Licensing arrangements are a major source of revenue in many industries, including entertainment, (film, TV, music), sports, corporate brands, and colleges/universities. Each year, rights holders collectively earn billions of dollars from licensing revenue. I have had the opportunity to negotiate hundreds of merchandise license agreements, from both sides of the table, with rights holders as diverse as Disney, Marvel, Live Nation, NFL, NBA, Dr. Seuss, Sesame Street, Frank Zappa and George Clinton. In addition to the basic provisions (length of term, territory, indemnification, insurance), there are a number of practical considerations that arise when negotiating merchandise license agreements. The following checklist can help with framing these key issues:
License and Products
Both parties will want extreme specificity as to what intellectual property is being licensed under the agreement. To protect itself from potential claims of infringement, the licensee should seek indemnification from the licensor against claims from any and all illustrators, photographers and designers involved in the creation of the asset. Also, permitted uses of the license should be well-defined. Generally, the licensor will seek to limit the licensee’s use to its areas of expertise. For a licensee looking to expand its product line, earlier success coupled with a larger guarantee may help in negotiating an expanded definition of permitted use (allowable licensed products). Finally, restrictions on use, including minimum royalties per unit or sales in violation of applicable laws/regulations, often protect the licensor’s interests.
In most deals, the licensee pays the licensor an advance on royalties upon execution of the agreement, and also makes proportional guarantee payments during its term. Although licensees often try to delay the timing of such payments, licensors are motivated to receive them as early as possible because they naturally incentivize a licensee to get the product to market as quickly as possible. An advance also helps to offset the licensor’s upfront costs in processing the agreement and approvals. In deals where the licensee provides sales projections, these estimates may be used to determine an appropriate the guarantee amount. Finally, a licensor with an unproven track record in the marketplace may need to settle for a small or no guarantee, which may be sensible in trying to build consumer demand.
Royalty payments are typically calculated as a percentage of Net Sales, and are paid to the licensor in accordance with a payment schedule agreed upon by both parties. A flat rate royalty is usually seen in most situations. However, with the proliferation of licensees selling directly to the consumer, as opposed to selling to a retailer, a licensor will likely seek a bifurcated royalty structure, which allows for a higher royalty on the licensee’s direct sales in order to share in the increased profit margin. This structure is only relevant if the licensee has an established direct-to-consumer website.
Since the term ‘Net Sales’ does not have a standard meaning and must be defined in the agreement, negotiation of this definition is extremely important to both parties. A licensor will prefer an air-tight definition of ‘Net Sales,’ allowing little room for deductions, as illustrated in the following statement: No costs incurred in the manufacture, sale, distribution, or exploitation of the Licensed Products may be deducted from any Royalties payable by Licensee. On the other hand, a licensee will strive to include exceptions to this definition, such as deductions for returns, cash sales and the like.
Exclusivity and Channels of Distribution
Licensees generally seek exclusive rights to sell merchandise using the licensor’s asset. The issue becomes how broad those exclusivity rights should be. Before the licensor can agree to proposed exclusivity terms, however, it must first ensure that the licensee is equipped to exploit in the designated channels of distribution, exercising even greater caution when licensing its intellectual property to first-time licensees.
Statements, Records, Audit
The licensee normally maintains all financial statements, sales reports, and other accounting records required under the licensing agreement. The licensor will prefer to receive royalty statements and payments as frequently as possible. Generally speaking, though, quarterly statements are reasonable, unless the licensee is selling directly to consumers, in which case the licensor may seek more frequent reporting. Regardless of frequency, the licensor should request that sales reports be broken down by products and channel, among other factors. Finally, while the licensor will expect regular access to the licensee’s accounting records to monitor the accuracy of royalty statements, the licensee should require the licensor to provide reasonable notice prior to exercising its audit rights and limit both the audit duration and scope. It is also common to include the provision of a penalty (a percent of discrepancy and audit costs) to be paid by the licensee in the event an underpayment is discovered by the licensor.
Product Approvals, Samples
Both sides will benefit from clearly defined quality assurance measures. Licensors often seek the right to approve merchandise at various stages of development and production to ensure that quality is sufficient, all copyright and/or trademark notices are included, and the product is not averse to the licensor’s brand image. Approval rights should also include advertising and promotion materials. While this feedback is helpful, the licensee should seek to define the period of time during which the licensor can provide approvals or comments in order to avoid production/distribution delays. A licensor who is typically hard to reach (such as an artist on tour) is wise to insist upon an open period of time to grant approval.
Inventory and Sell-Off
The licensee is basically in control of the production process, including how much inventory to produce in anticipation of consumer demand. However, the licensor should be mindful of product quantities, especially as the term of the agreement draws to a close, to protect its revenue stream in the event of overproduction by the licensee and “blow out” sales at liquidation prices to clear inventory. Because retail prices cannot be mandated in the U.S., licensors are advised to track inventory closely and include a sell-off provision in the agreement.
A growing number of merchandise licensing agreements require the licensee to ensure fair working conditions in all factories and production facilities where their products are made, as well as fair wages for all producers and workers involved in the production.
Although rights holders and their licensees tend to find middle ground at the end of the day, this checklist is intended to promote more efficient negotiations by highlighting key issues and what’s at stake for each party. If you need support for a merchandise license arrangement, or licensing for other products (such as film, TV, etc.), please contact Brad Auerbach at firstname.lastname@example.org or 310-382-0019.
Brad Auerbach is a Partner with our California-based team, bringing over three decades of senior in-house counsel experience in the media, gaming and technology industries. Brad has been involved in structuring many groundbreaking deals with a diverse range of rights holders, including NFL, NBA, NHL, HBO, MTV, ESPN, Sesame Workshop, Nickelodeon, Live Nation, Marvel Entertainment, International Olympic Committee, English Premier League, Screen Actors Guild, every significant Hollywood studio, each of the major record labels, many major book and news publishers, several world class photographers and Getty Images, among numerous others.