Many licensing agreements have a percentage royalty that the licensee must pay the licensor on sales of licensed products. This percentage is often the primary negotiation point in the entire deal. Yet, the royalty base on which this royalty will be paid—often defined as “Net Sales” (the invoiced or received sales income minus certain allowable deductions)—is nearly as important. This post below focuses on two aspects of the allowable Net Sales deductions element of the royalty base, one of many elements the parties should carefully consider.
When the royalty percentage on sales is based upon invoiced (rather than received) income—as is often the case—a licensee will likely request to add a provision allowing it to deduct any bad debts or uncollectable accounts from the royalty base. On its face, this demand seems reasonable – If a licensee will be writing off these sales, why should it have to pay a royalty on them?
From the perspective of the licensor, though, the issue is not so cut and dry. A licensor might want to consider why it should have to bear the brunt of the licensee’s bad business dealings. After all, it is not a collection agency. Moreover, eventual write-offs may be the result of more than just the licensee’s ‘bad luck’. For example, a licensee might consciously choose not to collect a debt with an eye to a future transaction with a customer that’s unrelated to the licensed products, i.e., a transaction in respect of which the licensor would not receive compensation.
It ultimately boils down to allocation of risk – Whether the licensor feels it should reasonably share in the licensee’s risk under the circumstances of the deal. Therefore, even in cases where a licensor is amenable to allowing bad debts deductions, it might be good strategy to present this as a concession rather than an allowance the licensee should be receiving automatically. Furthermore, the deduction should be subject to GAAP accounting practices applied consistently in the licensee’s financial statements.
From the licensee’s perspective, one often overlooked aspect while negotiating the royalty base in pass-through royalty licensing agreements (i.e., agreements where the licensee will be required to pay royalties on sales of licensed products by sublicensees without regard to the compensation it actually receives from sublicensees) is the relationship between the allowable deductions in the Net Sales definition and the licensee’s sublicensing rights.
The scope of a licensee’s discretion to grant sublicenses (e.g., whether the licensor’s advance consent to a sublicense is required, etc.) is often a heavily negotiated aspect of a licensing agreement. However, even where a licensee will succeed in obtaining sublicensing discretion, in pass-through royalty agreements the Net Sales allowable deductions can act as a ‘backdoor’ clause neutralizing this achievement. This is because these deductions are often negotiated solely with the licensee’s (and not a future sublicensee’s) business model in mind. As such, a licensee may find, in the context of future sublicense negotiations, that the differences in the allowable deductions in the initial licensing agreement and those deductions acceptable to a potential sublicensee make the entire sublicensing deal commercially impracticable. In such a case, the licensor’s involvement in the negotiations between licensee and sublicensee (something the licensee had sought to avoid) will be inevitable.
It is indeed a challenge to prevent the above scenario from occurring. Strategies available to the licensee include: (i) ensuring the allowable Net Sales deductions in the initial licensing agreement are in-line with industry standards; (ii) anticipating future sublicensees’ needs and incorporating the allowable deductions they are likely to demand into the initial licensing agreement; and (iii) inserting a Net Sales adjustment mechanism into the initial licensing agreement that would deal with such a future scenario (although a licensor may not so readily accept this last option, as it creates significant royalty base uncertainty).
Upcoming instalment – The Royalty Base: Combination Products
Disclaimer
The above is intended for informational purposes only and does not constitute advertising, a solicitation, or legal advice, is not promised to be correct or complete and may or may not reflect the most current legal developments. Cohen, Light & Associates expressly disclaims all liability in respect to actions taken or not taken based on the contents of the above.
