Tech & Sourcing @ Morgan Lewis


Picking up where we left off last week, we continue our refresher on common issues to consider when entering into a transaction that will include royalties. Today’s entry focuses on timing and reporting considerations for the calculation and payment of royalties.

Timing of the Royalty Payments

Will royalties be paid monthly, quarterly, biannually, annually, or otherwise? If there are any minimum royalty commitments that are also payable under the contract, how will those minimums be paid? Also, any "true-up" mechanisms by which minimums will be compared to actual royalties due should be detailed in the contract, including the frequency and mechanics of those true-up calculations.

Accrual of Revenue vs. Receipt of Payment

As we discussed in Part 1, royalty calculations are often expressed as a percentage of a revenue (gross or net) amount, and it is important to clearly define what is included in that revenue amount. A vital question to ask when drafting that definition is, “When is revenue considered subject to royalties?” More specifically, is it at the time of booking the sale to which the revenue is tied, or is it upon receipt of payment of funds from the customer? The first logical difference between these approaches is which party will bear the risk of uncollectible accounts—if royalties are payable on revenue booked, there may be situations where a royalty is paid out even where no money is ultimately received from a customer who fails to pay. Perhaps more importantly, this distinction can result in significant deviations for royalty calculations at the “tails” of the contract or where there are variable rates applicable to different periods of the contract. If a customer sale is booked during the first contract year but payment is actually made by the customer after completion of that year, this can alter the determination of which period's royalty rate applies (if different rates are applicable to the first and second years) and whether a royalty is due at all (if the contract expires at the end of the first year). Pay particular attention to these issues when it is anticipated that a large portion of revenues will be received during these "tail" periods; for instance, in highly seasonal industries or for customers whose purchases are driven by periodic external factors (e.g., annual board approvals occurring at the same time each year).

Duration of Obligation to Pay Royalties

For a typical term license arrangement subject to a royalty, the royalty will be payable on sales made throughout the term of the license period. For certain other strategic license arrangements, for instance, certain "license in lieu of sale" transactions or patent licenses with limited duration for intellectual property protections, royalties may be payable only for a more limited duration and/or may decrease over time.

Treatment of Modified and/or New Products

As products are modified and evolve over time, consider how this should affect the corresponding royalties. Are all products that use the licensed technology subject to the same royalty, regardless of any such changes? Or, do certain modifications result in products being subject to a lower royalty or excluded from the royalty structure altogether? Typically, terms regarding modified or new products try to consider whether the licensed technology is being used in the manner it was intended from the outset of the transaction, justifying the same royalties applying; or whether the products have been modified in such a way that the original royalties should no longer apply. Often, this determination is difficult to make at the start of the transaction as future modifications or product offerings aren't known, but even in such scenarios, there should be general terms as to how modified products will be treated.

Reporting & Audits

Reporting obligations should be clearly identified in the contract, including the frequency of reporting and any requisite components of the reports. Consider what level of insight the licensor will have into sales subject to the royalty, which can help inform the importance of reporting obligations. For instance, will this be a hosted software arrangement where the parties can remotely determine user access, or a sale of physical goods where the parties will rely on inventory and reporting of sales? At a minimum, sales/revenue reports should include all details necessary to calculate the particular royalties, including all sales amounts and, as applicable, those items that are deducted to arrive at a net revenue amount. Similarly, licensors should consider including detailed record retention obligations of their licensees and audit and inspection rights tied to those records in order to independently confirm royalty calculations and payments.

This post is part of our recurring Contract Corner series, which provides analysis of specific contract terms and clauses that may raise particular issues or problems. Check out our prior Contract Corner posts for more on contracts, and be on the lookout for future posts in the series.