Licensing: the dark side of the law?

The last decade has seen dramatic growth in the possibilities for licensing all forms of intellectual property (IP), from patents and know-how to copyrights and trademarks. These opportunities have been seen particularly in the entertainment industry.
The drivers behind the developments are clear: licensing makes sense because it maximises value while freeing companies from many of the risks associated with manufacturing products, providing services and establishing distribution chains.
The most important driver, however, is that licensing can be very profitable. With many traditional sources of revenue drying up, licensing represents a relatively cheap and easy way to enhance the bottom line, certainly in comparison with developing new products.
In the media and entertainment sector, licensing is a long-established route into new markets and is often used as a way to increase customer awareness without the heavy cost of advertising campaigns. There are few blockbuster movies aimed at children these days that are not associated in some way with a toy manufacturer or a fast food restaurant chain. Hasbro, for example, paid $590m (£376.1m) for the exclusive rights to produce toys based on the characters in the new Star Wars trilogy, while Star Wars Episode I: The Phantom Menace alone is estimated to have generated more than $3bn (£1.9bn) in total licensing fees.
The attractions of the licensing market are certainly to be taken very seriously, but in order to maximise the chances of success, there are certain issues of which companies need to be aware. At the heart of this is the fact that any licensing deal is only as good as the agreement underpinning it.
When negotiating a deal, it is vital that both licensor and licensee are clear as to exactly what the clauses state and that they agree that they say the same things. If such clarity is not established at the outset, discrepancies in interpretation will often mean disputes further down the line, as the licensor does not receive the income it was expecting or the licensee is asked to pay out more than it believes is fair. These disputes cost time and effort, as well as money, to sort out.
When a contract is drawn up, there are a number of areas that can cause potential difficulties.
If it is decided that the payment is to be made on a royalty basis, for example, should this be based on gross sales, net sales or on the number of units manufactured? Whatever is decided has to be very carefully defined. If it is net sales, for example, does 'net' mean invoice sales, less returns, less standard industry deductions? In such circumstances, what are the industry standard deductions?
You can be certain that if these are not set out in the agreement, the licensor will think there are none, while the licensee will want to do everything it can to keep payments down. But if everyone knows what they are agreeing from day one there is no room for manoeuvre and certainty will prevail.
Often just as important are the mechanics of payment. Parties should be clear as to what currency is to be used and how exchange rates will be applied.
A contract should also set out exactly where the licence is applicable. Some companies are happy to license rights on a global basis, while others, interested in preserving their own markets or in building a presence in a previously unvisited territory, will want to ensure that the rights to use the relevant product or service are limited to defined countries or regions.
The process needs to recognise any relationships that the licensee has with subsidiaries and its ability to sub-license has to be taken into account. Both sides must be absolutely clear about the scope that an agreement gives the licensee to manage the licence internally and to conclude deals further down the line with third parties. If licensors are happy for this to happen, they need to ensure there are transparent means to check that the strict wording of the agreement is followed. This can be done by ensuring the licensor's right to obtain copies of all sub-licensing agreements, copies of statements issued by the sub-licensee and access to the relevant books and records of the sub-licensee.
Despite the best laid plans, disputes can still arise. Licensors should look out for 'red flags', such as inadequate or late reporting, reluctance to answer questions and lower than expected returns. It could be that the licensee's business has changed – it has expanded into new territories, for example – but that its royalty payments have stayed the same. Sometimes this can happen as the result of a licensee's bad faith, but more often than not there may be other issues involved, such as oversight, market instability or sales falling below the expected numbers.
To address these red flags and highlight discrepancies, licensors should be prepared to exercise their right to inspect the licensee's books. Historically, this has often been considered bad practice, as it was thought that such action indicated mistrust and would therefore damage relationships.
But this is not the best way to view the matter. Licensors need to understand exactly what is happening so that both parties can work out if there are any differences. They can then resolve them and move forward. After all, both sides need each other in order to do business.
Melanie Butler is head of licensing management at Pricewaterhouse-Coopers' forensic services group