Are You Leaving Money on the Table?

By David Sarasua  |  Posted 2004-02-05 Email Print this article Print
 
 
 
 
 
 
 

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Too many companies that are licensing their technology are leaving dollars on the table in unreported royalties. How big is the problem? Huge! Here's what you can do about it.

Most companies that receive revenue from licensing their technology do not have a program in place to insure that they receive the correct amount of royalties. They should.

Why? Because they may very well be leaving dollars on the table—and considerable amounts, at that!

Most companies have procedures in place to insure they do not overpay expenses. However, few companies--even highly ethical companies--have procedures in place to assure expenses are not understated. Where licensing is concerned, this results in an under reporting of fees to the company that owns the technology. If your company is reselling its patent licenses, you may be missing out on significant revenues that are due to you. For any company, but particularly one whose only product (and therefore, its only revenue stream) is patent licenses, it makes good business sense.

There are a number of reasons to review the ways in which your clients are report the licensing revenue due to you.

  • Licensees inadvertently fail to report correct royalties.
  • Licensees purposely fail to report the correct royalties.
  • In patent licenses, accounting practices may not record sales of new or upgraded products or services.
  • In software licenses, users may be unaware of the license requirements.

    Note that three out of four of these reasons are oversights and not cases of licensees deliberately avoiding their obligations. Licensing reviews can raise their awareness. I strongly believe licensing reviews make everyone more honest. People have a tendency to make sure that the numbers are correct if they know that someone will be reviewing them.

    The IRS uses audits as a way of insuring people pay taxes. When I do my taxes, I examine each deduction I take and ask myself: Is it worth defending the issue with the IRS? Deductions must be greater than the amount you'll spend defending them to make them economically worthwhile. Think of it as passive enforcement.

    What does the IRS have to do with licensing reviews? (Notice, I did not say "audit.") It's a good comparison. The simple awareness that an auditing program is there makes people more astute to how they claim deductions.

    A licensing review program can insure you're receiving the revenue you're due when you license your products to others to use or resell in their own products. And a review program does not have to be onerous or objectionable to your clients. Often, simply having one in place will raise their awareness of their obligations.

    Why under-reporting occurs

    A licensing review program makes sense for a number of reasons. The first and foremost is that it is simply the right thing to do. But it also offers a means to detect and discuss changes in their business processes, helping you understand your licensees and their needs.

    It makes you smarter about your own license agreements and allows you to see how your technology is being put to work. It also gives you assurance that the royalty calculations are being reported correctly and raises the licensee's awareness that they have a responsibility in using your property. Consequently, it stimulates them to double check their calculations before they send them to you.

    Errors in the way your licensees are reporting royalties result from changes in their business processes, confusion, complex entity structures or simple ignorance of contractual terms.

    Frequently, the correct amount of revenue is not reported or paid to the Licensor because the licensee added a new part or service number that is not accounted for in the license agreement.

    For instance, say you own the technology for a ballpoint pen. The company that is manufacturing the product assigns a unique part number to the product and you are to receive royalties for each pen that is manufactured. An engineer comes along and notices that it is easier to manufacture the product with a steel shaft instead of a plastic shaft. The steel shaft is a hit and sales swell.

    A licensing problem results because no one included the steel shaft in the calculation of royalties to the owner of the technology. The change in production improved sales revenue, but was not reflected in the royalty calculation. This is just one example of how change can produce a situation in which royalties are under-reported inadvertently due to changes in the way your licensee does business.

    Frequently, too, under-reporting occurs when a computer program is assigned to determine the appropriate royalty by capturing every item that has a unique part or service number. If the licensee modifies the part or service, gives it another unique number and neglects to update the program, royalties are missed on the new part or service number.

    For instance, Company B licenses technology from Company A and imbeds it in its own product. Company A assigns a unique part number to this product. Along with the part number, there is a number that identifies the location where the part was shipped. Company B expands its shipping process, creates two other warehouses and begins drop shipments from both. However, they neglect to change the computer script that captured the liability to Company A, the owners of the technology.

    Since the computer script uses the part number and the number of the original warehouse as a criteria for capturing royalties, the drop shipments from the two new warehouses are not identified. The technology owner, Company A, is only paid on sales from the original warehouse.

    Why does this happen? It happens because people are not aware of their responsibility to the party that owns the technology.

    In the case of software licenses, the cause is often confusion. Many times the users of the product, the authors of the license agreement, and the accountants who pay the bill do not talk to each other.

    I once did work for a company that was licensing its software. It restricted the number of users who could use the software at any one time. The software was duplicated on several machines and systems staff assigned different users on different machines. The accountants did not know it was copied and the owner of the technology thought everything was fine because of the software key. For example they had a restriction of 100 users but they duplicated the software on four machines, therefore in reality the key would allow up to 400 users.

    How big is the problem? Huge!!

    The Business Software Alliance estimates the amount of revenue lost in unreported royalties to be $12 billion dollars per year. Within an individual company, the amount of unrecorded revenue could be as much as 50% of total revenue, depending on the type of property, software, or hardware sold. As an example, I once identified a deficiency of $1,000,000 for a company that had total revenues of only $2,000,000.

    Consider other industry statistics:

  • 40% of royalty calculations are inaccurate

  • 12%-20% incidence of underreporting

  • Thousands to millions of dollars in underpayments

    Such oversights are usually inadvertent. We are human and we make mistakes. More often they usually result from a lack of vigilance. The parties involved are not aware of exact reporting requirements and the licensee applied only a limited number of resources to insure that the amount due was correct or they had no one auditing the transaction to insure that it was correct.

    Increases in revenue almost always substantially exceed the cost. There have been very few cases where it has not. When there is a review plan in place, the licensor receives assurance that the calculation is correct. Consequently, the amount reported is scrutinized more carefully because they know there is a possibility that the result be challenged. Looking to the future, licensing reviews help refine the overall license process and agreements that you use. They also strengthen the relationship and communication channels between the licensor and licensee.

    You'll educate yourself and your licensees in the fine points of licensing by identifying ambiguities and differences of interpretation in your agreements. The licensing review process offers an opportunity for you to compare calculation methods used by different licensees and improve the royalty reporting process for all. They also allow you to define and refine the licensee's royalty reporting requirements as well as processes for measuring and monitoring performance.

    A license review process should not be confused with financial auditing in its traditional sense. Programs to review the license requirements can be done without upsetting licensees. A licensor is entitled to expect that the license requirements are being followed. The review program simply supports this requirement.

    But before you embark on a license review, be sure the licensee understands that this is not something like IRS auditing. Proper preparation must be done before you make the initial contact.

    What can happen?

    Let's look at some examples of what you may find during a review:

  • Example 1: Software may be passed around with little regard as to licensing agreements. This is usually done unintentionally but results in large amounts of unrecorded revenue.

  • Example 2: Software can often be used for multiple purposes. Engineers are good at recognizing software on the network and using it in a multitude of ways. Soon the software has migrated onto machines that are not licensed.

  • Example 3: The company buys all its equipment from a particular vendor. Down the road, they start buying equipment from a different supplier. Software on the new equipment is better than that on the old machines, so the new software is passed onto the old machines. This happens in PC's Mac's, Mini, Main Frames, and even Telephone switching equipment.

  • Example 4: A fabless semiconductor hardware company designs a chip and charges per die. Accounting charges per die input into each unit. The die is subsequently modified, but accounting is not informed of the change. Revenue goes unrecorded.

  • Example 5: In patent licensing, the product or service can be replaced or upgraded by the Licensee, but the accounting practice fails to pick this up. Each company has a particular problem associated with the products or services that they offer.

    It is important to insure the audit clause in your license agreements is written to address problems such as these. At a minimum, insure there is an audit clause in the license agreement. You should also have a program for regularly reviewing license compliance. We recommend that you review licenses at least once every three years.

    It is critical throughout the process that you understand your icensee's business. It is equally critical that you understand the processes that your licensees are using to capture the full amount of royalties that are due.

    Understand your licensee

    Be sure you understand how your Licensee is using your technology. This is very important. From there, ask yourself if the amount of royalties being collected is reasonable. If you do not know the answer to this question, you could have a major problem. License agreements are an evolving process. One benefit of reviewing the process is that the license agreement will improve over time. We have found the agreement drafters do not anticipate all ramifications of the product's use. For example, we saw a software company offer an entity license to a company, which was not very large. The Licensee became Apple Computer.

    Site licenses are difficult to define. There needs to be a common understanding about the meaning of "site." We have seen the "site" being defined as the finance department, a specific location, and a defined number of streets. Is the Finance Department the same as the Accounting Department? Sometimes the company using the product cannot define "Finance Department." Company acquisition is a common problem. If IBM, for instance, acquires a small company that holds an entity license for your technology, does IBM now have a license to use it?

    Software Keys Software keys are useful in monitoring licenses. But do not assume that because there is a key, the process for capturing revenue is secure. For example, a software company made this assumption and we found two weaknesses. First, in the OEM agreements, their vendor was setting the key to the highest number and not monitoring the process. Second, we found companies duplicating both the hardware and the software. The key was set to a specified number of users. The company using the software had no idea that they were not in compliance. They did not have two copies of the software, but rather they had eight duplicate copies, since they continued to add servers as they grew.

    Test Licenses Some companies give customers test or development licenses. These need to be monitored, as the keys are sometimes different on these types of licenses. Time and time again, we have found development software in production use.

    Who Should You Review?

    For most large companies, licensing reviews are selective by necessity. The customer list is too vast to review all. Instead, the company may review only a sample from the its total number of licensees. How do you determine whom to review. Here is a list of concerns you should consider before making that decision.

  • Educated suspicions

  • Size of royalty payments

  • Impact on relationship

  • Past payment history/trends

  • Past disputes

  • Noticeable inconsistencies

  • Market intelligence

  • Licensees with late or incomplete royalty payments

  • Omission of products from royalty reports

  • High growth Licensees

  • High turnover in Licensee's royalty accounting department

  • Failure of Licensee to comply with documentation requirements

  • Changes in ownership or control

    We identify potential weak points in the way the product can be misused. We then identify Licensees that might fit into that profile. For example if the product or service is used for financial consolidation purposes, we might want to identify companies with foreign subsidiaries because foreign subs are first rolled up and then consolidated at corporate. The point being that there may be multiple uses of your product or service, even though only a single use was contemplated in the license.

    How to find the problem

    As you look for problems, first, understand the product and how it is used. Second, understand the contract. Third, understand the Licensee's use of the product. These three issues shape the scope of the work to be performed

    We test the transactions taking place for the purpose of understanding the Licensee's process. Then, we identify the risks associated with the license agreement. Finally, we identify what can be done, keeping in mind the cost/benefit relationship.

    A good review program should be designed to:

  • Gain an understanding of what is covered in the license agreement.

  • Gain an understanding of the Licensee's interpretation of the agreement.

  • Review the Licensee's accounting and royalty reporting systems.

  • Recalculate royalties due using current records (may have been updated subsequent to submitting report).

  • Review and test supporting books and records.

  • Identify results and communicate findings.

  • Typically, your findings will include:

  • Exclusions

  • New covered products

  • Add-on products

  • Replacement – spare parts

  • Samples

  • Geographic or subsidiary sales

  • "Demo" or "training" products that have been with the customer for excessive periods of time

  • Inappropriate or excessive deductions from the royalty base

  • Incorrect royalty rate application

  • Inadequate documentation or support

  • You will also find commonly disputed terms, such as:

  • Product coverage (definition of "Licensed Product")

  • Sales covered by the license agreement

  • License agreement terminology

  • Definition of adequate "Books and Records"

  • Acceptable deductions from the royalty base

  • Appropriate royalty rates, especially when single and tiered rates are used

  • Zero dollar sales of products combined with non-license-bearing products

    By having a licensing review program in place (again, notice that I did not call it an audit) the company that is paying the royalties will think twice about calculating the amount due. We have found that most of the calculations for royalty payments are wrong. Actually, there has never been a client that we have worked for that did not have a problem in this area. In doing a licensing review, I like to believe that what we are doing is to raise the company's awareness as to the responsibilities of using technology that they do not own.

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    David Sarasua is a CPA who specializes in licensing contract reviews.
     
     
     
     
     
























     
     
     
     
     
     

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