Reasonable Royalties: What CPAs Should Know [Part 1] 

by Kimberly J. Schenk, CPA, CFF 
Published May 20, 2015

Proving damages in patent infringement matters is one of the most dynamic aspects of intellectual property law today. This area presents a large and growing opportunity for CPAs and CFFs, whose training in accounting, valuation, and forensics makes them well-suited to serve as expert witnesses and/or consulting experts in these matters. However, as the number of patent infringement suits has risen, the courts have begun to more closely scrutinize the damages evidence presented by the parties’ experts. Thus, it is important for a CPA serving as an expert in a patent infringement case to have a thorough understanding of the current state of case law in the area of damages analysis.

In particular, an expert engaged to testify about patent damages must understand the methodologies that courts have deemed acceptable for determining a reasonable royalty. More than 80% of patent damages awards today include reasonable royalties, which is a form of damages that typically involves more subjective expert opinion than a lost profits calculation. As the Federal Circuit has aptly noted,1  “[d]etermining a fair and reasonable royalty is often…a difficult judicial chore, seeming often to involve more the talents of a conjurer than those of a judge.”2

In the first part of this series, I’ll describe the basic framework of a reasonable royalty analysis. In the second part, I’ll provide more detail on approaches that are generally used by experts and accepted by courts for the determination of a reasonable royalty.

Reasonable Royalty Overview
The patent damages statute, 35 U.S.C. § 284, states that “[u]pon 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 for the use made of the invention by the infringer….” Reasonable royalties are determined in the context of a hypothetical negotiation involving the patent holder and the alleged infringer on the eve of the first infringement. A reasonable royalty determination typically takes into account information that was known at the time of the hypothetical negotiation which, in many circumstances, may be supplemented by consideration of actual events that took place after the hypothetical negotiation. The parties to the hypothetical negotiation are assumed to be willing to enter a license, and all parties believe the patent(s)-in-suit are valid and infringed.

There are two basic forms of reasonable royalties: lump sum and running royalty. Determining which is most appropriate requires consideration of typical industry practices, other licenses that are technically and economically comparable to the hypothetically negotiated license, and/or practical limitations on the ability to precisely quantify a royalty base.

Lump Sum
A lump sum royalty is typically a single up-front payment (e.g., $1 million) made for rights to a patent or group of patents. In real-world licensing situations, parties negotiate lump sum royalties for a variety of reasons, including decreasing the administrative burden of tracking and reporting licensed sales or usage of an invention. When negotiating a lump sum royalty, parties typically have some estimate of the extent of the licensee’s future use of the patented technology, and thus there is often a relationship between the amount of the lump sum and expected use. In the reasonable royalty context, a lump sum may be the most appropriate form of damages in instances where industry practice and/or the parties’ prior licensing practices frequently result in lump sum royalties, or where as a practical matter it is difficult to quantify a royalty base.

Running Royalty
A running royalty is an amount, typically expressed as either a percent of revenue (e.g., 1% of net sales) or a dollar amount per unit (e.g., $0.10 per unit), which is paid by the licensee according to the amount of licensed sales or use. A running royalty consists of two components: a royalty base, which reflects the amount of infringing sales or use, and a royalty rate, which is applied to that base to determine the total reasonable royalties. One advantage of a running royalty is that, unlike a lump sum, it ties the royalty payment to the actual use of the licensed technology.

Whether a reasonable royalty is more appropriately expressed as a percent of revenue or a dollar amount per unit depends on the circumstances of the case. Industry practice and comparable license agreements may provide some indication as to which structure is best in a given situation. However, recent case law surrounding the entire market value rule (“EMVR”) has drawn increasing scrutiny for percent of revenue royalties where the royalty base is a multi-component product such as a smartphone. To the extent that it is not possible or practicable to isolate the smallest saleable patent practicing unit that has close ties to the patented technology, a per-unit royalty or lump sum reasonable royalty may be the most appropriate.

The second part of this series will provide more detail on approaches that may be accepted by courts for the determination of a reasonable royalty. Discussion will include the use of comparable license agreements, profit apportionment, the EMVR, and Georgia-Pacific analysis.

Kimberly Schenk is a Principal at Charles River Associates whose practice focuses on the valuation of intellectual property in litigation and business consulting engagements. She has testified as an expert witness on economic damages in Federal and State Court matters, and her experience covers a variety of industries, including pharmaceuticals, telecommunications, financial services, and consumer products. The opinions expressed in this article are the author’s and do not reflect or represent the views of Charles River Associates or any of its respective affiliates.

1 The Court of Appeals for the Federal Circuit, also known as the Federal Circuit, is the appeals Court with jurisdiction over patent infringement matters.
2 Fromson v. Western Litho. Plate and Supply Co., 853 F.2d 1568, 1574 (Fed. Cir. 1988).

RELATED RESOURCE: The AICPA Forensic & Valuation Services Practice Aid: Calculating Intellectual Property Infringement Damages provides guidance to forensic accounting practitioners with business or litigation experience concerning intellectual property rights and calculating infringement damages. Members of the AICPA’s Forensic and Valuation Services (FVS) Section can download this Practice Aid in the Forensic & Valuation Services Library.

RELATED RESOURCE: Members of the AICPA’s Forensic and Valuation Services Section receive a discounted access option to the ktMINE Royalty Rate Finder database. The ktMINE Royalty Rate Finder database provides data, documentation and search tools that help analysts quickly locate the third-party evidence needed to determine and defend a reasonable royalty rate. Learn more.


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