“Into the Eye of the Storm”

June 2002
The Licensing Book

"Good Lord, man, you must be joking!"

"The topic is 'Equitable Risk Apportionment Between Licensor and Licensee'," Larry Lexus the Licensing Lawyer had replied to my query. He chuckled, "Yes, this can be a very emotional subject between those factions.  But I have a plan.

Larry had invited me to his office last evening to discuss the conference he'd been asked to lead at The Licensing Show.  Representatives of the major entertainment studios were being invited to discuss with executives of large consumer products manufacturers the perceived disparities in many license agreements.  Of course, each side perceived the disparities to favor the other.  My immediate concern was for Larry's personal safety.

Whose Risk is Greater?

"In order to defuse tension and generate positive results for everyone involved, I've spoken with knowledgeable representatives of each faction", he continued.

"First, my friends on the Licensee side posit that their startup costs can be quite large, while their opportunities to profit from a Licensed Property are much more limited than those of the entertainment studios.  A manufacturer can only profit at the end of a chain of events, all of which must be concluded favorably.

"Initially, a manufacturer must achieve an agreement for the property that makes profit possible.  Then it must invest in creating, designing, engineering and manufacturing its products and packaging, developing an advertising and marketing program, incentivizing its trade to carry the products, hoping for sell-through at retail in sufficient quantity to recoup tooling and marketing investments, and finally praying for reorders.  Only if the reorders come does the manufacturer stand to profit, if my friends on that side of the issue are correct.

"By contrast, they tell me, an entertainment studio has myriad opportunities to profit from its movies and television series: from U.S. theatrical distribution, U.S. television distribution, international theatrical and TV distribution and all of the other venues in which entertainment can be broadcast, cablecast, web-cast or video-cast, whether in-home, in-flight…soon, perhaps, in utero.  Any original music in the entertainment will result in royalty receipts from all broadcasts of the entertainment as well as from sound-track CD's and from many other uses, and such music can become a very lucrative source of revenue in its own right. 

"Original characters introduced in the entertainment can be extended into other media, such as publishing and interactive.  These sources of revenue are in addition to the merchandise royalties from licensing the property for use in apparel, toys and games, publishing, foods, gifts and novelties, and premiums, to mention a few.  One of my experienced manufacturer friends estimates that the studios have at least 150 separate ways to profit, while he has only one."

Impressed I said, "Well, those certainly sound like strong arguments in favor of the manufacturers.  Do you agree with them?"

Larry was thoughtful, "As in any substantive debate", he began, "you must listen to both sides before drawing conclusions.  My confidants with the entertainment studios are equally persuasive when they point to the vast outlays they must make in connection with any production.

"Today, my studio friends tell me, it is nearly impossible to create entertainment without a large payment to a rights-holder.  But that, they say, is only the beginning.  They tell me you simply must look at the extraordinary lists of credits after every motion picture and television program even to begin to understand the enormity of creating an entertainment vehicle. Even after the post-production edit has finally resulted in a usable product, the machinery for distribution and promotion must be fueled by large additional expenditures in hope of attracting an audience.  If the audience fails to materialize, my studio friends tell me the number of possible outlets becomes irrelevant because no one wants to buy a failed property, no matter what media they represent.  And the number of failures far exceeds the number of successes."

"I don't envy you this role, Larry," I said.  "How do you intend to approach the conference without its deteriorating into a shouting match, or worse?"

Absently, Larry withdrew his grandfather's timepiece from his vest pocket, checked the time and carefully wound it with precisely three strokes before returning it gently to its resting place.  "My purpose in having preliminary conversations is to prepare a comprehensive list of the principal arguments of each faction.  I will provide the entire list during my introductory remarks to the assembled group in order to forestall emotion.  If rationality prevails, each side will see that the other bears substantial risk no matter whose may be 'greater' in a particular instance. 

"Simply put, the risks and rewards must be reasonably apportioned between the parties in order that each has an interest in maximizing the success and longevity of the resulting entertainment and product lines.  If negotiation deteriorates into argument of whose exposure is greater, or if one side attempts to dictate terms that will likely prevent the other from profiting reasonably, long-term success for either is highly unlikely."

Variable Royalty Rates

Uncertain of his direction, I ventured, "You must have something up your sleeve, Larry.  Most significant License Agreements today already include the escalating royalty structure that you originated 20 years ago, or variations on that theme.  You've taught us all to give the Licensee an opportunity to recoup its start-up and product-refresh costs by beginning the period at lower than 'normal' royalty rates.  By providing top-end rates higher than normal, the Licensor can profit handsomely when the manufacturer has recouped and is enjoying greater profit margins.  The entire licensing industry has adopted your approach to royalty rate structures, Larry, and I'm sure that as a result many deals have succeeded that would otherwise have failed."

Larry withdrew and inspected his timepiece once again.  He said, "I appreciate your recalling the origin of that strategy, my friend.  And you are correct: Many successful licenses have been facilitated in that fashion - in fact, my colleagues have made such frequent use of royalty escalation that it has become the norm rather than the exception.  However, too frequently its underlying purpose and its inherent limitations have been forgotten.  Escalating royalty structures have been thought to be a panacea, but my contemporaries have come up short in that assessment. 

Structured Guaranties

"The reason I invited you here this evening is to ask your opinion of new suggestions I intend to make to the conference.  Unfortunately, time has gotten away, and I must soon leave for an appointment.  Can't keep Clients waiting, you know. Before I leave, however, I want to introduce a couple of concepts for your consideration. 

"Royalty rates obviously are central to License Agreements, not only in apportioning risk and profit, but also facilitating high quality products of which both Licensor and Licensee can be proud.  I've revised and refined and re-defined the basic escalation royalty structures many times in many deals to facilitate mutual success, and we can discuss some of my newer royalty rate concepts at another opportunity.

"An equally crucial aspect of a mutually beneficial License Agreement is a well-reasoned royalty guaranty.  The guaranty that a manufacturer must bear invariably affects its other commitments relative to the licensed product line.  Since manufacturers must operate within budgetary constraints, the greater the guaranty, the less risk a licensee may be able to take in product creation and product support.  One discussion topic I will put before the conference will be consideration of novel structures for royalty guaranties.

Adjusted Recoupment Rate?

"Consider this:  Do you think it might enhance the position of both parties to a License Agreement if the absolute sum of a guaranty were reduced by some percentage, while at the same time the recoupment rate of that guaranty against earned royalties were likewise reduced?"

From my blank expression, Larry knew that I was not following his point.  He continued, "Let me explain.  The Licensor invariably argues that it sets the guaranty at a level which recognizes the Licensee's potential to recoup, but which also forces the Licensee to maintain its focus on the property.  In other words, the guaranty must be large enough that the Licensee must strive to achieve recoupment, and the Licensor takes comfort in this incentive to diligence.  My concept retains this advantage for the Licensor while freeing a portion of the Licensee's assets for productive work.

"Larry, I still don't . . . ."

"Allow me to provide an example. If a royalty guaranty is set at $1,000,000, the Licensee must design its product line and promotional elements around that number so that the total of the three numbers - that is, royalty guaranty, product development budget and promotional budget - do not exceed its anticipated profitability for the line. If the royalty rate were 10%, $10 million in sales would have to be achieved before the $1,000,000 minimum royalty was earned under the original formula.

"What if, instead of $1,000,000, the minimum guaranty were $750,000, but at the same time the guaranty were recouped only at the rate of 75 cents per earned-royalty dollar.  Applying my suggestion, it would still take $10 million in sales to earn out a $750,000 minimum guaranty.  However, a creative Licensor who agreed to such a "risk-adjusted" guaranty would facilitate the Licensee's spending an additional $250,000 on product development and promotion in support of the Licensor's property while still ensuring the Licensee's diligence to achieve at least $10 million in sales.  In fact, I would suggest that the incremental sums spent on product development and promotion could spark a sales delta that would more than return the Licensor's apparent generosity.  And keep in mind that the guaranty is merely a protection of the 'downside'.  The $250,000 'reduction' has no effect whatsoever upon the Licensor's income once the sales level has equalized."

I said, "Larry, that sounds like a very good idea.  I'm curious to hear what the Licensors attending your conference will say."  "So am I," he answered.

Bearing the Cross?

"I am certain you are aware that many Licensors also require minimum periodic royalties." 

"Sure, Larry.  The purpose is to require Licensees to give continuing support to a property throughout the term of the license.  They cannot recoup the guaranty over a portion of the term and then lose interest in the property without also losing the subsequent periodic guaranties." 

"And Licensors are loathe to permit cross-collateralization in the earn-out among years of the term, correct?"

"Well, yes.  Wouldn't that defeat the purpose?"

"My friend, it depends upon what the purpose truly is.  Query: Would the Licensor have a sound basis to object to cross-collateralization of a small fraction, such as ten percent, of an annual minimum among adjacent years of the term?  Perhaps retail fluctuations may cause a Licensee's product demand to fall off in one year but to increase in the next.  Or perhaps the Licensee may have ramp-up problems in the first year of the term.  Should a Licensor permit crossing to a factional degree in order to address such unavoidable occurrences?  And if such a proposal were rejected by the Licensor during license negotiation, to what would you attribute such a refusal?" 

"I don't know, Larry, in answer to both questions." 

"My belief is that a reasonable Licensor should anticipate that its Licensee may experience unforeseeable problems and readily agree to a partial cross-collateralization of the annual minimum if its true interest is ensuring continuous diligence.  If the Licensor refuses, one might surmise the reason as a desire to, shall we say, profit from the unfortunate vagaries of the Licensee's business.  If, notwithstanding its good faith efforts, the Licensee experiences a deficiency in one year and surplus in the next, a refusal to allow recoupment of some fraction of the deficiency against the surplus merely raises the total guaranty at the Licensee's expense, and in a fashion that renders recoupment unachievable.

"For example, if the agreement calls for an annual minimum of $100,000 but permits 10% cross-collateralization, a deficiency of $15,000 in one year could be offset by an excess in another, but only to a $10,000 limit.  Thus, the Licensee would lose $5,000 of the shortfall rather than the entire sum.  In contrast, if the Licensor refuses to permit any crossing, it has effectively increased the Licensee's guaranty by $15,000, and that incremental amount is entirely unrecoupable.

"You seem to be onto something, Larry."
 "Yes, the response to this suggestion will be equally interesting."

Pay or Play? 

Larry continued, "Another proposal I intend to make is that the parties consider a further risk adjustment by allowing Licensees the option to cancel or to "buy-out" later years of the term of a license at a fraction of the minimum royalty associated with those years, if the Licensee gives timely notice to the Licensor.  In that way, the Licensee can increase its expenditure toward product development because it realizes that an unsuccessful line does not doom it to losing the entire royalty guaranty on top of its product development cost.  At the same time, the Licensor will have the opportunity to re-sell the property."

I said, "Am I understanding this one correctly?  If a multi-year license entails a minimum royalty of $100,000 per year, and if the Licensee were to give notice to the Licensor well in advance of the final year, it might then 'buy-out' its obligation for that year at something less than $100,000?" 

"That's correct," he said. "In fact, if the notice were sufficiently early, the final year"s guaranty might be cancalled in its entirety."

"I'm not quite as sure, Larry, that this suggestion will be successful.  The Licensor may argue that the Licensee would exercise this option only if the property were failing and it would be impossible to re-sell.  How would you answer that objection?"

Would Diogenese Stop Here?

He replied, "These are all areas where, in the absence of evidence to the contrary, the parties should assume that each is operating in good faith.  It's entirely possible in a particular situation that the Licensor will reject one or more of these proposals.  However, if the Licensor is wise and agrees, it should expect and require that, in return, the Licensee be willing to increase spending toward product development and promotion in order to provide a the "boost" that might turn a marginal property into a success.  Life is filled with uncertainty, and these suggestions are merely ways that the parties can increase flexibility and the potential for mutual success."

"I see.  Do you have other suggestions to make to the conference?", I asked.

"Certainly, but I really must run.  When we meet again, I would like to discuss a number of other ideas.  Of course", he grinned,  "you don't expect me to give all my ideas to the conference, do you?  In candor, I keep the best ones to myself and use them for the benefit of my Clients.  That goes without saying, my good friend."

With characteristic economy of movement, Larry Lexus plucked his briefcase from its accustomed place beside his massive desk and strode briskly from the office.

The writer is a veteran of 20 years representing Licensors and Licensees in negotiating entertainment, sports, artwork, brand, invention and technology agreements.  Mr. Kipling is Of Counsel with Frost Brown Todd LLC in Cincinnati, Ohio and can be reached at jkipling@fbtlaw.com and (513) 651-6101.