Royalties and Deductions: The Give and Take

Understanding royalties is the key to invention success.

Inventors often profit from their inventions by licensing them to manufacturers or distributors, with the idea that they will commercially use or develop them 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 for both your income and your taxes.

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 most significant 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 to include deductions for sales commissions, debts, uncollectable 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 Uncollectable Account Deductions

Sometimes a licensee may seek to deduct bad debts and uncollectable accounts. For example, say a third-party company 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. Obviously, this is not a good business model for a licensor; you could argue that the deduction of commissions is improper because they are merely 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 this reason, a licensor should 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.

Fee Deduction

This vague term, "fee deduction," 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/Shipping 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 that 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 that are part of some unscrupulous arrangement between distributors and retailers.

Tax Deductions

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. This can be done in your initial license agreement. For example, your license agreement 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 would no longer have to wonder whether net sales deductions are accurate.

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