THE BASICS OF A MERCHANDISE LICENSE AGREEMENT
The license agreement is at the heart of every merchandise licensing transaction. While there are some generally accepted rules in the industry, the licensor and the licensee are usually free to put together the best deal that each can negotiate. Some of the key issues to be addressed in a merchandise license agreement are discussed below:
The Licensed Property
The license agreement should clearly identify the property or properties to be licensed.The license agreement should clearly identify the property or properties to be licensed (e.g. character, design, trademark, etc.), and, if applicable, copies of the licensed property should be attached as exhibits to the agreement. The licensee should determine that the property is protectible under copyright, trademark or other applicable laws, and may want registration numbers to be listed in the agreement. If the licensed property is a trademark, the licensee may also want to require that the mark be registered for use on the types of merchandise to be produced under the license agreement.
The Licensed Products
The agreement should contain a complete description of the licensed merchandise, including dimensions, colors and materials. In most cases, the licensor will want to limit the licensee's rights to the specified merchandise only, and will want the right to approve any changes in that merchandise. The licensee may want an option or a right of first refusal in the event the licensor decides to license the property for certain other product lines.
The Grant of Rights
The agreement should grant the licensee the right to manufacture, import, market, distribute and sell licensed products, and should specify whether the grant will be exclusive or nonexclusive. If the grant is exclusive, the licensor will not be able to grant the same rights to any other licensee in the territory. If the grant is nonexclusive, the licensor will be able to grant the same rights to others, provided it does not try to do on an exclusive basis. In addition to manufacturing, importation and distribution rights, the licensee should acquire the right to use the licensed property in or on advertising for the merchandise to be produced.
The Territory and Channels of Distribution
The license agreement should specify the geographic areas and channels of trade in which the licensed merchandise can be sold. The licensor will want to limit the territory to countries in which the licensee has a presence, and may want to limit the channels of trade (e.g. upstairs department stores, mid-tier department stores, or mass market stores) in which the licensee can sell merchandise. The licensor will want to prohibit the licensee from selling to any of the licensee's affiliates at below market prices.
Quality Control
If the licensed property is a trademark, the license agreement must include adequate quality control provisions.The licensor should have the right to approve all licensed merchandise and all related packaging and advertising materials before any merchandise or advertisement is released to the public. Depending on the property and the type of merchandise covered by the agreement, the licensor may want approval rights at various stages, including initial plans and specifications, production mock-ups and final production runs. The licensor should also have the right to obtain random samples of merchandise and advertising materials during the term of the agreement to confirm that there has been no deviation from the previously approved samples. If the licensed property is a trademark, the license agreement must include adequate quality control provisions or the licensor will risk losing its rights in the mark.
Sales Efforts
The licensor will want to insure that the licensee makes a good faith effort to manufacture and sell licensed products, particularly if the license is exclusive.
Some of the provisions that can be used to insure licensed product sales are as follows:
- Guaranty. The licensor can require the licensee to guaranty that royalties will reach a certain amount. If total royalties do not reach that amount, the licensee will be obligated to pay the difference to the licensor. A portion of the guaranty may be payable as an advance, and the guaranty may be allocated on an annual basis over the term of the agreement. The amount of the guaranty is usually equal to 50% to 75% of the estimated royalties expected to be earned from sales of the licensed products, and as much as 25% of the guaranty may be payable as an advance.
- Minimum Sales Requirements. A guaranty will insure that the licensor receives some compensation for the license, but it may not insure that the licensee will actively sell licensed products. For example, a licensee may decide that it is more cost effective to pay the guaranty than to manufacture and sell licensed products, especially if the licensee enters into a license for other potentially competitive products that offer a greater profit potential. In order to prevent this from occurring, a licensor can also include annual minimum sales requirements.
- Product Introduction and Sale Dates. For some categories of products, failure to exhibit prototypes at an annual industry trade show (such as Toy Fair, held each February in New York) will effectively keep the licensed products out of the marketplace for another year. In these situations, the licensor will want to require that the licensee introduce a certain number of styles of the licensed products at the appropriate trade show. The licensor will also want to require that shipments of products begin no later than whatever date is determined to be the deadline for the appropriate peak marketing period (e.g. back to school, Halloween, Christmas holiday season, etc.). Failure to meet any of these dates will be grounds for termination of the license.
- Advertising Commitment. The licensor will often want the licensee to commit to spend a certain amount, usually calculated annually, for advertising for the licensed products. The agreement should list the types of expenditures that will be included or excluded in satisfying the advertising commitment. Some licensees may offer a large advertising commitment in lieu of or as a partial credit against a guaranty.
- Partial Termination. In some cases, a license may cover several different licensed product categories, territories or channels of distribution. The licensee may prove to be quite proficient in some of these categories, territories or channels of distribution, but may have little or no activity in others. In order to prevent segments covered by the license from lying fallow, the licensor may want to reserve a right to terminate the license only as to that segment if: (i) activity does not begin in that segment by a certain date; or (ii) activity in that segment does not reach a certain level by a specified date or remain at that level for a specified period of time.
Royalties
In negotiating the compensation for a licensing deal, it is important to look at both the royalty percentage and the base against which that percentage will be applied. Royalties are usually based on net sales of licensed products, but the definition of net sales can vary considerably from one agreement to another. The license agreement should address all of the following issues with respect to the calculation of royalties:
- Royalty Rate. Royalty rates can range from 2% to 20% of the licensee's net receipts. Rates will vary depending on the type of licensed property, the type or types of licensed products to be manufactured, the current or anticipated demand for the licensed products, and the track record of the licensor. Entertainment and sports properties and single event properties tend to command higher royalty rates than fashion, art and corporate trademark properties. Food products tend to yield a lower rate due to the generally low profit margins in the food industry. A licensor may want to include royalty rate escalators based on the number of units sold or the amount of net sales proceeds received.
- Royalty Base. In most cases, the royalty will be determined by multiplying the royalty rate by the "net sales" of licensed products. The starting point for determining net sales is usually the wholesale price of the licensed products. The problem comes in identifying items that will be permitted to be deducted from the wholesale price to arrive at net sales. Items that may or may not deductible include: credits for returns; quantity discounts; cash or early payment discounts; advertising allowances/coop advertising; new store allowances; freight charges; sales commissions; and uncollectible accounts. The licensor will want to limit deductions as much as possible, and may want to put a cap on the total amount that can be deducted. Any deductions that are allowed should be reflected on sales invoices or other records that can be easily audited by the licensor.
- F.O.B. Sales. In most cases, the licensor will expect the licensee to ship licensed products from the manufacturer's factory to the licensee's warehouse, and then sell those products from the warehouse to retailers. Under this scenario, the licensee's wholesale price will be set at a level that will be sufficient to cover manufacturing and shipping costs and the royalty paid to the licensor, and still provide some profit margin for the licensee. With an F.O.B. sale, the retailer still buys licensed products from the licensee, but takes delivery of those products at the manufacturer's factory, thereby saving the licensee the cost of freight. (The retailer may want to do this if it is already shipping other products from the same location, and can combine shipments and pay less in freight charges than the amount that would have been added to the licensee's wholesale price to cover freight.) The licensee will charge a lower wholesale price, since it will not have to recover any shipping costs. The licensee's profit margin may be substantially the same as or better than that for a regular domestic sale, but the licensor's royalty will be lower as a result of the lower "net sales" royalty base. In order to avoid this result, many licensors either prohibit F.O.B. sales, or provide for a special F.O.B. royalty rate that is 2% - 4% higher than the royalty rate for domestic sales. [Note that in some types of licensing transactions, such as the licensing of artwork for chinaware or collectibles, all royalties may be calculated as a percentage of the F.O.B. cost. In these situations, the licensor will usually have to follow the industry practice or look elsewhere for licensing opportunities.]
- Other Issues. The licensor may also have to consider other issues in the calculation of royalties. For example, will there be a minimum royalty for free goods given to purchasers as a bonus for buying a specified quantity of products, and how will royalties be determined on sales to affiliates of the licensee?
Statements and Payments
Royalties are usually accounted for and paid on a quarterly basis for all sales deemed to have occurred during the quarter. The license agreement should specify when a sale will be deemed to have occurred. Statements and payments are typically due thirty days after the end of each quarter. The licensee will usually apply the same accounting and payment practices to all of its licenses, and will not change those practices for any individual licensor.
Audit Rights
The licensor should have the right to audit the licensee's books and records to verify sales and royalty reports. The licensee may want to impose a time limit within which the books and records for any particular accounting period can be audited, and may want to bar the licensor from conducting more than one audit with respect to any particular accounting period. A licensor should be vary of any lengthy advance notice requirement for conducting an audit, since a substantial advance notice period may give the licensee time to cover up any shortages.
Notices and Credits
The agreement should require the licensee to include proper copyright and trademark notices on the merchandise or on labels or hang tags attached to the merchandise. The licensor may also want to be credited as the owner of the licensed property. This is especially true for artwork licenses, where the licensor's primary motivation for entering into the license is often to gain enhanced publicity and name or brand recognition rather than royalties.
Indemnification and Insurance
The licensee will want indemnification against copyright, trademark and other infringement claims arising out of its use of the licensed property. The licensor may try to limit its indemnification exposure by agreeing to indemnify only for actual infringements as determined by a final court judgment, or to cap the amount of indemnification at the total amount of royalties received under the license.
The licensor will want the licensee to indemnify it against any claims of product liability arising out of the sale or use of the licensed products, and will also want to be indemnified against fines imposed by any governmental agency for unsafe products and against any claims for unfair trade practices, deceptive advertising or other actions by the licensee in the advertising and distribution of the licensed products. In addition, the licensor will want the licensee to carry adequate product liability insurance, and will usually want to be named as an additional insured under the licensee's policy.
License Term
In most cases, it is to the licensor's advantage to have a shorter rather than a longer term. If the licensing arrangement is successful, a shorter term will give the licensor an opportunity to negotiate a higher royalty rate before renewing the license agreement. As a compromise, the licensor and the licensee may agree to a short initial term with an automatic renewal if certain sales or royalty targets are met, or, alternatively, to a longer term with an automatic termination if specific sales or royalty targets are not met.
Termination
The licensor will want the right to terminate the license prior to the end of the term if the licensee fails to perform certain obligations under the agreement or engages in certain activities outside the scope of the agreement. The agreement will often provide for three categories for events of termination: (1) events that are grounds for immediate termination without any cure period; (2) events that will become grounds for termination if not cured within a reasonable time after notice; and (3) events that are confined to only a portion of the license, and that will become grounds for the termination of that portion unless cured within a reasonable time after notice.
Sales After Termination
The licensee will usually want the right to distribute any licensed products remaining in its inventory after termination, provided termination is not due to a breach of the agreement by the licensee. If the licensed property is likely to have continuing value after the agreement terminates, the licensor will want to keep the licensee's sell-off period as short as possible, and will want to require that all sales during that period be made in the ordinary course of business at regular prices. The licensor should condition any sales after termination on the licensee having provided a sworn statement showing the total quantity of licensed merchandise in its inventory as of the termination date. The licensor may want to include additional safeguards in the agreement to prevent the licensee from overmanufacturing in anticipation of termination.
Merchandise licensing can be profitable for both the licensor and the licensee. A well-executed licensing program can provide the licensor with additional income, publicity and recognition, and can provide the licensee with an opportunity to profit from the goodwill associated with the licensor's properties. Before entering into a license transaction, the licensor and licensee should agree on the terms of the license, and should sign a written license agreement to serve as the road map for their relationship.