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Suggestions for Licensors to Implement a Best Practices Licensee Audit Program

by Tom Doug Harrison, and Molly of Royalty Management Associates (RMA)


This article highlights the key benefits, practical challenges, and major elements in establishing, maintaining, and improving this critical part of a fully functioning licensing program.

Licensee auditing done right helps make clear what is often obscure, cloudy, and full of suspicion. Through the auditing process, licensees better understand licensor expectations and licensors feel more comfortable that they know “what is going on” with their licensees. Good audits take an inherently opaque relationship and make it more transparent, a benefit to both the licensor and their licensees. As such, a good licensee audit program is not an option, but a necessity, for an over-all properly functioning licensing operation. And all the resulting benefits can be achieved at no net cost to licensors since the audit recoveries invariably, on an overall basis, will far exceed the out-of-pocket costs.

Licensee audits identify the unknowns in licensing’s somewhat unique largely self-reporting paradigm. For example, serious issues like unauthorized sub-licensing relationships are noted in which the licensor is not receiving a full royalty (and in some cases no royalty at all), placing the licensor in jeopardy as licensees effectively “license” other parties with the resulting potential issues and problems, etc. Audits are the best way for licensors to identify and deal with some otherwise unknown issues in a timely manner (before they grow into major and likely contentious issues).

Much like the necessity of adequate cyber security, licensee audits are a key part of a licensor’s security system, providing “eyes” and insight into certain critical aspects of their licensees’ activities important to trademark protection and enhancement.

And not all the benefits accrue solely to licensors. Licensees have expectations that audits help resolve, for example knowing other licensees are properly monitored and paying royalties and complying with key requirements that if not followed may negatively affect them. Licensees expect (and normally welcome audits to ensure their competitors are properly reporting) IF the auditors know what they are doing and don’t ask for overly burdensome and unnecessary information.

Practical Challenges to Establishing, Maintaining and Improving Licensee Audits
There are a number of very real and significant challenges to implementing and maintaining a good and ever-improving audit program, but once the answers to these concerns are known themission can be easily completed. Some of these key issues include:

An initial big question and concern is whether to complete the audits with in-house personnel versus using one of the many external licensee audit firms or individuals. Almost exclusively licensors (even the very largest licensors) use external auditors forseveral reasons:
1. The employee turnover is less of an issue when using outside personnel and, even when there is some turnover, the ability to be back “up and running” is far easier for Licensors, than when in-house personnel must be hired, trained and monitored on a day-to-day basis.
2. Outside personnel come largely trained and experienced in licensing (this should be a requirement of any outside contracted personnel–licensee auditing and the licensing industry have some quite unique features benefiting from “insider” knowledge and experience).
3. Some licensees are more comfortable sharing the necessary audit info with professional third-party auditors rather than licensor in-house personnel. In addition, based on their typically far greater experience, third-party auditors are generally more efficient and well-organized (while, at the same time, being more thorough in their testing).

      • Since even the largest licensing programs typically use outside auditors, the key then is determining how to best evaluate and monitor potential auditors. Besides having prior experience in licensee audits, it is vital the licensor–licensee–auditor relationship be established on a basis of continuing mutual respect. It cannot have aspects that are adversarial in nature. As examples:
        1. There should not be any real or seeming “conflicts of interest” – the interests of the licensor client, licensees, and auditor must be fully aligned. For example, the auditor compensation, obviously, cannot be on a contingency basis (based on monetary findings).
        2. Audit fee reimbursements should be used discriminately rather than as a licensor/auditor objective. Licensees naturally and rightly dislike it when auditors appear to do all they can to “find at least enough” so the licensee must reimburse the licensor for the audit fee. As stated earlier, a licensee audit program can be operated at
        no net cost to a licensor since the audit recoveries invariably, on an overall basis, will far exceed the out-of-pocket costs – therefore, the audit fee reimbursements should typically be enforced in no more than 15% of audits.
        3. A pattern should not be developed to negotiate clear audit findings with licensees. An auditor should be fair and objective in detailing and reporting their audit findings and, except in unusual cases, licensors should not entertain discussions with licensees about negotiating partial payment of the findings. This undercuts the auditor’s authority and virtually ensures every audit will require this licensor involvement (and resulting waste of their time). It also sends a signal to licensees that it is better to “get caught” owing (rather than fully paying royalties when due) since only a portion of the amount due will be required to be paid (exactly what licensors do not want to encourage)!
        4. Likewise, application of interest payments for audit findings should be at a reasonable, not punitive, rate unless the noted errors are egregious enough to call for the higher rate (normally a 18 percent per annum rate). Even if the license agreement calls for a high rate, licensors are wise to give the auditor the authority to assess (with a note in the report “Subject to Licensor Approval”) a lower (prior agreed-to) interest rate–this is a case of
        goodwill shown to licensees that does not encourage under-reporting as mentioned above.
        5. Based on an auditor’s experience, suggestions should be made (if noted in the course of the audit work) to make the licensee’s reporting more efficient and easier. A good auditor, based on their wide-ranging experience, can often make some very helpful (and much appreciated) suggestions to licensees.
      • There are typically two methods for selecting licensees for audit:
        1. The most common is based on Licensor concerns or suspicions (“One-off” Audits), versus
        2. An “If large enough to license – large enough to audit”/“Not a matter of if, but when,”
        FAR easier and more effective scheduling model.
        The above second approach is not only easier time-wise, for licensors, it will provide the greatest financial benefit while maintaining better licensor/licensee/auditor relationships than that which will invariably result from approach 1 (“One-off” Audits).
        Additionally, ALL new licensees (except in unusual extenuating circumstances) should be audited within the first 18 months of licensing to head off, early on, any significant reporting or operating issues.
      • An obvious requirement and very real challenge, sometimes noted in implementing an audit program, is that the licensor must have good in-house systems in-place for contract administration, royalty report processing, and other administrative functions to ensure key routine and important checks are completed and as a basis for providing reliable audit info to the auditor. This is another area in which a good Audit firm, based on their extensive experience, can often help new licensor clients “beef up” their internal systems and procedures.
      • Similarly, another benefit to both the licensor and licensees is that an experienced auditor can play a valuable consulting role, before the licensor makes significant reporting requirement changes, by providing input based on the auditor’s day-to-day hands-on experience with licensees–this should significantly reduce a current trend in which licensors, “out of the blue,” announce new and sometime onerous reporting requirements that greatly (and rightly!) frustrate licensees. Auditors should be expected—indeed welcomed—to make suggestion related to licensor/licensee reporting interface, potential license agreement changes, etc.

Elements of an Established, Properly Maintained and Ever-Improving Licensee Audit Program

Off-site audits: The typically “good” licensee audit is not the “traditional” broad-based financial audit (at a per audit cost $25,000 or more–ouch!), and it certainly is not a forensic audit (forensic audits should be completed by specialists in this area), but it is a practical and cost-effective royalty reporting review – exposure-directed in nature, seeking to identify and isolate the most common and significant reporting errors and issues.

The current trend of licensee audits is that they be completed off-site versus a visit to the licensee’s location. Off-site audits are more efficient and effective on several counts including the ability to audit smaller Licensees not feasible, on a cost basis, on-site.

We, at RMA, were “late to the party” (beginning almost exclusively off- site audits in 2006), but when we arrived we were, to our knowledge, the first there! And, unfortunately, in spite of the technological changes that clearly make this the best audit approach, many auditors have still not devoted the time and effort to develop these skills.

Based on an evolving realization that the licensee-supplied audit info was virtually all electronic in nature, much time was being wasted when visiting licensees in waiting for this info to be developed and supplied and the face-to-face interaction is far less necessary (in light of modern communication techniques) than in earlier times we found more time could be efficiently spent in actual testing (versus waiting and travel times on-site visits require) meaning off-site testing is more comprehensive while, at the same time, allowing licensees more time and flexibility with less immediate pressure in supplying audit files and answering and resolving audit questions and issues arising in the course of testing. There is certainly a learning curve in implementing off-site audits, but once this is realized, good off-site audits are typically better (and certainly more affordable) than “great” on-site audits.

Over-all plan, by auditors, for scheduling the audit of all licensees: Initially the auditor, based on
discussions with the licensor, should develop an over-all plan and strategy for the audit of all licensees–some (smaller licensees) on a three-year cycle, larger Licensees every 2 years and a few large and most critical licensees annually.

Annual preliminary auditor-prepared plan for upcoming audits: Based on the planning parameters
set-out in the above established planning strategy, an annual preliminary schedule (detailing the specific licensees to be audited) should be initially prepared by the auditor for licensor review and possible modification. Once approved, the auditor simply has to, during the year, periodically notify the appropriate licensor personnel for: sending licensees audit notification and forwarding the auditor the necessary info to complete the audit (licensee agreements, a schedule of royalty submissions, etc.).

Special note should be made of terminated licensees to ensure they are properly “closed out” on a full and timely basis (closeout period royalty reports are submitted, website references are “taken down,” any remaining inventory is properly disposed of, etc.).

New licensee on-boarding program: •The relatively new off-site audit template also allows licensors to implement an effective and efficient new licensee on-boarding Pprogram in which the auditor (either through one-time phone “interviews” with new licensees or in an electronic format) reviews common issues typically noted in initial audits to make new licensees aware of these issues so they note and head them off–better than noting issues in an initial audit is eliminating the issues altogether!

Yes, great technological changes and strides have made it the case now that licensors do not have a mature and fully credible program until it includes an effective, efficient, broad-based and cooperative (best practices) licensee audit plan and schedule. A program managed by outside specialized licensee auditors (not those completing audits as a side job or “hobby”) provide an important service for both licensors and their licensees at no cost to their licensor clients (in fact, a good program will be a profit center). A mature and fully credible licensee audit program will result in demonstrably better licensors and licensees!

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