Recently Qualcomm announced it was taking a hit on its revenue forecast. The reason is a royalty dispute with Apple who is withholding royalty payments on its contract. At issue is the royalty rate formula that determines how much Apple owes Qualcomm for the rights to use its chips in its iPhone. This royalty dispute is costly to Qualcomm’s revenue since Apple is one of two companies (Samsung is the other one) that generate about 40% of Qualcomm’s total revenue.
This is an example of why it’s critical royalty payments are very clear in the licensing agreement. It must specify how it’s calculated, such as a percentage of net sales. Net sales in turn is further defined, such as gross sales less damaged goods, taxes, or other agreed-upon deductions (as well as those costs that won’t be deducted such as production and advertising) before paying the royalties.
While there are many ways to calculate royalty payments, here is a quick summary of some of the most common ones.
- Lump Sum: This is a single payment, usually paid one time or annually, and it’s generally not tied to any sales or performance benchmark.
- Minimum Royalty: This is also known as a minimum guarantee,and it spreads the guaranteed royalty payments over time, such as quarterly.
- Running Royalty: This is one of the most common formulas and calculates royalties as a fixed percentage of sales ( i.e. 3%) or on a fee per unit basis.
Sometimes these are combined, and if the agreement doesn’t specify how it’s calculated or paid, it’s a potential dispute waiting to happen. Your licensing partner interprets it one way while you’re thinking it’s something else.
And that leads to not getting paid your full royalty amounts. A 2013 Royalty Compliance report by Invotex found 89% of audited licensees under-report and underpay royalties and 56% under-report sales.
Three types of errors account for more than 85% of all the unreported or under-reported royalties: “Questionable license interpretation,” royalties from under-reported sales,” and “royalties from disallowed deductions.” Vague or unclear terms in the licensing agreement accounted for over 40% of under reported royalties.
Another way to reduce royalty mistakes is providing a royalty report form that licensees submit with their sales and royalties owed information. Case in point. All the licensing deals I did while at the studios always included a royalty reporting template form. It detailed the specific information required, including licensed product description, units sold, selling price, discounts and total sales. These reporting templates made it more efficient and easier to track royalty payments, as well as verifying the licensee is only selling products covered in their licensing agreement.
Reporting isn’t the only way to manage your royalty payments. Another way is with a royalty audit, an important term to include in your licensing agreement. It gives you, the IP owner, the right to audit the licensees books to verify the sales and royalties they reported are correct.
Now in my experience, most licensees are not out to shortchange the IP owner on royalties. But sometimes there are situations where royalty payments come up short. Such as a big kids entertainment property, with dozens of licensees and hundreds of products (and product variations) generating millions in licensed merchandise sales. The size of these licensing programs requires auditors to verify royalty payments, which is some cases, resulted in collecting tens of thousands of dollars in more royalty payments. Under-reporting sales (and royalties) and, sometimes selling products not included in the licensing agreement, were the biggest reasons for these payment discrepancies.
Don’t leave your royalty rates open to interpretation. If the royalty calculation formula isn’t clear, you’ll receive less than what’s owed to you. It’s also important to detail when and how royalty payments are reported. And finally, you must watch your royalty payments, and if necessary, audit your licensees to make sure they’re paying the right amount of royalties.