Royalties Rates: Not as simple As you may think!
BY: Joshua Kaufman, Esq. © 2002
The vast majority of licensing agreements are based on the payment by the licensee to the licensor of a royalty. The royalty is a percentage based on a sales price of the goods. It sounds so simple, yet the difficulties which arise in negotiating and interpreting royalty rates is quite startling. The actual royalty rate, the percentage number is not usually a matter of difficult negotiations. Each industry has developed certain set of parameters in which most deals fall. There might be differences based on the type of licensed property, for example, the types of properties for royalty purposes are usually broken into art, celebrity, character/entertainment, collegiate, corporate, designer, event and sports. Each of those general categories will often have a different range of royalties rates. For example, when licensing for a scrapbook album covers, the royalty rates would be in the following ranges: Art 6-10%; Celebrity 3-7%; Character/Entertainment 8-12%; Collegiate 6-8.5%; Corporate 5-8%; designer 3-7%; Event 10-15% and Sports: 8-10%.
On what are these percentages based? Generally speaking in a licensing agreement, the licensee is the manufacturer of goods and is going sell them at the wholesale to a retailer, however, there are times when the licensee is a direct mail vendor and sells at retail or has two programs, one wholesale and one retail. If a royalty is based on receipts, than the licensor participants in the higher retail prices obtained by the licensee; however, we often find that licensees in their standard contracts propose a royalty rate of only half the amount being offered on a wholesale sale when the sale is at retail. Effectively, even though the licensee is receiving twice as much for the licensed product, the licensor earns the exact same amount. While there may be some additional cost incurred by a licensee when selling at retail, I have rarely seen it demonstrate that the additional expense justifies a payment of a royalty at half the wholesale rate.
Another issues which arises frequently in negotiations between licensees and licensors is when is the royalty is earned. It is in the licensor’s interest that the royalties are earned upon the shipment of goods (this would of course be subject to returns as a royalty should not paid on a product that was returned). While licensees seek to have the royalty earned only upon receipt of payment from their customers. The key distinctions here apply in regard to the timing of payment and the payment of a royalty in the event of non-payment by the licensee’s customers. If the royalties are due within thirty (30) days (or the end of the calendar quarter) from when the goods were shipped, versus when the license receives their money from their customers it can make the difference in receipt of royalty payments for the licensor of a period of several months.
A much larger problem is whether royalties are due on goods shipped but not paid for by a licensee’s customer. The licensee of course takes the view that they have already lost money by the non-payment of their customer on the goods their then having to pay a royalty on goods for which they were not paid is just adding salt to the wound. On the other hand the licensor’s position is that they are entitled to be paid regardless of the receipt of payment by a licensor. Their reasons are two fold. First, once the licensed products enter the stream of commerce, they are entitled to be paid no matter what, they have fulfilled their obligation, the goods are out there the sales made, and that is what they are being paid for. The other aspect of it is that the licensor does not want to be in the business of guaranteeing the credit of the licensee’s customers. It is up to the licensee to do credit checks and police its own collection. The licensor has no say over to whom the licensee sells to, whether they are choosing to take a credit risks, be aggressive in collection, etc. The licensor does not believe that it is their responsibility to guarantee or underwrite the credit of licensee’s customers. The licensee is receiving anywhere from 85-97% of the revenues and as part of that a calculation are sum put aside for uncollectables, and they should therefore be the licensee’s sole problem.
Another issue comes in to play regarding the exact figure upon which the royalties will be paid. Few contracts pay on "gross" generally royalty payments are based on a net figure. There is no magic or standard format for figuring out what the net should be. Certain sums are traditionally subtracted from grosses such as, returns and shipping/handling (when the customer pays a separate fee for the shipping and handling but the payment is incorporated in the overall payment). After these two fairly standard deductions, all others are up for negotiation. Obviously it is in the licensor’s interest to have as few deductions as possible and licensee’s are always seeming to come up with new items that they want to claim as non-compensatable and not part of the royalty basis. This issue can be very problematic when a licensed product is bundled with other products. In those situations the allocation of the price can be complex Licensors may request that the royalty be based on the total bundled item price not of the portion attributed to the licensed product alone.. For example, in art licensing, it is always a contentious negotiating point when the licensed product is the print but the licensee sales the print matted and framed. Is the royalty to be based on the total matted and frame price or just the value of the print? If you speak to any art licensor, they will argue strenuously that the royalty should be based on the total package then ask any licensee and they will with equal conviction argue that the royalty should be based only on pro-rata value of the print.
Another area, which seems to be of growing dispute is FOB based royalties. FOB means Free on Board and comes up as a major issue with imported goods. Traditionally, as stated above, the royalty is based on the wholesale price. As more and more licensees are taking possessions of their goods in foreign ports, they are trying to peg the royalty rate on the cost of the goods once they are on the ship in the foreign port, FOB. There can be a great difference in the royalties. The wholesale price is the price the licensee sells to the retail stores while the FOB cost of getting the goods on the ship bound for the USA (e.g. what they have paid the factory for the goods, the other incidental cost of getting it from the factory to the ship, packaging, getting the goods into a container, export duties and taxes, etc. The difference between the two pricing systems are the licensee’s profits and the additional costs which are built into the wholesale price from the time that the licensed products are shipped from the Far East until they are delivered to the licensee’s customers. These differences can be substantial. If the royalty is not adjusted upward for a FOB transaction, then the actual royalty being paid to the licensor if based on the same percentage point (i.e. 6%) is significantly less than the standard wholesale royalty. What multiple should be used to equalize the differential so that the licensor does not lose money by having the rate pegged at FOB has no universal answer. The most common single multiple is probably to multiply the wholesale royalty rate by three (3), however, that is certainly not universal. One can and should, in the course of the negotiations, find out what is the wholesale price, what is the FOB price, and do the mathematical calculations so that the net royalty numbers come out roughly the same.
As you can see from above, the simple idea of a standard royalty rate can in fact be very complex and even though there are "industry standards," they are only the beginning of the conversation and not the end point.
The other three related issues regarding royalties are advances against royalties, guaranteed royalties and the auditing of royalties. An advance, is generally a non-refundable fee paid up front upon the signing of the contract, (they can also be made annually or as part of any renewal period as well), in which the licensee pays the licensor a sum in anticipation of future royalty receipts. The licensor does not receive any more payments (of course they receive royalty statements, even without a check to ascertain the progress of the sales) until the licensee has fully recouped their advance. For example, if the royalty is to be a dollar per unit, and an advance of $10,000 has been paid, the licensor will not receive any additional royalty payments until 10,001 of the licensed products have been sold.
Guarantees work in a different way. Instead of looking to the front end of the transaction, one looks either to the end of each year of the transaction or until the end of the initial term of the agreement. The parties then add up how much money has been paid to the licensor. If they have not reached the guaranteed amount, then the licensee has to come up with a lump sum payment to make up the difference. For example, if the guarantee on a contract was $100,000, but at the end of the year or contract term the licensor only earned $90,000, the licensee owes a $10,000 lump sum to reach the level of the guarantee. The guarantees, depending on the nature of the arrangement can be monthly, quarterly, annual, or simply for the whole term of the contract. Advances and guarantees are not mutual exclusive, it all depends on the negotiating clot of the parties as to the size of the advance and guarantee.
Licensees will often attempt to lower the amount of an advance claiming that at the start up of the relationship, they want to have their funds available for product development, marketing, advertising for the new product and the more that they pay the licensor up front as an advance, the more they drain from the project. Licensors on the other hand believe that a bird in a hand is better than two in a bush and want to see as much money as they can up front to ensure that the transaction is worth their while and as an incentive to the licensee to push their product. The same holds true with the guarantee, the larger the guarantee the more incentive the licensee has to push the product. However, since the guarantee is usually paid later in the contract term, they provide the licensee the ability to expend funds on product development and promotion.
From a licensor’s point of view, advances and guarantees are imperative when dealing with exclusive contracts. A licensee can have many product lines, and if one is not working out well or the person who was behind the product leaves and it is left to wither on the vine, the licensee can, and often do have other products which they can push to make up for any shortfall in the sale of licensor’s product. On the other hand, the licensor often has one product or a limited line. If they have signed an exclusive contract with the licensee and the licensee is not performing, without a large advance or more importantly a substantial guarantee, because of the exclusive nature of their contract, they are sunk. They are precluded from going elsewhere, yet not earning any money with the licensee whom is not selling their goods. They are shut out of the market with no income and little recourse. It is very dangerous for a licensor to enter into any kind of exclusive agreement without a sufficient guarantee to offset the risk.
Audit clauses are an important term in every licensing arrangement based on royalties. With every royalty check or every royalty period, even if no money is due as a result of advances, the licensee provides the licensor with a set of information. What is included on a royalty report is often also an area of negotiations. The licensor wants a lot of information and the licensee want to protect what they believe to be confidential information and endeavors to provide less documentation. If at any point in time the licensor feels that the information they are getting is not accurate, they will need to have a right of audit in order to go in a inspect their licensee’s books. An audit right is included in almost every licensing contract. However, the frequency of the royalty audits, who pays for the royalty audits, what copies can be made, confidentiality agreements and other terms and conditions are points of negotiation. Also, a licensor would be well advised not to use their regular CPA or in-house accountant to do a royalty audit, there are accountants who specialize in licensing royalty audits and they should be used. It is a very different skill set that they have developed. The average CPA, no matter how good they are, will probably miss many of the nuances that crop up in these type of audits. Sadly to say, even the most honest companies often make mistakes. The underpayment of royalties to licensors based on mistakes, ignorance and intentional misconduct are quite common and as such the audit rights clause should be reviewed very, very carefully.
Royalties they are so simple, yet so complex!
Joshua Kaufman is a partner in the law firm of Venable, Baetjer, Howard and Civiletti, LLP. While he is based in Washington, DC, his practice is national in scope. He is one of the country’s foremost attorneys in the field of art and licensing law. He has published over 200 articles on various topics in the field. He is also an adjunct professor of law at American University Law School. A large number of his articles can be read and downloaded from his web site at, www.jjkaufman.com.