Reasonable Royalties: What CPAs Should Know [Part 2] 

by Kimberly J. Schenk, CPA, CFF 
Published June 03, 2015

Part 1 of this series explained the need for a CPA serving as a damages expert in a patent infringement case to have a thorough understanding of the current state of case law in the area of reasonable royalties, and described the basic framework of a reasonable royalty analysis. Part 2 will introduce some of the commonly-used methods for determining a reasonable royalty, and will discuss the current state of case law as it relates to the appropriate use of these methodologies.

Overview of Reasonable Royalty Rate Determination
At a high level, a reasonable royalty is the amount a licensee would willingly pay, and a licensor willingly accept, for the licensee’s use of the licensor’s patented technology.  A reasonable royalty is typically determined in the context of a hypothetical license agreement negotiated on the eve of the first infringement.  When determining a reasonable royalty, experts consider factors such as the profits the patent holder has generated through the use of the patented technology, the amounts paid for real world licenses that are comparable to the hypothetically negotiated license, the availability of acceptable non-infringing alternatives, and various qualitative factors such as those enumerated in the Georgia-Pacific v. U.S. Plywood1 case.   Although these basic approaches remain useful, courts have increased scrutiny on the way they are applied.

Comparable License Agreements
One method that is commonly used to determine a reasonable royalty for a patented technology is consideration of the royalties paid for license agreements that involve the same or similar technologies.  Comparable license agreements are useful in that they provide real-world evidence of the value of a particular technology, and courts have recognized that they may implicitly account for other factors relevant to a reasonable royalty such as market conditions and the cost of available non-infringing alternatives. In practice, it is rare to find an agreement that is perfectly comparable. Thus, it is important that the expert carefully consider and account for differences between a given agreement and the hypothetical license between the parties in suit. Among other things, an analysis of a potentially comparable agreement may account for the timing of the agreement, nature of the technology licensed, commercial relationship of the parties, and the economic terms of the agreement. It is also important for the expert to evaluate whether the comparable agreement was entered in settlement of litigation, and if so what impact that has on the reliability of the agreement. Courts have accepted settlement agreements as evidence relevant to a reasonable royalty determination, but in limited circumstances.

Profit Apportionment
It is commonly accepted that a reasonable royalty represents a sharing of the profits earned through the use of the patented technology between the licensor and licensee in accordance with each party’s relative contribution to those profits, and consistent with the relative bargaining strengths of each party.  Historically, experts have relied on various methodologies as “rules of thumb” for determining how the parties would divide the profits earned from the use of the patented technology, such as the so-called “25% Rule” and the Nash Bargaining Solution.  However, the courts have recently rejected the application of these approaches on the basis that the experts relying on them did not sufficiently establish that the approaches were grounded in the facts of the case.  Thus, experts who employ a profit apportionment methodology in reaching their royalty conclusions should be able to clearly articulate how their selected division of profit is based on the specific facts of the case at hand.

Entire Market Value Rule (“EMVR”)
One of the most challenging and controversial areas of the law surrounding reasonable royalty determination today is interpretation and application of the EMVR.  The EMVR permits damages on technology beyond the scope of the claimed invention, but only in instances where the patented feature creates the basis of demand for the product.  If this requirement is not met, as is often the case where the patent is used in a multicomponent product such as a smartphone or a laptop computer, damages must be apportioned such that the reasonable royalty reflects only the contribution of the patented technology to the product’s sales or profits.  Under current case law, this apportionment must be reflected in not only the royalty rate, but also the royalty base.  Experts should carefully construct their reasonable royalty to ensure that they do not violate the EMVR, especially when opining to a royalty that is expressed as a percent of sales of the patented product.

Georgia-Pacific Analysis
One of the most well-known and frequently used methodologies for determining a reasonable royalty is the Georgia-Pacific analysis.  The 1970 Georgia-Pacific v. U.S. Plywood case provides a list of 15 factors that courts and experts have found useful as a qualitative framework for determining the outcome of the hypothetical negotiation.  Generally, these factors relate to the nature of the license, the relationship between the parties, the benefits of the technology, and the extent of use of the technology.  Courts and experts alike often employ all 15 of the Georgia-Pacific factors when evaluating a reasonable royalty.  However, recent case law suggests that in some cases not all of the Georgia-Pacific factors are appropriate to consider, such as when the patent at issue covers technology that has been deemed essential to an industry standard.2   Experts opining on reasonable royalties should carefully consider whether the use of any or all of the Georgia-Pacific factors is appropriate given the facts of the case.

Conclusion
Establishing a well-supported reasonable royalty opinion is one of the most challenging aspects of patent damages analysis today.  Courts have recently increased scrutiny on damages experts’ analyses, while acknowledging that reasonable royalty determination requires some creativity and subjectivity.  This state of affairs presents opportunities for CPAs and CFFs to provide a valuable service to their clients by combining their training in accounting, valuation, and forensics with a thorough understanding of the current case law on patent damages, and reasonable royalties in particular.

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 Georgia-Pacific Corporation v. United States Plywood Corporation, 318 F. Supp. 1116 (S.D.N.Y. 1970).
2 See, e.g., Ericsson, Inc., et al. v. D-Link Systems, Inc. et al., 773 F.3d 1201, 1230-1232, 1235 (Fed. Cir. 2014).

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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