How Reasonable Is Your Royalty?

BY GLENN S. NEWMAN, RICHARD J. GERING AND JEFFREY N. PRESS
September 1, 2008

EXECUTIVE SUMMARY

In recent years, focus has shifted to the increased value of intangible assets. As such, competition, sometimes unlawful, has resulted in extensive litigation and/or negotiation between parties for the use of intangibles.

Methodologies to quantify a reasonable royalty are consistent with general valuation approaches–market (other licenses), income (profitability), and cost (design–around).

The Georgia-Pacific dispute is the seminal case that identified15 factors to consider in estimating a hypothetical reasonable royalty.

Be careful in determining an appropriate royalty base—consider what the market considers important, and the functional relationship between patented and unpatented products sold together.

Whichever method is used to determine a royalty, be forewarned that others will likely have an opposing point of view. Accordingly, make sure it passes the smell test.

Glenn S. Newman, CPA/ABV, CFE, is the principal in charge of Parente Randolph LLC’s Forensic & Litigation Services Practice based in Philadelphia. Richard J. Gering, Ph.D., is a principal and Jeffrey N. Press, CPA, CFE, is a senior manager, in the Forensic & Litigation Services Practice at Parente Randolph. Their e-mail addresses, respectively, are gnewman@parentenet.com, rgering@parentenet.com and jpress@parentenet.com.

 

Today, a company’s intellectual property is integral to its success. Intellectual property or intangible assets can be patents, trademarks, copyrights, trade dress (the visual characteristics of a product’s packaging), trade secrets, certain proprietary methods of doing business, and the human capital of the owners and employees.

The importance of intellectual property has spurred many CPAs to specialize in calculating infringement damages. These disputes often result in high-risk exposure for the company. In addition, corporate finance professionals involved in licensing apply many of the same techniques in negotiating royalty agreements. This article is intended for experienced litigation consultants and focuses on measuring economic harm in the form of reasonable royalties in intellectual property disputes.

Intangible assets allow a company to differentiate itself in the marketplace, which can generate significant economic opportunities and successes. According to a 2006 publication by PricewaterhouseCoopers, approximately 80% of the Fortune 500’s market capitalization is related to various forms of intellectual property. The significance of intangibles has given rise to an increase in disputes among owners of such properties.

With respect to quantifying damages for patent infringement disputes, the U.S. Code provides that:

   Upon finding for the claimant, the court shall award the claimant damages adequate to compensate for the infringement, but in no event less than a reasonable royalty…

A 2006 study by PricewaterhouseCoopers concluded that from 1991 to 2004, the annual number of patent infringement cases filed rose 162% from 1,171 to 3,075 (2006 Patent and Trademark Damages Study). Since 2000, the frequency of damages awards based on lost profits decreased (compared to the 1990s) from 73% to 38% while awards of reasonable royalties increased from 24% to 59%. The study further concluded that the shift toward reasonable royalty damages awards was the result of, among other things, the obtrusiveness to operations in supporting a lost profits analysis, the desire to not disclose sensitive cost and profit data, the cost of performing a lost profits analysis compared to a reasonable royalty analysis, and the prevalence of IP holding companies that do not actually manufacture or distribute the patented products.

GETTING STARTED
The CPA/damage expert typically begins the analysis with certain assumptions. Specifically, he or she will assume that the patent or patents in the dispute are valid, enforceable and infringed. It is not his or her role to express opinions on liability matters. The CPA/damage expert also typically gains an understanding of the patent and the products/processes that embody the patent from counsel or technical witnesses. These technical issues help form a foundation for the analysis.

As discussed later in this article, the reasonable royalty is analyzed in the context of a hypothetical negotiation between the patent holder (licensor) and the alleged infringer (licensee). Setting the hypothetical negotiation date is important in determining the royalty rate. The date helps to frame the negotiation and the respective bargaining positions of the parties. The hypothetical negotiation typically takes place at or around the date of first infringement. The CPA/damage expert should always confirm the date of first infringement with counsel.

Once the CPA/damage expert has the date of the hypothetical negotiation and the start of the damage period, it is his or her responsibility to quantify both the royalty base and the royalty rate. Each analysis depends on the facts and circumstances surrounding the negotiation and the information available to the CPA/damage expert. It is important to remember that there is no single formula or recipe for determining royalty rates.

 

Types of Royalties
The licensor and licensee may structure royalty payments in many ways. Here are some typical forms of royalty payment:

A running royalty based on a percent of the net sales price

A running royalty based on a dollar amount per unit

Lump sum or paid-up amounts

Hybrid agreements that combine lump-sum milestone payments with running rates

Tiered rates that adjust at different sales levels

Different rates for different fields-of-use or geographic markets

Different rates when there are multiple patents that cover a single product or technology

Minimums and maximums both annually and over the life of the agreement

THE ROYALTY BASE
The CPA/damage expert needs to quantify the infringing sales, typically in units and dollars from the date of first infringement until the end of the damages period. In certain fact patterns, the infringing sales may be a component of a larger product, such as part of a kit or package that has infringing and non-infringing components. The Entire Market Value rule (for example, the entire automobile as opposed to just the patented windshield wiper) may be applied in those situations. Typically, unpatented products may be included in the royalty base when unpatented components function together with the patented product, but not when items sold “have essentially no functional relationship to the patented invention and that may have been sold with an infringing device only as a matter of convenience or business advantage.” (Rite-Hite Corp. v. Kelley Co., Inc., 56 F.3d 1538 (Fed. Cir. 1995)). The CPA/damage expert should consider the relationship of the patented technology to the overall product and its importance to that product’s functionality. The CPA/damage expert should address this issue with counsel early in the engagement since it may require legal or technical analysis and can have a bearing on the damages analysis.

THE ROYALTY RATE
One common method of calculating a reasonable royalty is to consider the 15 factors identified in Georgia-Pacific v. United States Plywood Corp. (see sidebar below). Most CPA/damage experts consider the factors relative to the determination of the reasonable royalty rate while the specific weight attributed to each factor is a matter of judgment that depends in part on the facts and circumstances of the matter.

ESTABLISHED ROYALTIES
The existence of an established royalty for the patents or underlying technology in dispute may preclude the need for determining a reasonable royalty. If an established royalty exists, it can be used and applied to the royalty base (Sun Studs, Inc. v. ATA Equipment Leasing, Inc. 872 F.2d 978 (Fed. Cir. 1989)). This requires a consideration of the facts and circumstances regarding whether there is an established royalty:

Agreed to prior to the infringement.

Paid to/by enough parties to indicate reasonableness.

Not paid under threat of litigation or in settlement of a lawsuit.

Paid for comparable rights.

Georgia-Pacific v. United States Plywood Corp.

In the 1970 case of Georgia-Pacific v. United States Plywood Corp. (318 F. Supp. 1116), the U.S. District Court for the Southern District of New York used the following 15 factors to determine what type of monetary award would compensate for infringement:

  1. The royalties received by the patentee for the licensing of the patent in suit, proving or tending to prove an established royalty.
  2. The rates paid by the licensee for the use of other patents comparable to the patent in suit.
  3. The nature and scope of the license, as exclusive or nonexclusive, or as restricted or nonrestricted in terms of territory or with respect to whom the manufactured product may be sold.
  4. The licensor’s established policy and marketing program to maintain a patent monopoly by not licensing others to use the invention or by granting licenses under special conditions designed to preserve that monopoly.
  5. The commercial relationship between the licensor and licensee, such as whether they are competitors in the same territory in the same line of business, or whether they are inventor and promoter.
  6. The effect of selling the patented specialty in promoting sales of other products of the licensee, the existing value of the invention to the licensor as a generator of sales of non-patented items, and the extent of such derivative or convoyed sales.
  7. The duration of the patent and the term of the license.
  8. The established profitability of the product made under the patent, its commercial success, and its current popularity.
  9. The utility and advantages of the patent property over the old modes or devices, if any, that had been used for working out similar results.
  10. The nature of the patented invention, the character of the commercial embodiment of it as owned and produced by the licensor, and the benefits to those who have used the invention.
  11. The extent to which the infringer has made use of the invention and any evidence probative of the value of that use.
  12. The portion of the profit or of the selling price that may be customary in the particular business or in comparable businesses to allow for the use of the invention or analogous inventions.
  13. The portion of the realizable profit that should be credited to the invention as distinguished from non-patented elements, the manufacturing process, business risks, or significant features or improvements added by the infringer.
  14. The opinion testimony of qualified experts.
  15. The amount that a licensor (such as the patentee) and a licensee (such as the infringer) would have agreed upon (at the time the infringement began) if both had been reasonably and voluntarily trying to reach an agreement, that is, the amoun obtain a license to manufacture and sell a particular article embodying the patented invention—would have been willing to pay as a royalty and yet be able to make a reasonable profit and which amount would have been acceptable by a prudent patentee who was willing to grant a license.

GEORGIA–PACIFIC
While not the only method for determining a reasonable royalty, the factors outlined in Georgia-Pacific are perhaps the most common framework used by CPA/damage experts. These factors provide a structure for analyzing the licensor’s and licensee’s respective positions regarding a license for the intellectual property at issue.

The CPA/damage expert must consider the types of available information and types of analyses to determine how to apply the Georgia-Pacific factors to form an opinion as to a reasonable royalty. It is important to remember that Georgia-Pacific does not provide a specific formula to determine a royalty rate. There is no road map, recipe, or hard-and-fast rule as to how to weigh the information and the different factors. This is where experience and judgment come into play.

Some CPA/damage experts may choose to look at each Georgia-Pacific factor individually, reaching a conclusion on the impact of each individual factor on the royalty rate. Other CPA/damage experts may choose to “group” certain factors and reach a single conclusion after considering the collective factors as a whole. CPA/damage experts may group the factors differently based on their experience or the facts and circumstances of a particular matter. The following paragraphs group and address the Georgia-Pacific factors.

MARKET COMPARABLE ROYALTIES—FACTORS 1&2
Factors 1 and 2 relate to license agreements. The CPA/damage expert should determine whether licenses exist and determine how to incorporate them into the analysis of what a willing licensor and licensee would agree upon in the hypothetical negotiation. It is up to the CPA/damage expert to determine whether a license is comparable and how much weight to give the agreement. The CPA/damage expert typically considers factors such as whether the license involves:

The same patent(s) at issue.

Similar technology.

Technology in the same or a similar industry.

The relationship of the licensor and licensee.

The date of the agreement relative to the hypothetical negotiation.

The subject license may have been executed as part of a settlement or resolution of litigation. Also, there may be documents and testimony related to negotiations that did not result in signed agreements. In certain cases, these negotiations or agreements may be excluded for legal reasons, and the CPA/damage expert should consult counsel. When using these agreements, the CPA/damage expert typically considers such factors as:

The respective parties’ positions in the litigation.

The use of lump-sum payments as paid-up licenses of historical sales.

Running royalties on future sales.

In many instances, license agreements executed or contemplated by the parties in the litigation will be produced by the parties in discovery. However, other data sources are available that may identify additional licenses that the CPA/damage expert can consider in analyzing comparable license agreements. These sources include:

Public Databases. Databases, such as www.royaltysource.com and www.royaltystat.com, can be accessed through a subscription or on a pay-per-use basis to accumulate publicly disclosed license agreements including the negotiated royalty rate.

Public Filings. Public companies may disclose the terms of license agreements in public filings such as SEC Form 10-K.

Accounting Records. The parties’ accounting records may identify royalty income or expenses as well as analyses performed for negotiations that may not result in an agreement.

Third-Party Publications. Industry publications, books, articles, consultants and associations may contain relevant data.

LICENSOR’S POLICIES/POTENTIAL TERMS—FACTORS 3, 4, 5 & 7
These factors relate to the licensors’ policies and terms of the agreement. The CPA/damage expert must understand how the facts and circumstances impact these factors and then determine how to weigh them in determining the royalty rate.

In analyzing the nature and scope of the license or the licensor’s policies toward licensing, the CPA/damage expert should analyze whether the prospective license would be issued on an exclusive or nonexclusive basis, as exclusivity (in total or with respect to specific geographies, industries, fields of use, or customers) usually commands a premium. The terms of the licensor’s other agreements may provide an indication of its position with respect to exclusivity or its willingness to license the technology.

The commercial relationship between the parties is also important. Whether the parties are direct competitors or have an inventor/promoter relationship will affect the royalty rate. Typically, a licensor would demand a premium when licensing a direct competitor.

The license agreement typically runs until the last patent in the dispute expires. The CPA/damage expert should consult counsel regarding the expiration of the patent. The duration of the license may also affect the royalty rate.

TECHNOLOGY—FACTORS 9 & 10
Factors 9 and 10 consider the technological impact on the royalty rate. The CPA/damage expert should consider the nature of the technology at issue in the litigation in terms of the advantages over older technologies or the benefits from the use of the patented technology. Products that offer increased benefits would likely boost a prospective royalty rate. Many times, the features, benefits and advantages of patented technologies are outlined in advertisements, product brochures, and sales and marketing presentations. Discussions with technical witnesses or experts is often useful for the CPA/damage expert to understand the impact of these factors.

PROFITABILITY AND OTHER FINANCIAL METRICS— FACTORS 6, 8, 11, 12, 13 & 14
These factors consider the actual and expected profitability of the technology on the licensor and the licensee. They typically allow the CPA/damage expert to perform quantitative analyses on the parties’ sales and profitability. Since the anticipated or expected profitability is important, the CPA/damage expert may want to compare budgets and forecasts to actual results as parties.

The ability of the patented technology to generate sales of non-patented products further affects the parties’ profitability. The frequency of these non-patented sales as well as their relative importance also will have a bearing on the royalty rate.

Where possible, the CPA/damage expert should consider the profit that can be directly attributed to the patented technology as opposed to non-patented elements. Relevant questions to investigate may include: What profits are generated by the patented technology? Does the patented technology offer increased profitability over other available products?

Simply put, a patent is a right to exclude. The licensee’s ability to design around the patent and still be able to manufacture or sell a product that provides the market the same features and benefits will directly affect the value of the technology and the royalty rate. Factors such as the timing, cost and speed of the design-around will affect the economic impact of the alternative design. Factors that are out of the licensee’s control—regulatory approval, the need for customers to test the new product or recalibrate some other part of their operations as well as how the market accepts the alternative— will also help determine whether the alternate design is viable. Often these alternative design issues may require the CPA/damage expert to get input from counsel, and technical and marketing witnesses.

HYPOTHETICAL NEGOTIATION—FACTOR 15
The final Georgia-Pacific factor summarizes the hypothetical negotiation and is also somewhat of a catchall. No formal requirement outlines how one should consider the hypothetical negotiation. In many cases CPA/damage experts use this factor as a place to summarize their analysis and list the "pros" and "cons" that the licensor and licensee might argue and face at the hypothetical negotiation.

OTHER METHODS
While Georgia-Pacific is the most frequently used approach for evaluating a reasonable royalty, some CPA/damage experts also use other methods in conjunction with or in place of it. Two of the most common are the rule of thumb and the analytical method.

The rule of thumb, or “25 Percent Rule,” often attributed to Robert Goldscheider, is an example of the profit split or profit-sharing approach and suggests that a licensor and licensee would negotiate a royalty ranging from 25% to 33% of the licensee’s expected profits from the patented technology. The rule is typically applied to operating profits of the product being licensed. Due to data limitations and other issues, in many cases actual profits, or the profits for product line or the company, are analyzed. The 25 Percent Rule has been accepted by some courts and rejected by others as an appropriate method to estimate a reasonable royalty. Many CPA/damage experts use it as a starting point and then apply the Georgia-Pacific analysis, or use it as a corroborating check or benchmark after they complete their analysis. Caution must be exercised in blindly applying this or any rule of thumb.

The analytical method considers the additional profits anticipated by an infringer above its "normal" profits resulting from the use of the patented technology. Under this method, a portion of the additional profits attributable to the patented technology could be allocated to the patent, as follows:

It is often useful to reconcile royalty amounts quantified under different methodologies. That way, you will be ready for cross-examination or a counterproposal.

AICPA RESOURCES

JofA articles
Intangible Value: Delineating Between Shades of Gray,” May 07, page 66
20 Steps for Pricing a Patent,” Nov. 04, page 31
Damages Aren’t Always Patently Obvious,” Nov. 04, page 36

Publication
Calculating Intellectual Property Infringement Damages–FVS (Formerly BVFLS) Practice Aid 06-1 (#055300)

Web site
The FVS Section Members Web site contains resources for the CPA/damage expert, including FVS Practice Aid 06-1, Calculating Intellectual Property Infringement Damages, which is free to all FVS Section members. Visit the FVS Center at http://fvs.aicpa.org.

For more information or to place an order, visit www.cpa2biz.com or call the Institute at 888-777-7077.

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