Protecting your IP with an Audit – and what to do if you’re audited

“IP audit” can have two different meanings.

One form of IP audit is more like an IP inventory – it looks at what IP a company has in its portfolio.

The second type of IP audit involves checking whether a licensee is in compliance with its license terms, and that’s the type we’ll be talking about in this blog.

The Licensor’s Perspective

If your company owns and licenses out software or other forms of intellectual property, an audit can be an important tool for protecting your rights and your revenue stream.

You want to make sure that if, for example, a client is paying to use your software on 1,000 computers in Minnesota, they’re actually using it on only 1,000 computers in Minnesota – and not 10,000 computers all over the world.

If your software is being installed on devices sold by the licensee, you need to be sure that you’re being paid the appropriate royalty for each device sold.

Ensuring Your Audit Rights

The best way to assure that you’ll have the right to audit your clients’ IP use is to include an IP audit clause in your license agreements.

If your client is using your software for its internal purposes, an audit clause might be something like this:

Audit. Licensor will have the right, upon reasonable prior written notice to Licensee and at a mutually agreeable time no more than once per calendar year, to have an independent audit firm selected by Licensor and reasonably acceptable to Licensee, that is subject to an executed confidentiality agreement, audit Licensee’s equipment and books and records relating to Licensee’s use of the Software to verify compliance with this Agreement. The audit will be conducted at Licensor’s expense, unless the audit reveals that Licensee has failed to pay license fees consistent with its use of the Software, in which case Licensee will reimburse Licensor for all reasonable costs and expenses incurred by Licensor in connection with such audit, together with any applicable License Fees.

If you need to make sure you’re being paid for software that your licensee is distributing to its own customers, an audit clause could be similar to this example provided by the Association of Corporate Counsel:

Audit Rights. Licensee shall maintain for a period of two (2) years after the end of the year to which they pertain, complete records of the Software distributed by Licensee and to Licensee Customers in order to calculate and confirm Licensee's royalty obligations hereunder. Upon reasonable prior notice, Licensor will have the right, exercisable not more than once every twelve (12) months, to appoint a representative, at Licensor's expense, to examine such books, records and accounts during Licensee's normal business hours to verify the royalties due by Licensee to Licensor herein. Licensor may audit more than once every twelve (12) months if there has already been a previous audit and some discrepancy of payment has been found. In the event such audit discloses an underpayment or overpayment of royalties due hereunder, the appropriate party will promptly remit the amounts due to the other party. If any such audit discloses a shortfall in payment to Licensor of more than five percent (5%) for any quarter, Licensee agrees to pay or reimburse Licensor for the expenses of such audit.

Conducting the Audit

Your license agreement should include the procedure for notifying the licensee of the audit. You might be required to give a specific amount of notice (for example, two weeks), or the notice might need to be “reasonable” – which will depend on how disruptive the process is likely to be to the licensee’s operations.

Obviously, your goal in the IP audit is to protect your rights without alienating the customer. Thus, it’s best to see the audit as a cooperative rather than an adversarial procedure, and to take steps to minimize the disruptions to your licensee’s business.

Following Up

If your audit does uncover a discrepancy in usage or payments, then you’ll need to adjust the license terms (and fees) to accurately reflect actual usage.

You’ll also need to determine how much unlicensed use of your IP the client made and collect the appropriate fees.

To discourage clients from deliberately misusing your software, you may want to charge a premium for unlicensed use. The client shouldn’t merely pay what it would have paid if its use was properly licensed.

As in the second audit clause example above, you may want to conduct more frequent audits if you’ve caught your client in a license violation.

Often, clients are embarrassed to be caught violating license agreements and will settle up without a serious argument. However, as a worst case, you may need to go to court to enforce your license rights.

If you do go to court and can establish that your client’s unlicensed use of your software was willful (which seems likely if they refuse to settle in the aftermath of an audit showing their misuse), you may be entitled to treble damages for infringement of your IP rights.

Surviving an Audit

If you’re an IP licensee, it’s wise to be pro-active about assuring your compliance with license terms.

If yours is an established company with an experienced and responsible IT department, an IP audit may be only an inconvenience but not a major concern.

However, if your company is a startup and your IT department is unseasoned, or if your employees are using their own software in a “bring your own device” environment, you may be facing more of a risk of serious consequences if you “fail” an audit.

If you don’t already perform internal IP audits as a matter of course, receiving a notice of audit from a licensor gives you a chance to “clean house” before the “guests” show up.

If you do your own audit and discover that you’ve been in violation of your license, your best policy is to admit this to the licensor, apologize, and quickly negotiate a reasonable settlement. Stonewalling or trying to conceal your wrongdoing could get you into serious trouble – including the termination of IP rights that your company needs in order to operate, plus legal fees and damages for willful infringement that could cripple your business.