Owners and managers of intellectual property rights (IP) often need to rely on third parties to calculate the income generated by IP rights, usually under an IP licence. How do you confirm that the amounts paid are correct? And what consequences can this have for the value of the IP assets?
A well-drafted licence agreement will normally include an audit clause. This gives you the right to hire an independent firm of accountants to review the books and records of the licensee in order to determine whether the rights owner has been correctly remunerated. In our experience of the music industry, rights owners have long recognised the need to exercise these rights on a regular basis. Other industries have been slower to adopt this approach.
We are now seeing an enormous expansion in distribution channels and innovative IP licensing arrangements, such as “per click” revenue streams. Consequently, rights owners such as content creators and software licensors would do well to consider their audit processes and to exercise their audit rights regularly in order to manage IP rights effectively.
Managing the relationship
Errors in the calculation of the profit share or royalties due to the rights owner can be caused by incorrect interpretation of the contractual provisions, undetected errors or omissions in accountings received by the licensee from its sub-licensees, limitations in the licensee’s accounting system or simple human error. If left unchecked, these errors can quite easily develop into a significant shortfall in the payments accounted to the licensor.
Within the music industry, rights holders such as songwriters and recording artists, together with their managers and other business advisors, now view regular royalty audits as a matter of good business practice. This is something that the digital media and technology sector should also be looking to adopt. Regular audits are important because:
• the royalty statements rendered by the licensee do not usually disclose enough information to see the complete picture of how the royalties have been calculated;
• as well as including an audit clause, a licensing agreement may also include a clause that restricts the period during which the rights holder can dispute an accounting. If errors in accountings are discovered after this period, the rights holder may no longer be able to legally pursue a retrospective correction;
• if managed and conducted in the appropriate manner, an audit does not need to signify or lead to a break down in the relationship between the licensor and licensee and should indeed show a degree of professionalism; and
• in the vast majority of cases, an audit results in the recovery of unaccounted royalties that are in excess of the cost of the audit.
Maximising capital value
Exercising the contractual audit provisions can also be extremely beneficial to rights holders who are looking to sell their rights. The valuation of IP rights is frequently based on a multiple of the income that has been generated in previous years. An audit will therefore ensure that the income is correctly stated, such that the rights are correctly valued and the seller does not unknowingly sell the rights for less than they are worth. Buyers or investors should also consider undertaking an audit of revenue license revenues as part of their due diligence.
Whatever the industry, the failure to exercise your audit rights within the appropriate time period may lead to an irretrievable loss of income and capital growth. Tech sector rights owners and managers should therefore carefully consider their rights and adopt appropriate audit routines and strategies.
This article was produced for the ebizlaw team by Austin Jacobs, who is a partner in the London office of the accounting firm Prager and Fenton LLP (www.pragerfenton.com), specialising in IP profit participation, royalty audits and IP valuations.