Unless an inventor decides to manufacture their own invention, they usually will obtain income through royalties from licensing the invention to other companies. These entities control the manufacturing, distribution, and marketing processes. Royalties are usually measured in terms of net sales. This means that they are a percentage of the net sales derived from the invention.
The licensee will want to include certain deductions from the net sales amount in the license agreement. Deductions will limit the amount that the inventor earns, so the two sides may need to negotiate the scope of the deductions. Most licenses arrange for deductions for taxes, credits and returns, and certain discounts, among other examples. By contrast, deductions for items such as sales commissions, marketing, and advertising may be less reasonable. An inventor will want to review the specific deductions in detail before agreeing to a license.
Common Types of Deductions
A product may be taxed in the state where it is sold, and the tax rate may vary among different states. If your invention is something that would be subject to tax, you should expect the licensee to impose a tax deduction. They also probably will require a deduction to cover the freight and shipping costs of the product.
Since certain specimens of the product may be defective or not used, the licensee may reasonably ask for a credit and returns deduction. You may be able to limit this deduction to returns that have a good-faith basis so that a distributor does not take advantage of you by making a secret agreement with retailers.
Also, a license may include a quantity discount (or volume discount) on orders above a certain size. The discount must be made at the time of shipment or appear on the invoice. A licensor may have an incentive to accept this deduction because it may increase the appeal of the product to the licensee’s customers. This may result in greater sales, more profits, and more royalties. If you agree to this type of deduction, you will want to ask the licensee to give you regular reports on sales.
Unusual Types of Deductions
If a licensee pays salespeople a commission for each sale of the product, they may ask you to deduct the commissions from the net sales. This is not usually a reasonable request, since it arises from the business decisions of the licensee, and you may want to push back against this suggestion. Another unreasonable deduction that is based on the licensee’s business choices is a deduction for bad debts and uncollectable accounts. If a customer of the licensee fails to pay, the licensee will get nothing from those sales and may not want to pay royalties based on them. You should not feel compelled to pay the price of the licensee’s poor choices in business partners.
Other types of deductions may be unreasonable because they are excessively vague. Fee deductions and processing deductions often fall into this category. You may want to refuse a fee deduction unless the licensee can tie it to specific fees. Also, you may want to avoid deductions for marketing, advertising, or promoting the product. This is supposed to be part of the licensee’s normal business operations.
The license agreement can provide that the deductions from net sales cannot exceed a certain amount. This usually would be defined as a percentage of the gross sales of the product. Some license agreements will provide caps for specific deductions, while other license agreements will provide a cap for the total amount deducted.