Royalties and Deductions: The Give and Take
Understanding royalties is the key to invention success
Inventors ordinarily profit from their inventions by licensing them to manufacturers or distributors to commercially use or develop for a period of time. Inventors’ compensation typically takes the form of royalties based upon the invention’s sales. How such royalties are measured is extremely important.
Net sales are the most common measurement for royalty payments. In a net sales license, the royalty rate is multiplied against the net sales. The big issue when negotiating net sales is what deductions should be included in the definition of net sales. Obviously, the more deductions there are, the less money the inventor will earn. It is generally acceptable for net sales to include deductions for shipping freight, taxes, credits, returns and discounts made at time of sale. It is less desirable deductions for sales commissions, debts, uncollectible accounts, promotions, marketing and advertising.
Quantity Discount Deduction
Sometimes a licensee may seek to increase sales by offering a discount on large quantity orders. The licensee then deducts this discount (also referred to as a volume discount) from net sales. This can be favorable to the licensor because it increases sales. If you choose to include it, you should qualify the discount by describing a quantity discount as “a discount made at the time of shipment” or “a discount actually shown on the invoice,” since it is possible that an unscrupulous licensee may attempt to offer a discount after items are shipped, splitting the discount with the purchaser and diminishing your royalty payment.
Debts and Uncollectible Account Deductions
Sometimes a licensee may seek to deduct bad debts and uncollectible accounts. For example, say a third party orders products and then fails to pay. The licensee feels no royalty should be paid since no money was earned for these sales. On the other hand, you are not a collection agency and should not have to lose money because of the licensee’s bad business dealings. Even though insolvency and uncollected debts are not especially common, it would be better for you to avoid this deduction.
Sales Commission Deductions
Sometimes a salesperson is paid a commission for each sale of the licensed product. The licensee may seek to deduct these commissions under the net sales definition. We would discourage the deduction of commissions because they are a cost of the licensee’s business.
Promotion/Marketing/ Advertising Deduction
Net sales are supposed to be total sales, not a collection of business deductions. For that reason we would discourage the use of promotional, marketing or advertising deductions in the definition of net sales. Marketing should be a cost of doing business, not a licensor expense.
This vague term includes a wide range of costs and business expenses. If the term “fees” can be made more specific, you may be more comfortable with the deduction.
Freight and shipping costs of the product, although a cost of doing business, are traditionally treated as a deduction against net sales.
Credits and Returns Deduction
It is acceptable for a licensee to deduct credits and returns from the total net sales, since returns reflect merchandise which was not purchased or was defective. Some licensors prefer to qualify the definition to state “bona fide returns” or “returns actually made or allowed as supported by credit memoranda” in order to weed out returns which are part of some unscrupulous arrangement between distributors and retailers.
If a product is taxed locally, it is common to include this as a deduction against net sales.
Putting a Cap on Net Sales Deductions
One way to limit net sales deductions is to place a limit on the amount to be deducted. For example, in your license agreement you could include a statement that reads as follows:
“In no event may the total amount deducted from net sales (for discounts, credits or returns) during any royalty period exceed ten percent of the gross sales of the products during that royalty period.”
A provision such as this guarantees that the deductions will never be more than 10% of gross sales. Some license agreements forego a listing of the deductions and simply state that net sales are “gross sales minus ten percent for shipping, freight, taxes, returns and other deductions.” This provision may not accurately reflect the actual deductions but it does remove any accounting issues. That is, you no longer have to wonder whether net sales deductions are accurate.