spreadsheets for monitoring and calculating royalties allows clerical errors to creep in. They can be as simple as pasting the wrong royalty rate into a column, or as complicated as allocating royalties for one contract against a completely different entity.
We all know how hectic it can be at quarter’s end, when all the reports for different licenses must be prepared simultaneously working into the wee hours of the evening to make the deadline.
Rescue comes in the form of an automated system that tracks and inputs metrics like sales, rate escalations, recoupable advance, and more. This ensures that no numbers are missed and any potential errors or issues with compliance are caught/resolved quickly.
SKU numbers often result in headaches during an audit. Perhaps the SKU number changed to reflect a multi-pack. How can a
licensee be sure that it has properly picked up the individual royalty due for each of the components?
Or after a product was approved under one SKU number, that the number was altered at the time of sale. How can the licensee demonstrate that the changed SKU was approved for that item?
Whilst most errors are unintentional, the licensee may still be liable for painful penalties on overdue amounts should the value of the anomalies be greater than the tolerance level provided in the contract.
Plus, there are the auditors’ fees to boot paid by the licensee.
It is therefore well worth taking the time to review current processes to ensure that all aspects of the contracts are executed correctly. You may even consider approaching an audit firm or licensing specialist to give your procedures a ‘health check’.
TOP TEN TIPS FOR LICENSEES TO ‘AUDIT-PROOF’ THEIR BUSINESS
- Ensure that the accounts, sales, and creative teams are clear on their responsibilities within the contract.
- Check that the financial requirements and definitions are understood and in line with your pricing policy, taking into consideration discount allowances, returns caps, currency conversions, and marketing contributions.
- Brief the sales team on territories, channels, and categories permitted within the agreement and encourage feedback on new areas that could be negotiated into the contract at a later point during the term, thus avoiding any breach.
- Establish a procedure within the creative area for tracking permitted product categories and approvals, particularly the critical events such as pre-production sign-off and sending the correct number of final samples.
- Keep accurate records of any changes or concessions agreed upon during the term of the contract. It is advisable to request official amendment paperwork, which should be filed with the original agreement.
- Implement a product coding system that reconciles approved products with sales reports, to ensure that royalties are reported on approved items and to catch any that have fallen through the net. This advice should also be applied to ethical and safety certification, packaging approvals, and manufacturer details.
- Endeavor to capture all sales data in the correct quarter, to avoid interest charges on overdue royalties, and to submit royalty statements on time.
- Take care to track guarantee recoupment and beware of any triggers in the contract relating to sliding royalties, thresholds, and cross-collateralization.
- Avoid using your own ‘standard’ formulas for calculating royalties owed. Each contract is likely to have subtle differences depending on the licensor’s typical contract terms. It is important that you take advantage of all the unique discounts and allowances contained in each of your licensing contracts.
- Consider installing a brand licensing management software solution to keep track of your sales, royalties, approvals, and other contractual obligations. This step can help to ensure royalty accounting is accurate, product approvals watertight, and all data is readily available in the event of an audit.
This can result in valuable time and cost savings in generating royalty statements and tracking approval timelines. An added benefit is that you can analyze contract performance, keeping track of minimum guarantee exposure and contract expiry dates – all the while improving communication across departments.
Remember, you are unlikely to have more than a few weeks’ notice before an audit. Instilling good practice within your company, perhaps supported by a well-organized automation system, will help ensure that you have the right information on hand, demonstrate compliance across all parts of the contract, and, above all, save your money and your reputation.
We would be happy to answer any questions you have and see how our solutions can help your business. Give us a call at +1 877-289-8431, +1 424-213-6663 and +44 203 882 3370 (UK) or email us email@example.com.