Implementing a Royalty Compliance Program Presentation to the Federal Laboratory Consortium Mid-Atlantic Regional Meeting September 15, 2005

2 Why a royalty compliance program?

3 Post-license considerations How to…  Maximize revenue from negotiated financial terms  Maintain a good licensee relationship  Protect your IP rights

4 License process  Identify IP (patent)  Get approval to out-license  Research possible licensees  Contact and sell idea to target  Negotiate terms  Monitor / collect royalty R&D Prosecute Patent Application Pay Maintenance Fees

5 Post-license considerations  How to maximize revenue from negotiated financial terms?  Avoid misinterpretation  Avoid unintentional human errors  How to maintain a good licensee relationship?  Minimize misunderstanding and improve trust  How to protect your IP rights?  Licensor continues to assert IP rights even after the license

6 Royalty compliance program systems / procedures

7 Royalty compliance program systems / procedures  Flexibility  Clear language  Specific reporting requirements  Agreed upon reporting policy  Continued communication  Desk audits  On-site compliance audits

8 Flexibility  Include internal accounting representatives  Update the agreement as accounting systems change

9 Clear language in agreement Definitions BE SPECIFIC! Sales  Amount billed or invoiced on sales of licensed products, technology, process, etc. Where applicable, sales need to include lease or rental payments Credits / Charges –  Flat % rate vs. actual  Customary quantity, trade or cash discounts actually taken if stated separately on the bill or invoice. Beware of total corporate discount experience vs. actual product line discount  Amounts repaid or credited by reason of return  Freight expense between the Licensee and its customers, to the extent it is not charged to or reimbursed by the customer. Beware of total corporate freight deduction vs. actual freight incurred

10 Clear language in agreement Grants  Licensor hereby grants to Licensee, subject to the terms and conditions herein, an exclusive/non-exclusive license, under the Licensed Patents to make, have made…  Disclose the name and location of the sub-contractor  Bind the sub-contractor to all of the terms and conditions  Ensure all audit rights extend

11 Clear language in agreement Audit paragraph Specify rights:  To audit, at least annually  To audit for “completeness” of royalty report  To receive electronic files  To inspect books and records

12 Clear language in agreement Audit paragraph  Right to inspect books and records should include but not be limited to:  Invoice registers and original invoices  Sales analysis reports  Accounting general ledgers  Sub-license and distributor agreements  Price lists, catalogs and marketing materials  Audited financial statements and or income tax returns  Sales tax returns  Inventory records  Shipping documents  Commission reports  Purchasing documents

13 Clear language in agreement Late or underpaid royalties  Should bear interest  Simple vs. compound  Rate and source  Threshold for Licensee to bear audit fees and expenses:  >5% -- entire cost  >2%-5% -- 50% cost

14 Specific reporting requirements Royalty reports  Attach royalty report template to the license agreement. Royalty report should include:  Product identification  Units sold  Unit price  Extended sales dollars  Royalty rate  Extended royalty dollars due  Foreign currency conversion rate, if applicable  Information detailed by country of sales origin / manufacturing location

15 Specific reporting requirements Foreign currency translation  Multi-nationals generally convert local currencies to home country of Licensee before converting to US dollars even if agreement calls for conversion to US dollars based on the country in which the sale occurred  Specify:  How calculation should be made or as customary in licensee business  Source of rates

16 Agreed upon reporting policy for the Licensee  Specify period covered by royalty report and when each is due  Detailed procedures

17 Continued communication with a Licensee  Consider yourself their bank; they owe you money  Need open lines of communication at various levels  Decision maker  Person preparing royalty report  Annually, distribute a Licensee questionnaire  Who calculates royalties due?  Do they have the agreement?  What procedures are performed in calculating royalties?  Is a second review performed?  Etc.

18 Desk audits  With each payment:  Historical payment trend analysis  Overall company health analysis  Industry trend analysis  Math check  Follow up on all questions  Communicate, communicate, communicate

19 Royalty compliance audit for all Licensees The confirmation that a license/contract is being complied with, including:  Payments  Research milestones  Advertising, or  Any other clause that allows itself to be tested by an independent party What is a royalty compliance audit?

20 Identify Licensee for royalty review Prepare Licensee for review – work plan, documents, timing Field Work Review Licensee product listings, books and records, royalty calculations, interviews, process review, etc. Report findings to Licensor and communicate to Licensee – exceptions and improvements Collect background data (external/internal) to understand license agreement and relationship Royalty audit process

21 Royalty reporting red flags

22 Red flags: there may be errors in the royalty report if…  Change in the person preparing royalty report  New products launched  Selling product in new territories  New manufacturing facility  Licensee has been acquired or has merged  Licensee is having financial difficulty

23 More red flags: there may be errors in the royalty report if…  Accounting systems change  Royalty reports are progressively late  Licensee’s sales of the covered product are not in line with the industry  Humans are involved in report preparation

24 Common findings

25 Common findings Errors discovered  Clerical math  Conversion rates  Omission of new products developed  Transfer pricing to affiliates  Controls not in place to ensure data accuracy  Misinterpretation  Arbitrary interpretations Unintentional Intentional

26 The cost of royalty reporting errors Audit Fees & Expenses Interest Unreported Product Line (and license misinterpretation) Unreported Geographic Region (and license misinterpretation) Reported Royalties

27 Why have a royalty compliance program?  To maximize revenue negotiated  To maintain a good licensee relationship  To ensure compliance  To demonstrate intent to protect rights

28 Speakers Karen H. Wang, CPA, CVA Senior Vice President (410) Judy Ann Byrd, CPA, CIRA Vice President (410) Intellectual Property Management & Finance 1637 Thames Street Baltimore, MD