What Is A Reasonable Royalty?

Did somebody say royalty?

What is a reasonable royalty rate for licensed intellectual property?

According to the Court of Appeals for the Federal Circuit, it is not 25%–at least not as a rule of thumb.

The U.S. Patent Act requires that damages in a successful patent infringement lawsuit equal the reasonable royalty that a licensee would pay a licensor in a hypothetical license negotiation at the time the infringement began.

In Uniloc USA, Inc. v. Microsoft Corp., Uniloc prevailed at trial in its patent infringement claim and was awarded damages of $388 million, based in part on its expert witness’s testimony that 25% of Microsoft’s expected profits on its Office software suite was a reasonable baseline from which to calculate patent royalties. The infringed invention was a product activation key designed to deter illegal software copying.

The 25% rule of thumb starts with the infringer’s gross profit margin (profits divided by nets sales), multiplies that by 25%, then multiplies the resulting royalty rate by the infringer’s net sales from the infringing products, to calculate the patent owner’s damages. For example, if the present value of net sales of an invention is $6, and the present value of manufacturing expenses is $4, the gross profit margin is 33.3% (6 – 4/ 6), and the 25% rule royalty rate would be one-quarter of that, or 8.3% of net sales. The initial royalty rate is often adjusted upwards or downwards, according to the 15 factors detailed in the 1970 case, Georgia-Pacific Corp. v. U.S. Plywood Corp.

On appeal, Uniloc argued that academic studies had proven that the 25% rule of thumb was supported by evidence that patent royalties negotiated in the real world averaged around 25% of profits.

The CAFC conceded that it had tolerated the 25% rule of thumb in cases where the parties had not contested it, but ultimately overturned Uniloc’s damages award on the grounds that to be admissible, a general theory must be sufficiently tied to the facts of the case, however Uniloc’s expert had not laid the necessary groundwork to introduce the 25% rule of thumb in that case.

More broadly, the CAFC said the 25% rule failed because: 1) it did not account for the importance of the patent to the product in which it was incorporated; 2) it did not account for the difference in market power and risk assumed by the parties; and 3) it is essentially arbitrary, and does not fit within the model of a hypothetical negotiation assumed to occur prior to a finding of infringement.

So what then is a “reasonable royalty” for licensed IP?

The CAFC endorsed three of the 15 Georgia-Pacific factors for calculating a reasonable patent royalty: looking at royalties paid or received in licenses for the patent or in comparable licenses, and looking at the portion of profit that is customarily allowed in the particular business for use of the invention or similar inventions. But even these must be tied to the facts of the particular case.

By way of reference, a frequently cited rule of thumb for calculating a fair trademark royalty rate is 10% to 25% of the licensee’s expected gross profit margin, depending on the type of goods, the size of the market, and the strength of the mark. In the same ballpark as patent law’s deposed 25% rule of thumb, but with more flexibility to allow calibration of the licensed IP’s actual contribution to the profitability of the product that incorporates it.

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