Compensation Provisions in License Agreements

While compensation provisions in license agreements can vary greatly, the most common form of compensation is a “royalty” paid by the licensee based on its “Net Sales” of licensed products. In addition, in most instances, the licensor will require that a licensee pay an advance against future royalties due upon execution of the agreement and then agree to certain Minimum Guarantee payments throughout the agreement term.

“Net Sales” is always a defined term and is one of the most critical provisions in the agreement for two reasons: a) it is the base on which the royalty rate is calculated, and b) because licensees and licensors will frequently have a different understanding of what should be included in net sales. For example, licensors will want the definition to include virtually every sale the licensee makes to maximize earned royalties. In contrast, licensees will want to be able to offset as many costs as possible to Minimum earned royalties. As such, both parties must carefully consider how “net sales” is defined, as this can enormously impact a licensee’s royalty obligation.

The “wholesale” or “domestic” royalty rate is the most common royalty rate stated in license agreements and covers sales to a retailer or distributor. However, agreements will also frequently provide for other types of royalty rates, depending upon how the licensed products will be sold. For example, the FOB Royalty Rate applies to sales made to a retailer at the place of manufacture, frequently off-shore. The retailer assumes all transportation and insurance costs back to the retail outlet. FOB rates are generally between two and four percentage points higher than wholesale rates because the FOB selling price will be lower.

Where the licensee intends to sell products on a direct-to-consumer basis on, for example, its website, the agreement will typically include a “direct sales” royalty rate. However, since that royalty is based on a higher retail selling price, most licensees will negotiate a lower royalty rate than the wholesale rate.

Most licensors require licensees to pay an advance against royalties due upon execution of the license agreement and some form of minimum guarantee obligation. The advance against royalties is just that—an advance against the licensee’s actual earned royalty obligations. It is usually creditable against the licensee’s future earned royalty payments due to the licensor.

Advances are important to licensors as they accelerate the licensor’s cash flow rather than waiting months or even years before royalties begin to flow. The other reason is that an advance ensures that the licensee takes the license seriously since it has “skin in the game.”

There may be instances where a licensor requires a licensee to pay of non-refundable, non-creditable licensee fee upon execution. While not common, it does occur in some categories.

Many license agreements also include a minimum royalty and/or a minimum guarantee provision. A minimum royalty provision is just that—if the licensee fails to achieve a minimum level of royalties, the licensor can terminate the agreement. In contrast, a minimum guarantee ensures that the licensor will receive a minimum compensation if all else fails.

Setting guarantees and advances is a bit of black art. In most instances, a licensor will set the guarantee at fifty percent (50%) of the licensee’s projected royalties for a particular period, with the advance being set at half the initial guarantee.