Most commentaries on license agreements analyze the agreement from the viewpoint of the licensor, probably because the licensor owns the property to be licensed and thus is presumed to have more at risk if the license transaction goes downhill.  However, the risks in a license transaction are not entirely one-sided, and a licensee can incur substantial losses as well if the transaction does not develop as planned or if the licensee later discovers that it cannot comply with the terms of the agreement.

With this in mind, licensees should pay close attention to the following provisions before signing a license agreement:

Exclusive vs. Nonexclusive

A licensor will typically prefer to grant a nonexclusive license, while a licensee will want to be the exclusive seller of the product covered by the license.  If the licensor is only willing to grant a nonexclusive license, then before signing the agreement, the licensee should determine if there is a likelihood of others entering the market.  In some cases, even though the license is nonexclusive, the licensor may have difficulty finding other licensees willing to take on a license for the same products, given that there will already be one licensee with those products in the marketplace.  If this is the case, the licensee can probably accept a nonexclusive license, and may even be able to use that fact to its advantage to negotiate for a lower advance, guaranty or royalty than would be the case for an exclusive license.  However, if there is a risk of others taking on the same license and flooding the market with the same types of licensed products, the licensee may want to pass on the license.

Limits on Channels of Distribution

License agreements often unduly restrict the channels of distribution into which the licensee can sell the licensed products.  For example, an agreement may limit distribution to a few classes of retail stores, but the licensee may typically sell its products to gift stores, hardware stores, grocers or other stores not included in the channels of distribution.  A licensee should ensure that the channels of distribution identified in the agreement include all types of stores into which the licensee normally sells its products.

Methods of Distribution

License agreements often appear to contemplate a single method of distribution, in the form of a wholesale sale by the licensee directly to a retailer.  However, many licensees, and in particular many smaller licensees, utilize several different methods of distribution to get their products to market.  Some licensees only sell to distributors or wholesalers, which in turn sell to retailers.  If this is the case, this method of distribution needs to be acknowledged in the license agreement, as the sale price/royalty base from sales of the licensed products to distributors or wholesalers will be less than that for sales made directly to retailers.  This can result in a disparity between the royalty expected by the licensor and what is actually paid, and the licensor may argue that the licensee is in breach of the agreement for failing to pay a royalty based on the price paid by a retailer to acquire the licensed products for resale.  For example, assume that the regular price for sales of the licensed products to retailers is $10 per unit, but the licensee sells through a distributor and only receives $9 per unit.  If the agreement calls for a royalty of 5% of Net Sales and “Net Sales” are defined as “gross wholesale sales, less returns,” the licensee will pay a royalty of 5% x $9.00, but the licensor may interpret the agreement as meaning that the royalty due is 5% x $10.00.

In addition, if minimum guaranties are set based on the expected price to retailers but the licensee is only receiving the lower distributor or wholesaler price, the licensee will most likely not make the minimum guarantee, and will have to pay additional money at the end of each year or risk losing the license.

Some licensees also want the opportunity to sell the licensed products directly to consumers, through a website, mail order or regular brick and mortar store.  If a licensee plans to make these types of sales, it will need to ensure that it has the right to do under the agreement, and it should negotiate a lower royalty rate for all direct to consumer sales, as it will be incurring the costs of functioning as both producer/distributor and retailer.     

Onerous Approval Requirements

Licensors legitimately want to retain control over the quality of the licensed products.  If the licensed property is a trademark, the licensor will risk losing rights in the trademark unless it has adequate control over the quality of the products using the mark.  However, requiring plans, drawings or samples at each stage of the product development and manufacturing process may be impractical or, for some types of products, impossible.  For example, many licensed products are produced by offshore manufacturers in large production runs, and it may not be cost-effective or even possible for the licensee to obtain a single pre-production unit as a sample.

There is no single solution as to what should or should not be required in the way of product approval, and the terms will vary with each agreement, depending on the products covered by that agreement.  The key is that the licensee has to ensure that it has the ability to comply with the approval provisions in the agreement or it has to get a waiver from the licensor to prove that it has done all that is required by way of product approval.  Also, the licensee must obtain written evidence of approvals or waivers at each stage of the approval process as required under the agreement, and each approval or waiver has to come from an authorized employee of the licensor.  Failure to follow these steps may result in a subsequent claim of breach by the licensor or its auditors, and this can result in additional costs for the licensee, and, under a worst case scenario, the termination of the license.

Sales to the Licensor

Some licensors want the right to purchase quantities of the licensed products, either for resale or for distribution to existing or potential customers, or both.  Before agreeing to this, a licensee will need to determine if distribution of the licensed products by the licensor is likely to compete with the sale of those products by the licensee or to otherwise interfere with the licensee’s marketing efforts.  Also, even if the licensee agrees to sell licensed products to the licensor, it will most likely want to place a limit on the quantities that the licensor can purchase, and it should be obligated to sell to the licensor only on a nonroyalty and nonreturnable basis, and only if it has a sufficient inventory of licensed products on hand or in the process of manufacture to cover anticipated sales to its regular trade buyers.  

Warranties and Indemnification

Perhaps the worst scenario for a licensee is to embark on a promotional campaign for the licensed products, accumulate a significant stock of products in inventory and begin taking orders, only to discover that the licensed property is not secure.  This can occur if a third party challenges the licensor’s ownership or the property, or claims to hold an exclusive license for the use of the property, or claims that the property infringes on its rights.  It can also occur in the case of a celebrity licensed property if the celebrity loses favor with the public due to acts of the celebrity.  Thus depending on the nature of the licensed property, the licensee should secure appropriate warranties and indemnification to cover the licensee both for third party claims and for unsaleable inventory in the event the property can no longer be used and the licensed products cannot be sold.

Audits and Fees

A license agreement will almost always grant the licensor the right to audit the licensee’s books with respect to sales of the licensed products to verify that the licensee has correctly calculated and paid the royalty due.  This is legitimate, but the licensee may want to impose some conditions and time limits on an audit, such as requiring an audit to be conducted by a CPA, restricting the conduct of an audit to regular business hours, and providing that the books for any accounting period can only be audited once.  In addition, the licensee may want to cut off any audit rights beyond a specified number of months or years after the statements for an accounting period have been issued.

Audit clauses deserve close attention, because in many cases they will not only require payment of deficiencies, with interest, but may also require payment of audit costs and liquidated damages if the amount of the deficiency exceeds a specified level or if the audit reveals other breaches of the agreement, such as failure to secure required product approvals.  In the latter case, a licensee may want to add a cap on its potential liability.  

In Conclusion, Look Before Signing

All too often licensees simply sign license agreements regardless of the terms, on the assumption that as long as the licensed products get to market and the licensor receives a royalty check, there will be no complaints.  However, this is not always the case, particularly if the licensor chooses to conduct an audit during the term of the license.  A licensee who signs an agreement with terms that it does not intend to keep or that it cannot keep runs the risk of a claim of breach, which may result in substantial damages and costs, including being left with inventory of products which the licensee can no longer sell.