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ITEMS OF INTEREST
Description: The following article, dealing with certain royalty provisions of a licensee agreement, is scheduled to be published in the June 2002 issue of The Licensing Book (a trade publication of the licensing industry):
by: Sidney D. Bluming ---------------- ©2002 Sidney D. Bluming, P.C. Licensing is supposed to be a strategic alliance between two businesses which each have something that the other wants. Regrettably, in many cases such as in the fashion and apparel industries, it has become something else. Licensors are creating fiefdoms and imposing ever more one- sided agreements on licensees. License agreements are taking on the appearance of commercial leases, one-sided missives drafted to suit every whim of the Landlord – or worse, the zealous lawyer. One example is the fundamental section of a license agreement which deals with the accounting for and payment of royalties. It has been skewed away from a straight-forward balanced set of administrative guidelines that is should be, and has evolved into a series of heavily leveraged clauses imposing clearly unnecessary financial requirements on licensees for the sake of enhancing both the economics and the contractual advantages of the licensor. The purpose of this section of a license agreement is to provide a schedule for royalty payments and statements, and should be even handed. Yet it has become one which can and often does pervert legitimate business objectives, and can even cause severe cash-flow hardship to the licensee. A license agreement is not a lease, nor is it a debtor-creditor instrument. While it is true that brands are unique (as is land), the relationship is not a passive hand-off of possession of a property to a person to do what it wishes with the property with the only real concern on the part of the owner being security for the payment of lease obligations by the tenant. If that were the case, the licensor, like the landlord, would have little concern for the success of the user, as long as it survived to pay the rent (or royalties). In a license relationship, however, the hoped-for financial return of the brand owner is directly linked to the success of the licensee. Without one you simply cannot have the other. A licensee should not be put behind the proverbial eight-ball. This is not to argue that controls and remedies have no place or that the licensor should not be allowed its protections and advantages; not at all. Rather, it is a petition for common sense. A popular brand can provide a licensee with a great business opportunity (all the reasons to engage in licensing are not addressed in this piece); but if it is loaded with burdensome requirements and significant cash flow pressures which serve no end toward the success of the license and feed only the licensor’s voracious yen for contractual advantage, the end may not be achievable - or may come at an unduly high price and risk. With respect to the payment of royalties, the licensee has the right to, and should, raise the question of economic fairness and balance in structuring a payment program that works for both parties. It may be better off with a lesser known brand that allows greater economic flexibility. Typically, a license will have the licensee pay an “Earned Royalty” based on a percentage of “Net Sales,” most often calculated and payable within some specified period of days (30 or 45) following the end of each fiscal quarter. On top of this the licensor will usually require “Minimum Royalties” to be guaranteed and paid in installments, e.g., quarterly. In the same context, the licensor will insist upon payments in advance of each ensuing fiscal period (quarter), and will combine the Minimum Royalties with the desired advances. Too often the merger of the advance concept with the Minimum Royalties component is what precipitates the paradox discussed below. By getting its money up front, usually quarterly in advance of the fiscal period rather than at the end after the selling results are determined, the licensor not only has the cash flow advantage, but also has the assurance of the payment of the Minimum Royalties promised by the licensee before the selling effort proceeds – presumably with the ability to exercise its remedies if payment is not made. The royalties themselves, which are based on Net Sales, obviously can be calculated only at some reasonable time after the end of the specified fiscal period. Minimum Royalties, which are artificial creatures of contract, can be paid any time the parties agree. The most logical way to coordinate Earned Royalties with Minimum Royalties is virtually never the way it is done, i.e., calculate Earned Royalties and Minimum Royalties at the end of a period for the year to date, and pay the higher of the two. The licensor will instead engraft the advance concept and require that Minimum Royalty payments be made early in or at the beginning of each fiscal quarter. Why? Because it usually can. But this doesn’t do anything helpful for the licensee. A licensor should want a strong licensee, and should work with that licensee to make the business a prosperous and positive one. It should not want the license to reduce or restrict the licensee’s prospects for building a successful business. Too many licensors ignore the licensee and the exigencies of its operations, and impose their contractual mandates irrespective of the impact on the licensee’s ability to succeed. Oddly, this can even happen with a licensor whose brand is not necessarily that strong, but who is licensing into product categories eager for labels. This means that the likelihood of the licensee succeeding with that license is further handicapped. The paradox comes with the next little “gotcha.” The licensor will require that the calculation of the Earned Royalties due for a particular quarter can only take into account the Minimum Royalty payment made with respect to that same quarter. This is a prohibition against what is sometimes referred to as cross-collateralization of royalties, i.e., against utilizing excess payments in one period to reduce an obligation in another period. It is not difficult to see that if the Minimum Royalties are due on the first day of each quarter in advance, and Earned Royalties are payable 30 or 45 days after the end of the quarter, such latter payments are made after the further Minimum Royalty payment for the second quarter. E.g., Minimum Royalties are due on January 1, April 1, July 1 and October 1, for a calendar year agreement; while Earned Royalties are payable 30 days after the quarter. Licensee makes its January 1 Minimum Royalty payment. The licensee does not account for the first quarter’s Earned Royalties until April 30, a month after the second Minimum Royalty payment is to have been made. Yet that second Minimum Royalty payment is not permitted to be taken into account as a credit against the Earned Royalties being calculated and paid for the first quarter. Moreover, Earned Royalties in excess of the Minimum Royalties paid may not be used as a credit against subsequent Minimum Royalty installments as they accrue. This procedure is followed throughout the year, and has the effect of potentially requiring the licensee to pay licensor well in excess of the actual amount ultimately determined to be due in the final year’s reconciliation (i.e., the greater of the Minimum Royalties and the Earned Royalties). And there is an additional element of this no cross collateralization mandate. The Earned Royalties paid which are in excess of the Minimum Royalties paid with respect to any fiscal quarter, may not be applied as a credit against licensee’s obligation to pay its Minimum Royalties in the next period (on the one-side theory that licensee will do better than the guaranty for each quarter). Consequently, by April 30, the licensee has paid two quarterly installments of Minimum Royalties which, in the aggregate, may well exceed the Earned Royalties due for the first quarter. Yet despite the fact that licensee has paid more than what is owed for Earned Royalties, based on its actual Net Sales, it must still make the full payment of Minimum Royalties. Conversely, if a licensee has had a huge quarter and, on April 30 owes an amount which exceeds not only the first and second quarter installments of Minimum Royalties but the balance of Minimum Royalties due for the remainder of the year, the licensee will nonetheless still have to pay the full Minimum Royalty installment due on July 1. By the time the October 1 Minimum Royalty payment is due, it is known that there has already been an excess payment of $20,000 (20% of the full annual guaranty and 80% of the Minimum Royalty due for the entire year). Yet under the licensor’s procedure, the licensee must make the payment on October 1 at a time when sales are declining badly and it has already suffered a quarter with actual Earned Royalties well below Minimum Royalties. Because the licensee may not cross collateralize, it winds up making a payment on every due date except the date for accounting for year end royalties. By then, it has paid $650,000.00, which includes $100,000.00 for the ensuing year, and $550,000.00 for the principal year. Its obligation for the year, based on Earned Royalty, was only $500,000.00, so it overpaid $50,000 for the year, but its excess aggregate excess payment was $150,000 since it got no credit each quarter for the sums paid earlier. There are numerous balanced ways to deal with royalties, if one treats the Minimum Royalty as what it is meant to be, i.e., an assurance that if Net Sales fall short the licensor will still be entitled to a base level of license revenue; and if one treats the advance component as what it is meant to be, i.e., a pre-payment of the actual royalties that will be due for the period. Consider the following two of many available alternatives, which are more beneficial from the licensee’s point of view, but are, arguably, abundantly fair to the licensor and are believed to be nothing more than balanced. Alternative #1: Fairly estimate the Net Sales for each of the contract years (always a slippery slope), set the Minimum Royalties, and have the Earned Royalties calculated only at the end of the year with a single reconciliation (this would not preclude quarterly reporting to allow the licensor to monitor the performance of the licensee). The licensor will never have an overpayment (as the Minimum Royalty payments are non-refundable), and the licensee will pay any excess based on actual calculated results. Licensee Advantages: (1) Licensee’s cash flow can be more certain. (2) Licensee will not make overpayments, which do not earn interest (and are sometimes not even refunded, but rather applied to the following year’s Minimum Royalty obligations). (3) There are no overlap periods. Licensee Disadvantages: May result in a large excess royalty obligation at the end of the year. (4) Payment is due in the subsequent year, which may not be experiencing the same success and cash flow. (5) Distorts P&L in each year unless royalties are accrued. Alternative #2: Allow licensee to reconcile all Minimum Payments and all Earned Royalty payments made to date and thus make payments more closely representative of the ultimate royalties due by the end of the year Licensee Advantages: (1) The cash flow burden shifts off of licensee. (2) More accurately reflects reality. (3) Reconciliation is much simpler. (4) Little chance for excess payment. (5) Truer P&L in each quarter. (6) Allows cash flow requirements consistent with seasonal fluctuations. Licensee Disadvantages: None. There are not only additional methods for calculating and paying royalties in a more balanced and reality based way on a year by year basis, but there are also methods which bring the entirety of the royalty calculation process closer to reality. These would include cross collateralizing royalties from year to year; imposing Minimum Royalties on an aggregate period basis (e.g., $300,000 for a full three years rather than $100,000 per year, reconciled at the end of the term) and adjusting Minimum Royalties to reflect the reality of actual Net Sales (up or down). Like anything else, the negotiating strength of the parties will usually dictate the results, but a licensor, despite its leverage, should want a win- win situation and should not impose on the licensee imperious provisions for the sole purpose of demonstrating its market domination. If it is insecure about being paid, it has chosen the wrong licensee or failed to request adequate security for the royalty obligations and shouldn’t make the deal at all. If it decides to go forward, it should treat the licensee more as a partner than a tenant. Realistically, the power realized by a licensor, to a significant extent, is a reflection of the strength and success of its licensees. Often restraint and balance produce a far richer return at the end of the day. |
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