We are often asked to provide expert evidence associated with the quantification of damages arising from intellectual property disputes. In this article, we consider some of the factors surrounding the quantification of a “reasonable royalty” in the absence of comparable licence transactions. For simplicity, in the remainder of this article we refer to the holder of an intellectual property right as a patent holder.

Under English law, a claimant in a dispute relating to the alleged infringement of intellectual property rights (e.g., patents, trademarks and copyrights) has a choice of two remedies for compensation as follows:

- An enquiry as to damages; or
- An account for profits.

Should it choose the former, a likely component of its claim will be a “reasonable royalty.” This would normally be quantified as the amount a willing licensee would pay a willing licensor for the right to make, use or sell a patented item in the marketplace. In practice, this is often quantified by reference to comparable licensing transactions (the “market approach”).

In our experience, the courts place significant weight on the use of the market approach. However, on many occasions, comparable licensing transactions do not exist for the intellectual property in question. Accordingly, an expert must consider other factors including the economic factors associated with a hypothetical licensing negotiation.

In many cases, the absence of comparables leads to reliance by experts on so called “rules of thumb”. The most famous of these is Robert Goldscheider’s “25% Rule” which imputes a royalty rate based on the assumption that a licensee would be willing to pay a royalty equivalent to 25% of its expected profits from the use of the intellectual property. However, it is unclear what measure of profit (e.g., gross profit, net profit, or operating margins) the 25% should be applied. The use of such rules, without an analysis of the economic factors of a licensing transaction, is speculative at best. As indicated by Mr. Goldscheider, “the Rule is best used as one pricing tool and should be considered in conjunction with other (quantitative and qualitative) factors that can and do affect royalty rates”. Accordingly, whilst rules of thumb on their own may not be sufficiently robust, they may provide some assistance in arriving at a reasonable royalty rate.

Having established that rules of thumb are not sufficient in themselves to arrive at a reasonable royalty rate, it is essential to consider the economic and financial factors surrounding the relative bargaining positions of the licensor and licensee.

In this context, the legal rights conferred by a patent may provide future economic benefits to the patent holder. These benefits are quantified by reference to the profits attributed to the patented technology (whether derived from increased revenues or cost savings). A licensing agreement provides the opportunity for a patent holder to transfer these benefits to the licensee in return for compensation (i.e., royalties). For example, a licensor may enter into the licence agreement for the purpose of introducing its patented technology into geographical regions which it is unable to service.

From the licensee’s perspective, a licence agreement allows for the acquisition of patented technology which may provide a technical advantage and in turn higher profits.

A licensing negotiation is likely to occur within a range that is determined by the parties’ estimates of the economic value of the patent in question. The range is generally subject to a floor, which can be calculated by reference to the present value of the following:

- The licensor’s cost of transferring the patented technology to the licensee, which may include engineering, legal and accounting costs, among others; and
- The licensor’s foregone profits (i.e., opportunity costs) associated with the licensee’s use of the patented technology.

The range is also subject to a ceiling, which can be quantified by reference to the lowest of the present values of the following:

- The licensee’s incremental profits from the use or sale of the patented invention;
- The costs of obtaining similar technology (i.e., non-infringing substitutes) from another source;
- The cost of designing around the patented technology; and
- The cost of obtaining the technology through infringement.

These factors provide a framework for identifying the range in a licensing negotiation on a non-contentious basis. However, in the context of litigation certain of these factors may not apply. For example, in an enquiry as to damages, a claimant cannot recover both reasonable royalties and lost profits on the same unit. Accordingly, it is not typically necessary to address the licensor’s forgone profits when considering the negotiating range. In addition, for obvious reasons, the cost of infringement is also not relevant in a litigation environment.

Consideration of the negotiating range may provide a broad indicator of the maximum royalty a licensee is likely to pay (i.e., the ceiling) and the minimum royalty the licensor is likely to accept (i.e., the floor). However, in order to narrow the negotiating range and determine the likely level of royalty that would have arisen in practice, it is often necessary to consider additional factors. In Georgia-Pacific Corp. v United States Plywood Corp., the US court identified 15 factors associated with the determination of a reasonable royalty rate which we summarise as follows:

1. The royalties received by the patentee, if any, associated with licensing the technology incorporated in the patent in suit.
2. The royalties paid by the licensee for the use of other patents comparable to the patents in suit.
3. The nature and scope of the prospective licence including whether the licence is exclusive or non-exclusive and restricted or non-restricted (e.g., in terms of territory).
4. The licensor’s established licensing policy and marketing program with respect to protecting its patented monopoly (i.e., not licensing the technology).
5. The commercial relationship between the licensor and licensee, which may include licensor and licensee, inventor and promoter, or competitors.
6. The extent to which the sale of a patented item drives the sales of other non-patented items (i.e., collateral or convoyed sales).
7. The duration of the patent and term of the licence.
8. The established profitability, commercial success and popularity of the product incorporating the patented technology.
9. The utility and advantages of the product incorporating the patented technology over older technology or products performing similar functions.
10. The nature of the patented invention, its commercial embodiment and the benefits to those who have used the invention.
11. The extent to which the infringer has made use of the patented technology.
12. The customary portion of the profit or selling price that allows for the use the patented technology.
13. The portion of the realisable profit attributable to the invention as distinguished from non-patented elements, improvements added by the infringer, among others.
14. The opinion of qualified experts.
15. This factor represents the hypothetical negotiation between the parties and incorporates the information from the previous fourteen factors. It essentially answers the question of the amount the parties would have agreed upon if they had been reasonably and voluntarily trying to reach an agreement.

Consistent with the United Kingdom, these factors emphasise the importance of comparable licence agreements. However, a majority of the factors addresses criteria that can be considered in the absence of comparable licence agreements. Whilst not an exhaustive list, the Georgia-Pacific Factors nonetheless incorporate many of the major economic considerations included in a reasonable royalty calculation.

In conclusion, the quantification of reasonable royalties in the absence of comparable licensing transactions is laden with difficulties. Failure to consider the economic factors inherently associated with a hypothetical licensing negotiation or over reliance on rules of thumb could result in unrealistic royalty rates. To minimise this risk and ensure the robustness of a reasonable royalty analysis it is necessary to understand and analyse the factors affecting the likely negotiating range of the parties entering into a hypothetical negotiation. The qualitative and quantitative results of these analyses are likely to result in a reasonable royalty analysis that is robust and reflects the relative strengths and weaknesses of the parties entering into the hypothetical negotiation.

Michael Taub is a Partner and the National Head of Forensic Services for Baker Tilly. Michael can be reached via email at michael.taub@bakertilly.co.uk.

Gregory J. Urbanchuk is a Senior Manager in the Forensic Services Group of Baker Tilly and specialises in the quantification of damages surrounding intellectual property disputes. Gregory can be reached via email at gregory.urbanchuk@bakertilly.co.uk.