3 Pitfalls to Avoid in Licensing Agreements

Whether you are a licensee manufacturing a product or the brand owner licensing your product, the definitions, requirements and terms stipulated in the licensing contract are crucially important. Since many of us have no idea how to go about finding a brand licensing professional, we relegate negotiation of the business terms to our attorneys.

The truth is, attorneys are qualified to address the legal language, such as reps & warranties, indemnification and infringement, but in most cases are not familiar enough with licensing agreement terms, including test protocols, authorized channels, approvals and quality controls, to negotiate them properly on our behalf. Unless you, or someone on your team, has experience in negotiating licensing agreements, you risk falling into one of the three most egregious business term pitfalls in standard licensing contracts. Watch out for:

Nets sales. This may be the most important definition in any licensing contract. The royalties owed are dependent on this definition. The definition contemplates that items such as returns, allowances and discounts are not subject to royalty.

It is critical that both the manufacturer and brand owner understand the definition and can live with it. Each party should pay particular attention to the deducted amounts. Often, the amount is limited to a specific percentage of the gross sales. Both parties must understand what items cannot be deducted from net sales. If the parties are unaware, the unplanned costs can turn out to be significant and, if caught in an audit, can be subject to penalty.

Royalties and guaranteed payments. Royalties are calculated by multiplying net sales by the royalty rate. The royalty rate is the percentage of net sales to be paid by the licensee to the licensor. Licensing contracts often stipulate that royalties are to be paid on inter-company, as well as, third-party transactions.

Guaranteed periodic minimum royalty payments, also referred to as “minimums,” are calculated based on a percentage of the forecasted net sales and royalties earned. It is customary for the minimums to become fully earned upon execution of the agreement, even if the agreement is legally terminated. That is why it is critical that the licensee be prepared to make an investment in the license over the entire life of the agreement.

Quality control and compliance. This is one of the most important sections to the licensor. If the licensed products do not meet the quality standards stipulated in the contract, they will not be approved for sale. Most licensing agreements will stipulate the licensor’s quality standards as a test protocol.

Test protocols are standards set out by the industry for each product category. If no standards are provided, the licensee should inquire as to what the standards are to ensure the licensed product will be approved in time to meet committed ship dates. The licensee must comply at all times with all laws in the development of their licensed product. Any breach of the compliance standards can result in recalls, with devastating impact to both the licensor and the licensee.

While licensing agreements by their nature tend to be one-sided to protect the brand owner, a solid understanding by both parties will ensure everyone gets off on the right foot.