You’ve drafted and redrafted. You’ve negotiated, compromised, redlined and tweaked. Countless hours, conversations, and rewrites go into each agreement before it is finally inked. But then what?
A solid contract is only the first step before your client truly receives the benefit of your work. Your contract is the playbook, but a contract compliance examination or royalty audit ensures the execution that is necessary for the most valuable results, long term. So what exactly is this process and why is it so helpful?
As with most things, the devil is in the details for executing the terms of a contract. Contracts with pricing arrangements often include things like tiered pricing for different purchasing levels, royalty rates that adjust with different sales base amounts, or other package or bundling deals. While these details are typically given much attention at the outset of the contract life, all too often they go unnoticed when purchases fluctuate into a different pricing tier months or years later. A contract compliance examination simply works with your client and their contracting party to obtain the transaction information for a defined period of time. This focused review allows dedicated time to scrutinize whether the contract is still being followed. The process brings value to your client and you in a couple of ways.
Is your client truly receiving the benefit of the “deal” that you crafted? In the past, we worked with a company which had pricing agreements with a number of its vendors. Each year they simply selected one vendor to perform some testing. These relatively limited procedures consistently found some error or difference in interpretation resulting in candid and cooperative conversations and often “true-up” payments, which increased the client’s bottom line and typically strengthened their relationship with the vendor. In one case, just the initiation of the process encouraged a vendor to perform their own internal review and voluntarily identify issues. This review resulted in a check for hundreds of thousands of dollars to correct an unintended oversight.
In another example, a company had been collecting royalties from a business relationship over a number of years. Management grew concerned that the royalties may not be calculated off the proper base, as both businesses had added product lines. After initiating an examination, the client became aware of seemingly deliberate abuse of the contract language. They eventually settled the disagreement for millions of dollars and discontinued the relationship.
How does this process work? For many clients, the idea of adding another task to their staff’s workload is simply impractical. Instead, these examinations often utilize an outside accountant or similar consultant to perform the work. Using a third party is more efficient, and eliminates the potential awkwardness when a client’s employees ask vendors for additional information and explanations as they work through the testing process. For other clients, cost is a bigger issue than workload. In those situations, the outside accountant can lead the process but utilize the client’s in-house people for some procedures as a way to reduce fees. For some clients, it makes sense to bring the entire process in-house, without external assistance. No matter what your client’s preference, the discretionary nature of these engagements allows a lot of freedom to determine the degree and scope of the process. The process does not need to involve excessive time or resources, and the results often provide tangible value in the near term.
What is your role? First, ensure that the contract contains a clause granting your client the “ability to audit” its execution. Preferably, this clause also specifies that any professional fees incurred will be paid by the other contracting party if discrepancies are significant. Then, consider developing a relationship with a third party accounting or consulting firm that you can recommend to your client as a resource for regular contract compliance testing. By facilitating this relationship, you solidify yourself as a resource during the testing procedures, and you’ll gain an increased understanding of your clients business, allowing you to improve future contracts as well.
No matter what your client’s line of business is, regular contract compliance examinations and royalty audits can add value to the contracts you create. Suggest this best practice to your clients, and help them realize and appreciate the full value of your well-crafted contract.