ROYALTY BASES IN MERCHANDISE LICENSE AGREEMENTS
Merchandise license agreement negotiations typically focus on the royalty rate that the licensee is willing to pay for the license. However, in many cases, the royalty base (i.e., the number against which the rate will be applied) is of greater importance than the royalty rate.
The royalty base for most merchandise licenses is “Net Sales.” The starting point for determining Net Sales is usually the gross invoice price. Beyond this, the licensor and the licensee may differ as to what deductions should or should not be allowed to arrive at Net Sales. Points of discussion may include the following:
- Returns. The licensee will not want to pay royalties on sales that have been reversed by product returns. The licensor will usually allow returns to be deducted, provided the license agreement permits sales on a returns basis. If the licensee is only authorized to sell on a no-returns basis, the licensor will want to limit deductions for returns to damaged or defective merchandise. Regardless of what returns are permitted, the licensor will usually require that the licensee issue credit memoranda to verify that credit was in fact given for all amounts claimed as returns. The licensor may also want to cap the total amount of returns permitted in any accounting period at the Net Sales for that period, in order to avoid a negative royalty situation.
- Taxes. If the licensee is required to collect tax as the result of a sale and the amount of that tax is included in the gross invoice price, then the amount of the tax should be deductible, provided the licensee actually pays the tax to the proper governmental authority. Most sales by licensees are wholesale sales, and therefore taxes are usually not an issue. However, if the licensee is making sales directly to consumers, through a website or otherwise, the licensee may be obligated to collect sales tax, at least on sales to consumers located in the same state as the licensee.
- Shipping. Shipping costs that are reflected on the invoice and paid by the purchaser should be deductible. However, the licensor will want to insure that the licensee is paying all amounts collected to the third party shipper, and is not using the “shipping cost” line item to add mark-ups or handling or other charges that simply become a non-royalty earning revenue stream for the licensee.
- Discounts and Allowances. Discounts and allowances provide perhaps the most fertile ground for differences of opinion between the licensor and the licensee. As a general rule, the licensor can legitimately argue that discounts that have little or no impact on making a sale should not be deductible, and the licensee can legitimately argue that discounts that are likely to cause a sale to happen should be deductible. Following this reasoning, the licensor will usually prohibit deductions for cash or early payment discounts, while the licensee will demand that it be permitted to deduct quantity discounts and similar discounts forced on it by large mass market purchasers. The licensor will often require that quantity discounts be tied only to quantities of licensed products sold, in order to prevent the licensee from bunching a small order for licensed products with a large order for other products and spreading the quantity discount equally over the combined order. The licensor may also want to cap the cumulative total of all allowed discounts at some percentage (for example, no more than 10% - 15%) of the gross invoice amount.
In summary, in a typical merchandise license, the royalty base is at least as important as the royalty rate, and licensors and licensees should devote attention to both issues when negotiating a deal.