Business Pitfalls to Avoid before Signing a Licensing Agreement

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Are you currently a licensee (manufacturer) or licensor (brand owner) or contemplating entering alicensing arrangement? If so, you may have been weighing the business impact and exposure inherent in the definitions, requirements and terms stipulated in the licensing contract.  If you have not read the contract language completely or understood it fully you may not be aware of the obligations you have already committed, or are about to commit, your business to.  A example of this kind of exposure can be illustrated in how the business term Work Product is defined.  Many licensees feel that the Work Product they create remains their intellectual property.  However, Work Product often becomes the property of the licensor as is indicated in the sample language written below.

“To the extent any Work Product qualifies as a “work made for hire” under applicable copyright law, Licensee agrees that such Work Product shall be a work made for hire owned by Licensor.

Licensee irrevocably assigns to Licensor all right, title and interest (including without limitation all patent, copyright and trademark rights therein) in and to the Work Product. Licensee shall take all actions reasonably required by Licensor to secure and perfect its title to such Work Product.”

Sample Work Product Contract Language

If the manufacturer is not aware of this provision, they may invest a substantial amount of money into new technology for a licensed product only to find out that the technology no longer belongs to them. That is why it is crucial to not only consult an attorney before signing a licensing contract but also to seek the advice of someone experienced in brand licensing who can review and revise, if necessary, the specific language in a standard licensing contract.

Traditionally, many of us relegate the negotiation of the business terms and language in our contracts to attorneys.  While attorneys are trained and qualified to address the legal language – reps & warranties, indemnification, infringement – found in a contract, in many cases with licensing agreements, they are not familiar enough with the business terms within the agreement – test protocols, authorized channels, approvals, and quality controls – to negotiate them properly on our behalf.  I recently heard of a story where a client asked his attorney to negotiate an agreement.  In the contract, the manufacturer was provided three months at the end of the contract to sell off any licensed inventory held in stock.  In this particular case three months was a punitively short time period.  As the attorney did not understand the business impact of this provision, he did not negotiate the additional time needed.  In the end, the client lost thousands of dollars when he had to unload the excess licensed product.

Unless you or someone on your team has experience negotiating licensing agreements, you will likely fall into one, if not several, of the many business term pitfalls that are embedded inside standard licensing contracts.

This article highlights three of the fifteen critical business term pitfalls every brand owner and manufacturer should be aware of before they enter into a licensing agreement.   To avoid falling into one of these pitfalls, it is important to research and review sample licensing agreements.   They not only make you aware of what a standard agreement looks like but they also illustrate each of the pitfalls so that you are cognizant of what they are, what language to pay attention to and what to watch out for.

Nets Sales – this may be the most important definition in any licensing contract as the royalties owed are dependent on this definition.  The definition of Net Sales contemplates that items such as returns, allowances and discounts should not be subject to royalty.  However, 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 as often the amount is limited to a specific percentage of the gross sales.  Also, it is critical for both parties to 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.

“Net Sales” means the gross invoice price billed for Licensed Products (without the deduction of anymark-down sums), less (i) allowances and discounts actually given in the ordinary course of business (as reflected in Licensee’s invoices to customers); and (ii) actual returns (collectively, the “Deducted Amounts”); provided however that the Deducted Amounts for any calendar quarter shall not exceed 5% of the gross sales in that calendar quarter. No deductions shall be made for uncollectible accounts. No costs incurred in the manufacture, sale, marketing, advertising, or distribution of the Licensed Products shall be deducted from any Royalties paid by Licensee. The Licensed Products shall be deemed to have been sold for purposes of this Agreement when billed out, when shipped, or when paid for, whichever occurs first.”

Sample Net Sales Contract Language

Royalties and Guaranteed Payments – Royalties are calculated by taking the Net Sales and multiplying them by the Royalty Rate.  The Royalty Rate is the percentage of Net Sales to be paid by the licensee (manufacturer) to the licensor (brand owner).  That is why the definition of Net Sales is so important to understand.  Often licensing contracts 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 (see sample language below).  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.

“If the Agreement is terminated for any reason, all Guaranteed Periodic Minimum Royalty Payments not yet paid by Licensee must be paid to Licensor within twenty (20) days after the effective date of termination.”

Sample Guaranteed Periodic Minimum Royalty Contract Language

Quality Control and Compliance – this section is one of the most important sections to the licensor (brand owner).  If the licensed products do not meet the quality standards stipulated in the contract, they will not be approved for sale.  Recently, I was working with a manufacturer of key chains whose product has been fully approved except for the testing of lead paint.  The retailer was clamoring for the product as consumers were expecting it.  It turned out the test involved sending multiple samples of the key chains to a testing lab so they could scrape enough paint off of the finished product to conduct a thorough test.  This testing procedure was causing them significant delays.  Unbeknownst to the licensor, the manufacturer feeling confident that the product was safe, shipped it to the retailer before the testing was completed.  When we discovered this omission, we had to have the entire product pulled from the shelf as a safety precaution (see below).  This resulted in a substantial cost to the licensee.

“Quality. Licensee agrees that all Licensed Products and all Materials (as that term is defined in Section 4.1. below) shall comply with Licensor’s quality standards. No Licensed Products or Materials will be manufactured, marketed, distributed, or sold without Licensor’s prior written approval and without Licensee’s prior compliance with the provisions of Section 4.”

Sample Quality Control and Compliance Contract Language

Most licensing agreements will stipulate the licensor’s quality standards as a Test Protocol and are often found in the appendices section of the agreement. Test Protocols are standards set out by the industry for each product category.  If no standards are provided, the licensee should inquire with the licensor as to what the standards are to ensure the licensed product will be approved in time to meet committed ship dates.  At all times the licensee must comply with all government laws in the development of their licensed product.  Any breach of the compliance standards can result in recalls which can have a devastating impact to both the licensor and the licensee.

I hope these three examples have given you a good appreciation for what can happen if either party agrees to standard contract business language without fully understanding what they are agreeing to.  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.

To learn more about licensing agreements or business term pitfalls see our Sample License Agreement.

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