Kat Shoa asked about licensing audits on LinkedIn:

How do you know if your IP licensees are paying you properly?
I sat on a presentation about royalty audits today and think it’s a fantastic to collect due royalties – wrote about it here[.]
But I’d be interested to know what other methods are used to ensure proper payment, especially for smaller companies that license out to larger companies and either can’t afford an audit or don’t feel right about it.

Here’s an edited version of my answer:

First off, “not feeling right” about making sure you’re getting paid is a bad strategy. If you need excuses or a way to eliminate the decision-making, institute a program of auditing some random number of customers (volume/dollar weighted, to be sure) each period – month, quarter, year. You can certainly “blame” your accountants, and as a lawyer I’ve often told my clients to use me as an excuse. Most businesses will commiserate with you, rather than complain, if you tell them your lawyer’s making you do it.

Now, as for how to structure payments, the best course is to choose metrics that are easily measured and hard to game. For example, one person I know will only take a percentage of the gross sales, since there’s much less room for fudging costs of goods sold and SG&A for a particular item. Of course, the number has to change, but the amount should be close, if a little lower, to a % of the net model. (Why would the dollar amount be lower? You’re accepting less risk by taking part of the gross vs. the net, even apart from reduced fudging; it’s fair to share that with the licensee.)

Others suggest a similar approach by using other easily audited materials, such as checking the gross weight of a key component for a licensed process. That’s a great example because invoices from a third party are good proof and easy to cross-check with the actual third party.

At the end of the day, the best model will depend on what type of IP you’re licensing and your goals about risk/reward. Is it easy to measure the contribution to value from your IP, like a Tiger Woods sneaker where you can count pairs, or is it something more vague, like using music in an advertisement? Probably the best advice I can give is to price your license based on your business model and not on someone else’s. Most licensees want either a pure net basis percentage fee or a fixed fee regardless of how much money they make. You should be able to analyze these models under various scenarios and see how they work for you. Once you know what you want, then turn the plan over to your licensing lawyer to translate it into a legal structure that implements what you want.