Business Pitfalls to Avoid Before Signing a Licensing Agreement

Are you currently a licensee (manufacturer), licensor (brand owner) or contemplating entering a licensing 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 do not understand it fully you may not be aware of the obligations in which you have already committed, or are about to commit, your business. While it is important to consult an attorney before signing a licensing contract, you may not have considered talking with an experienced brand licensing professional about the specific language in a standard licensing contract.  Or, even if you have thought about soliciting advice from a licensing professional, you may not have had any idea how to go about finding one.

For this reason many of us relegate the negotiation of the business terms and language in our contracts to our attorneys. The truth is that attorneys are trained and qualified to address the legal language – reps & warranties, indemnification, infringement – found in a contract. However, in most cases with licensing agreements, attorneys are not familiar enough with the business terms within the agreement – test protocols, authorized channels, approvals, and quality controls – to negotiate them properly on your behalf.

In this instance, unless you or someone on your team has experience negotiating licensing agreements, you will become an ideal candidate to fall into one, if not several, of the many business term pitfalls that are imbedded inside standard licensing contracts. At Licensing Brands, we have identified 15 critical business pitfalls every brand owner and manufacturer should be aware of before they enter into a licensing agreement.   In our Brand Licensing Agreement Template, we not only show you what a standard agreement looks like, we point out each of the pitfalls so that you are aware of what they are, what language to pay attention to and what to watch out for.  While there isn’t any room to address all 15 pitfalls in this article, I wanted to share with you three of those that can be most egregious.

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.

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 to the licensor. 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.  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.

Quality Control and Compliance: this section is one of the most important sections to the licensor.  If the licensed products do not meet the quality standards stipulated in the contract, they will not be approved for sale.  Most licensing agreements will stipulate the licensor's quality standards as a Test Protocol. Test Protocols are standards set out by the industry for each product category.  If no standards are provided, the licensee should inquire 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.  

Pete Canalichio is the author of Expand, Grow, Thrive, a brand expansion and licensing strategist, expert witness and TEDx speaker.