The Rules of Royalty Accounting | Vincent Leoni, Miller Kaplan

From royalties to GMRs, the financial side of licensing can feel overwhelming. But no need to fear! This week’s episode of The Brand Licensing Podcast has you covered with our guest, Miller Kaplan Partner and CPA, Vincent Leoni. 

Vincent Leoni is a partner with Miller Kaplan in Los Angeles. He has more than thirty years of experience performing entertainment consulting, royalty/contract compliance, and profit participation examinations. Vincent performs these services on behalf of licensors, owners of intellectual property film studios, production companies, recording artists, music publishers, profit participants, and software developers.
In addition to his work in the US, Vincent has traveled extensively throughout the world, performing a number of licensee exams on behalf of major trademark licensors in Asia, Europe, and Australia. Vincent has provided litigation support services on behalf of profit participants and licensors, and on multiple occasions has analyzed income streams in order to determine damages and the appropriate share of profits, revenues, and royalties due to participants. He has also been called upon to serve as an expert witness testifying in the Superior Court of the State of California.

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This episode is brought to you by Brainbase. Learn more here: https://hubs.la/H0G7KqQ0

Episode Transcription

Emily Randles: Hi Vincent! Welcome to The Brand Licensing Podcast. Will this be your first time on the podcast or are you a seasoned podcast guest?

Vincent Leoni: Well, first of all, thanks for having me, Emily. I am not a seasoned podcast participant, just a seasoned podcast listener.

ER: Great! Well, we’re excited to have you today.

VL: I’m excited to be here.

ER: For our listeners, today we’re speaking with Vincent Leoni of Miller Kaplan. Vincent’s here to talk to us about royalty accounting and audits. Now most of the time when people hear royalty accounting, It’s not the sexiest topic. But I am so excited to talk with you today because it’s a question we get asked a lot and it’s content that people look for on our website. And at the end of the day, everybody really wants to know about the numbers. I think this will be a great, great podcast. And I think our listeners will learn a lot from you. I’m excited to cover it. I do know that your firm covers a wide range of capabilities. I’m sure we can talk in-depth about those. But really today we’re focusing on royalty accounting and auditing. And then we can maybe jump back on another podcast and talk about some of the other services that you offer.

But before we jump into more things, can you just give us a quick rundown on your experience and your resume?

VL: Sure. I have been involved in royalty auditing and consulting my entire career, and that spans over 30 years. Initially, I spent the majority of my time in the music space, performing royalty audits on behalf of recording artists, music, publishers, songwriters, and independent record companies. And as part of that experience, kind of expanded to doing other types of consulting services in the music space, specifically assisting folks in the selling and acquisition of music catalog. Although we do continue to service those types of clients, the way music is consumed today, it’s evolved greatly in my career. We also perform these types of royalty audits mostly on behalf of licensors, although we do represent a fair share of licensees. And our clients are in the consumer product area. We do a lot of interactive gaming audits, toy audits, all kinds of consumer products, apparel, technology, housewares, and appliances. And I manage a group of about ten folks at Miller Kaplan that spent their entire day doing these types of things. We consider ourselves experts in contract compliance. We can cover a lot of different industries.

ER: You said you have ten people working with you. Tell us exactly what they’re looking for? What does an audit comprise of? Or how do they do it? Because there’s a picture of me and somebody in the back counting beans. So I know it doesn’t work quite like that. Can you give us an overview of how the auditing process works?

VL: Sure. Generally, we’re getting involved in the licensing arrangements where they’ve been quite successful. Our clients want to make sure they’re getting accounted for what they’re entitled to. So we will review the license agreements and the accountings and determine if we believe an audit is viable. And we’ll communicate that back to our client. We go through the mundane stuff like preparing a time budget and getting an agreement with our client. But once we are engaged and we analyze and summarize the licensing agreements, we compile a database of all the royalty accounting. We review those accountings and the contracts for risk areas and ultimately schedule time with the licensee to historically go onsite and perform the fieldwork and analyze all the sales data, etc. Just as a sidebar, we’ve been very successful during the pandemic of starting and completing royalty audits remotely. It’s our new reality. Since March, we have not ventured out into the field. All of this work is done remotely. And so we’ll prepare a listing of documents to be reviewed. The licensee will upload those through a secure portal that we set up. And then we reconcile all of the data that they provided. Reconcile the sales and deductions against what has been accounted for on the royalty statements and make sure that those have been accounted for according to the terms of the agreement.

ER: Okay, this is a pretty obvious question, but as a licensor, what would you want to audit a licensee? And then what are some red flags that license words should be looking for that should make them want to reach out or start thinking about it?

VL: The nature of the licensing business is self-reporting. The licensee is responsible to exploit the intellectual property range for the manufacturing and distribution of the products. The agreement between the licensee and licensor contains an audit clause, which enables a licensor an opportunity to review those sales records and manufacturing records to make sure that they’ve been accounted for properly. Just by the nature of the self-reporting, it makes sense for a licensor to engage somebody to go in and make sure that everything has been accounted for according to the terms of the agreement. From a licensor’s standpoint, they’re receiving accountings from the licensee. And there are a number of things that can raise their suspicion that there may be some issues in the licensee’s ability to account according to the terms of the agreement. If they’re receiving late accountings from the licensee and they’re getting paid late from the licensee, there may be an indication that the licensee is having some financial problems. If the licensee is not consistent in the method of accounting, they’re making adjustments to the royalty statements.

And if those statements are not mathematically accurate, it’s a huge red flag that there may be issues with the ability of the licensee to account according to the terms of the agreement. From our perspective, when we are dealing with a licensee and performing a royalty audit, some of the red flags for us are if the licensee lacks proper accounting software if they’re implementing a new enterprise accounting system. When they’re preparing the statements, there are errors in the transfer of the information from the enterprise accounting system to an excel statement or something like that. If there’s been a merger and acquisition during the audit period, that’s kind of a risk that they may not be accounting properly. And all of these things that I’m describing vary from instance to instance, but those are generally the things that will raise some eyebrows and have a licensor institute and audit.

ER: Those are some great pointers. And I know because some of our clients have asked should we consider an audit? And so just knowing what to look for or when to recommend will be really helpful in the future. If we were to recommend an audit, what does an audit cost and how long does it take?

VL: It’s a loaded question. The fees are charged depending on the scope. And there’s a number of factors that we have to consider in determining what that scope is. The number of years that are going to be audited, the number of license agreements between the licensee and licensor, the complexity of the reporting. It’s based on net sales or per unit or profit participation. Those are factors that will increase or decrease the amount of time that we need to spend. The conditions of the licensee’s accounting records will impact the amount of time that we have to spend, the number of properties that are under audit, and the number of skews. The items or articles that the licensee is distributing will impact the amount of time that we need to spend.

Now, having said that the audit is usually conducted in four stages. There’s a pre-audit stage where, as I referred to earlier, the agreements are summarized and the royalty statements are compiled. On-site fieldwork, which historically we would perform. But today all of that information is sent to us, which is the review of all the accounting records, etc. And then post fieldwork and wrap up. And then preparing the report. Regardless of the size of the audit, those are the phases that we go through. These can range as low as $5,000 for a desk audit and complex audits can run into the hundreds of thousands of dollars. And the length of time varies as well. But just to get to the answer you’re looking for – an average audit costs between $25,000 and $30,000 and will generally be completed in about six months.

ER: Okay, interesting. And a lot of, or some of the agreements that we work with, the audit states that if a certain amount of errors are found, then the licensee is responsible for the cost of the audit. Do you run into that a lot?

VL: Yes. We have clients that is standard language in their license agreements. And it’s not uncommon that we assess a damage calculation for the fees and expenses incurred.

ER: Flipping the script here a little bit. One, you had noted that you do work with licensees. I would love to understand how you can help a licensee? And then what are some best practices or recommendations that you have for licensees that they don’t run into compliance issues?

VL: We have assisted licensees in the negotiation of license agreements. There are some very large licensors that may have a boilerplate agreement that really needs the massage for the specific industry. We assist the licensees after they’ve been audited as well to assess the findings that an auditor may have raised and determined if those are accurate, and assist with the licensee to mitigate the ultimate settlement amount.

ER: And how can licensees maybe avoid audits with a licensor or make them, if maybe not avoid, if they’re in an audit, how can they make it easier on them and helpful to the licensor?

VL: Having royalty accounting software really helps in preparing accurate royalty accounting. But there’s a lot of licensees that we audit. There’s just not that large a company. It would be a huge cost for them to undertake that. But one of the things that we run into is licensee entering into agreements that they may or may not have the ability to account under. Very, very complex profit participation agreements, for example. Or net sales agreements where the deductions are limited. And it becomes a very, very manual process for them to reduce the number of deductions to the limits that are set forth in the contract. Or isolate the types of expenses that are deductible to arrive at the profit that is to be split. So entering into an agreement that makes sense for the licensee where they don’t spend an inordinate amount of time just preparing the accountant. To have transparency in the accountings that they do issue is important as well. We recommend to all of our clients that they spend some time every month or every quarter or semiannual period, whichever, however many times they get accounted for per year. Reviewing those accountings to see if they make sense.

And if the licensee is just reporting and that sales amount and multiplying that by a royalty percentage, that’s going to give the licensor a little bit of heartburn and they’re going to probably try to institute an audit. Whereas if the accountings are detailed in terms of, by skew, by territory, by distribution channel types of deductions that are being taken, the licensor may be satisfied that based on the level of detail they’re receiving, they’re willing to trust that the accountings are materially accurate and may not institute an audit.

ER: Yeah, that makes a lot of sense and that’s kind of how we approach things too. We have one licensee that is very detailed in how they’re reporting. And so, it just feels like everything’s there. But we do a double check and put it into a royalty accounting software as well. Before we tackle our next question, here’s a quick word from our sponsor.

Today’s episode is sponsored by Brainbase. Brainbase is a technology platform that helps brands manage and monetize their intellectual property. The current platform assist helps brands track their legal contracts, sales, royalties, creative, and product approval, files, analytics, and so much more. Additionally, they’re working on launching a new service marketplace. Marketplace will allow you to showcase your brand and discover new opportunities from a global network of prospective partners. We use Brainbase Assist Program to manage and track licensing programs for our clients. We love the analytics and reporting tools and are excited about the new role two reporting features they’re rolling out. Check it out if you’re looking for an online management tool for your program. We’ve linked to their site in our show notes now back to our show.

Great. So, you just touched on what a licensee should be looking for or include in the license agreement so that they can make sure they’re reporting on the license. What could a licensor ask for from a licensee for reporting sales?

VL: I think similar information that is in certain instances, the licensor has reporting responsibilities as well. They may have participants in the merchandise deals they have. It’s really, really important that the accountants they receive include sufficient details so they can meet their financial obligations as well. Things like item number territory, the sales channel, gross sales, deductions, and net sale; should give, again, would give them enough information that they can run a smell test to see if what they’re being accounted for is inappropriate. Many of these deals will cover multiple properties. And so to make sure that the leads accountings are made by the property is important as well. Some of these properties may not be cross-collateralized. So if properties are not separately identified in the accountings they’re receiving, the licensor may not have the ability to determine if the royalties are improperly crossed.

ER: You also touched on this, but the role of your accounting software. We have some licenses that just report in Excel. We also have some clients that require them to use like a royalty zone or Brainbase. Do you recommend having the licensor, the brand owner be responsible for the royalty accounting software and having licensees report in? Or you had noted earlier that licensees should maybe invest in that?

VL: So several of our clients also invest in royalty accounting software. And there are many times requirements in the contract on various fields that need to be accounted for. And whether that’s issued in a format that’s from the actual royalty accounting software the licensee utilizes, or if it’s in a clean excel spreadsheet, I find that our, that the licensors can manage both as long as it’s a readable, sortable format.

ER: What’s the recommended reporting cadence to the license, or, and does that differ depending on the program or the type of industry?

VL: It does vary based on a number of factors, including the properties and the industry. We do a number of royalty audits in the interactive space. And for mobile gaming, the licensees are receiving monthly statements and payments from the various digital service providers. So in a situation like that, monthly accounting would not be as onerous. But what we generally see are quarterly accounting and some of the older agreements specifically in the film and TV space, we see semi-annual agreements. And we’ve also run across situations where their annual accountings. And those are very, very old contracts. But as you may or may not know, some of those films still generate a tremendous amount of revenue. Certainly a license, or wants to be accounted as frequently as possible, because that means they’re receiving their royalties that a more timely basis. As long as it’s not too onerous on the licensee to account on a monthly basis, I think quarterly is a reasonable expectation not to make the royalty accounting process for the licensee 50% of their business or something like that.

One of the things that changed tremendously in my career is the relationship between the licensees and the licensors, historically, are very adversarial, or at least the situations we got involved with were very adversarial. And now on the most part, they’re referring to each other as business partners because the successful license agreement is everybody’s, benefiting from it financially. And if that’s done correctly, the IP value is also increasing. The licensor should not be too demanding in requesting the cadence in which they are getting accounted.

ER: Great. You kind of just stole my last question, which is just the role that relationships play in deals. We have found that by having a strong relationship and partnership between the licensor and licensee, your programs last longer and they’re more successful. And so we’re really wanting to touch on, there are so many pieces of the licensing program. How do relationships play a role in this area? Any other thoughts there?

VL: Yeah, I think certainly the decisions made by licensees and licensors are not always financially driven. It may be important for a licensor to license particular intellectual property in, let’s say, food products. They may not have a food product licensee. And so that relationship that they develop with a distributor, a licensee may be more important than others that they have because they want to make sure they have representation in that space. And I do agree with you that the relationships on a business partner basis are more successful because there is an inherent cost in changing licensees. There may be six months of time for a seminal brand that there may not be anything on the shelves because they’ve changed the relay a 25-year relationship with a licensee and they have to go find a new one. And to change over every couple of years. It just doesn’t make sense unless the relationship isn’t thriving.

ER: You mentioned gaming earlier, which is just very popular these days in terms of licensing. Can you say more about how you audit for gaming versus how you audit for maybe CBG or other tangible goods?

VL: Sure. Even within gaming, there are a lot of differences between the techniques and the procedures that applied for a digital game versus a physical product that is being distributed. When you’re looking at a situation where cartridges are being distributed, there are factors that have to be looked at that don’t necessarily exist in online gaming as an example. Things like price protection that exists for cartridges need to be analyzed very closely in conjunction with reconciling, whatever was manufactured or distributed was accounted for. With respect to interactive gaming, where games are downloaded either to a mobile device or directly to a computer, the licensee will be receiving reports from the digital service providers that then they’ll account to the licensor. And sometimes it’s a hybrid of both. Like I said earlier, those accountings are generally received on a monthly basis by the licensees.

ER: Okay. I’m sure they love that. I would love monthly reporting. What are some up and coming trends that again, maybe not the most exciting, but from an accounting perspective and your perspective, what are some upcoming trends that you’re most excited about?

VL: Well, I wouldn’t say necessarily excited, but starting next year, we’ll be starting to audit agreements that were active during the pandemic. I know my clients have been very active and connected to their licensee. Some of these licensees have flourished as gaming licenses have flourished. But certain types of apparel have taken a big hit and other types of classes as well. Normally when we’d be just looking at written agreements and licenses and accountings. I have a feeling, upcoming, we’re going to be looking at a lot of emails going back and forth where licensees and licensors have negotiated payment, timetables, royalty rates, and minimum guarantees.

ER: Any other kind of impacts that you’re seeing in the industry after COVID?

VL: Yeah. Initially, we got push back from licensees because virtually everybody that we’re dealing with is working remotely. During the first two weeks of the pandemic, everybody was setting up their home office so they could securely obtain data from their company servers, etc. But after those first two couple of weeks, most of the licensee we’ve been dealing with has been very cooperative and provide the information that we need. From just an industry-wide perspective, the way that deals are being made is going to change. The various trade shows and things of that nature. Those are going to change. Whether they’re a hundred percent virtual or a combination of the two, it’ll be an evolution on how that works. And I think there’s going to be opportunities for folks that are able to adapt to that new reality, whether it be from a licensee perspective, professional services perspective, or from licensors. Obviously, folks have not, businesses have not made it through this pandemic. Other businesses have been vertically integrated into larger companies. And so I think there are opportunities out there as we move forward for new licensees to emerge.

ER: How can you advise people or help before you get to the audit stage? So, you know, what kind of services should people come looking for you beforehand so that they don’t get to the audit stage? And how do people contact you if they do want to connect with you?

VL: Sure. I think a lot of the clients that we act on behalf of, are licensing their intellectual property and industries that they’re not familiar with necessarily. You have a large entertainment company that’s involved in interactive gaming toys, apparel, collectibles, and all of these industries do business a bit differently. We have fairly broad experience in terms of negotiating the terms of an agreement, the types of deductions that should be allowed, and things of that nature, we certainly can consult as those agreements are being reached. Again, large companies insist on certain language in an agreement that a licensee may not be able to count on. And in those cases, invariably, there’ll be a royalty audit afterward. But again, companies have a fiduciary responsibility, whether it’s to their stockholders or other participants in the royalties, to monitor the royalties that they’re receiving. It’s evolving more into the monitoring of those royalties. And of course, folks want to be able to settle on amounts that are going to cover their costs. But more and more we’re conducting these types of inspections where governance is driving the inspection versus let’s go get the rest of our money.

ER: It’s interesting and a good perspective. And I think it probably helpful also for licensees to understand that. Because I’m sure you get on the defensive when it’s like “We’re coming to audit you”.

VL: Yes. And other folks that we’ll talk to, are very sensitive about the timing of putting the licensee on notice. When the folks that they deal with at that licensee may never find out that a royalty audit was conducted because it’s handled by a completely different set of folks. There are times where we talk folks out of doing royalty audits because we just don’t think it’s going to be worth their while financially to incur that type of cost.

ER: Really helpful. I think, again, this will be helpful to both licensees and licensors and our listeners. If people want to find you online and connect, what’s the best way to do that?

VL: My firm is called Miller Kaplan, so our website is millerkaplan.com. I can be reached at my email address vleoni@millerkaplan.com.

ER: Great. Well, thank you again for chatting with us today and for your time. And I’m sure some potential licensees and licensors we’ll be in touch.

VL: That would be great, Emily. I really enjoyed the conversation and I look forward to speaking with you.