Tech & Sourcing @ Morgan Lewis

Contract Corner

Rights holders are almost always looking for ways to monetize the intellectual property (IP) that they own or license. For owners of rights in popular logos; characters from TV shows, movies, or video games; or similar IP, one way to generate a revenue stream is to enter into merchandise license agreements.

In a merchandise license agreement, the licensor typically grants a licensee the right to manufacture, market, distribute, and sell products that use the licensed IP. This type of license benefits the licensor by creating revenue from merchandise that the licensor does not have the experience or desire to manufacture and sell in its own normal course of business. Licensees benefit from being able to use the licensed IP as a means to drive product sales.

In this Contract Corner, we discuss some of the top issues to consider when drafting and negotiating merchandise license agreements.

Scope of License

As with other licensing agreements, it is important to ensure that the scope of the license grant is appropriate for the business deal. The license should have a defined term and should extend for any post-term sell-off period to allow the licensee to sell existing inventory after expiration of the agreement. The license grant should also identify the specific IP being licensed, in either a description of the property or an exhibit to the agreement, and the permitted uses of the IP, such as the development, manufacture, distribution, promotion, advertisement, and sale of a set of products or articles.

If the products require packaging, containers, labels, or similar materials, then the license will need to extend to the creation of those materials. The same goes for any marketing or promotional materials. Other key terms include the geographic territories where the products can be sold and what channels of distribution may be used (e.g., ecommerce, brick-and-mortar retailers, wholesalers, distributors). In addition, consider whether the license is exclusive in any manner, such as with respect to a certain product category or a geographic territory.

Royalties and Payment

The financial details of a merchandise license agreement usually revolve around a few key terms, such as the royalty rate, the method for calculating royalties based on sales, a minimum guarantee, and royalty statements.

After the royalty rate is agreed, it is important to think through how that rate is applied to sales of products. Is it based on gross sales or net sales? What deductions from sales amounts are permitted? How are product returns, promotional allowances, and taxes treated? These details are critical to iron out and define clearly in the agreement to avoid auditing issues for both parties.

In addition to the ongoing royalty payments, licensors will often seek a minimum royalty guarantee that is paid either in advance or on a defined schedule to ensure a certain level of revenue is achieved. Another important detail to work out is the manner in which royalty statements are created and reported by the licensee.

Similar to the royalty calculation, there are certain details that a licensor may expect in a statement that a licensee is not able to reasonably produce. For example, are statements reported by product category or at an individual SKU level? Do the statements include inventory reporting? The practicalities of royalty statements will need to be worked out by the parties to ensure both sides’ expectations are met.

Quality Control and Approvals

Not surprisingly, the licensor will likely want strict quality control and approval procedures throughout the preproduction and production processes. These may include requirements for concept drawings or layouts, artwork samples, preproduction product samples, final production samples, and copies of advertising material.

These procedures are designed for the licensor to ensure that its IP is being represented on the merchandise in a manner that conforms with its style guides and branding requirements. A licensee should review these procedures carefully to confirm it has internal processes in place to meet the requirements and avoid being in breach of the agreement. In addition, the parties should align on the approval process for samples and products to ensure that the licensee receives timely approvals from the licensor in order to meet its own obligations under the agreement.

Audit Rights

One of the most important issues in merchandise license agreements is the extent of the licensor’s audit rights. As mentioned above, if the royalty calculation and reporting provisions are not tightly drafted in line with the parties’ expectations, the licensee may be subject to burdensome audits and unexpected additional costs. For example, if the licensor believes it is not receiving enough royalties, it may conduct an audit and find that the licensee is improperly deducting certain expenses from the royalty calculation.

Aside from getting the royalty calculation and reporting provisions accurate in the first place, it is key for a licensee to limit the licensor’s audit rights, including in terms of frequency, duration, notice period, and scope of records. In addition, think about an appropriate remedy for the licensor if the audit finds a deficiency in royalty payments: Is the remedy a termination right, reimbursement of certain out-of-pocket audit costs, or both?