Patent Value Guide – Part I

By: Fernando Torres, MSc

In our intellectual property valuation practice, we are often asked by patentees how they can get a proverbial back-of-the-envelope assessment of the value of their patents. What at first blush sounds like a reasonable request, its proper answer is not as easy as most would like to think.

In this series of blog posts, I will strive to address the question from a practical perspective. In the end, I believe we shall see that not only is there no simple answer, but the question might not be the right one to begin with.

General Principle No. 1

“A patent has no intrinsic value independently of the value of a business”

At the risk of repeating what must have been replied myriad times by patent attorneys and IP professionals, a patent is only the temporary right to exclude others from a specific market delimited by a written description of an innovation [USPTO Patents Portal]. It does not represent the right to practice an invention, or title to a royalty income stream; several factors are co-determinants of the economic value of the opportunity the patent represents.

For example, if an inventor is issued a patent on an innovation which he/she cannot implement directly and no one else needs such invention to operate their business and satisfy actual consumer demands, then no actual market segment exists for the invention. That patent is not simply worthless, rather it represents a net cost to the patent holder as obtaining a patent in the first place requires one to cover drafting, drawings, filing fees, and other prosecution costs which, realistically, are no less than $1,500 and could be as high as ten times that amount [Current USPTO fees].

By contrast, consider a situation where there is market demand for, e.g., an accessory that props up touchscreen cell phones because: (a) a large number of such cell phones are in use; (b) the phones must be held at an angle for confortable viewing of videos; (c) the cost of manufacturing the accessory is low relative to the phone at the appropriate volume levels. In this case, the value of this limited accessory business would be proportional to the net profits of the venture.

Phone Accessory (www.theGlif.com)

Then, a patent that claims that invention would likely have economic value because the patent holder can exclude others from making, importing, using, and offering for sale, or selling that invention throughout the US and sell the product at a monopoly price. This price would be greater than the competitive price and, thus, the patent holder would effectively be reaping an economic rent: the incremental profit at the monopoly price over the net profit at the competitive price. Only this portion of incremental profit would be attributable to the patent and would therefore be the value of the patent.

Patent Effects on Market Price

Thus, it is because the phone accessory business has value that a patent on the device would have economic value and, furthermore, the value of the patent is different from the value of the underlying business (and always smaller if the business is profitable in a competitive environment).

Consequently, at this initial level of the inquiry, the right question would be closer to: What is the value of the underlying business, and how much can a patent contribute to that business value?

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We shall cover additional principles in the IPmetrics® Blog, and dig deeper into useful tools for estimating the elusive patent values.

The 25% Rule is legally inadequate — CAFC

Yesterday, the Court of Appeals for the Federal Circuit (“CAFC”) issued a precedential ruling to the effect that, among other issues in the Uniloc v. Microsoft case, as a matter of Federal Circuit law the 25 percent rule of thumb is a fundamentally flawed tool for determining a baseline royalty rate in a hypothetical negotiation. Evidence relying on the 25 percent rule of thumb is thus inadmissible under Daubert and the Federal Rules of Evidence, because it fails to tie a reasonable royalty base to the facts of the case at issue.

The appeals court was very explicit in stating that Uniloc’s damages expert Joseph Gemini’s starting point of a 25 percent royalty had no relation to the facts of the case, and as such, was arbitrary, unreliable, and irrelevant. The use of such a rule fails to pass muster under Daubert and taints the jury’s damages calculation.

Consequently, as the jury’s damages award was fundamentally tainted by the use of a legally inadequate methodology, the CAFC affirmed the grant of a new trial on damages.

A rule is found

In the late 1950s, Robert Goldscheider performed an empirical study of 18 commercial licenses involving the Swiss subsidiary of a large American company (see e.g.- R. Goldschider, “Litigation Backgrounder for Licensing,”Les Nouvelles, 29 (March 1994), p 20-25). Those licenses referred to the transfer of intellectual property rights to a portfolio of patents, the flow of know-how, trademarks, and copyrights to marketing materials (Goldscheider, Jaroz, and Mulhern, “Use of the 25% Rule in Valuing Intellectual Property”, Chapter 22 in G. Smith & R. Parr, Intellectual Property, Wiley & Sons, 2005). The licensees paid royalties of 5% of sales and typically generated operating profits of 20% of sales. Thus the 5/20 or 25% rule was “discovered.”

The Uniloc damages story

Uniloc’s patent (US5,490,216) covers a system for software registration which Microsoft is allegedly infringing by the way software activation works in Microsoft’s Product Activation feature that acts as a gatekeeper to Microsoft’s Word XP, Word 2003, and Windows XP software programs.

Uniloc’s damages expert arbitrarily picked out an unexplained value attribution of $10, at a minimum, for a Product Key in the context of Microsoft’s business. While it is clear that software piracy prevention measures are valuable, this initial approach completely ignored any specific analysis of the contribution of the software registration algorithm. Dr. Gemini then applied the 25% rule to this $10 amount and posited that $2.50 per activation was the proper royalty due to the patent holder. Multiplying this amount times the number of the accused Microsoft Office and Windows activations, 225,978,721 in all, generates the purported “reasonable royalty” of $564,946,803. The jury found Microsoft willfully infringed the ‘216 patent and awarded $388,000,000 in damages. (The expert then performed a “reality check” of this number by misapplying the Total Market Rule. This is an additional topic we shall touch on in a later post).

Why it is wrong

Over the years, the 25% Rule has been used without much attention being paid to its significance and applicability. From the outset, the “rule” reflected a post-fact measure of the contribution of a complete bundle of intellectual property rights which included all four major categories of IP (trade secrets, patents, copyrights, and trademarks) in a specific industry and economic environment. Based on our collective experience in valuation, licensing, and damages calculations, the specific facts and context of a transaction, license, or case are the arbiters of the value of intellectual property. To adequately reflect the fair market value of a patent, as in this situation, attention must center of what specific contributions are made from an economic perspective, e.g. does it reduce the cost of production, enable new applications, attract market demand? In fact, the determination of a reasonable royalty as the base measure of patent infringement damages has a well-established process that lists the multitude of factors to be considered (the Georgia-Pacific Factors). It is also well established that the 25% Rule of Thumb is not an appropriate guide line for the determination of a reasonable royalty rate under a Georgia-Pacific analysis. A proper patent infringement damages expert analysis must carefully tie the damages amount to the invention’s market significance and this cannot be accomplished with a rule of thumb.

Next

A new trial on the question of damages has been ordered by the CAFC and we shall expect a reconsideration of the economic analysis behind the reasonable royalty attributable to the ‘216 patent. But, more than that, this opinion raises the bar for all future intellectual property damages analyses that must determine a reasonable royalty; no longer can superficial applications of pre-determined percentages be passed-off as “expert testimony.”

(Simultaneously published on the IPmetrics Blog)

Software Copyright Litigation Issues

Software commercialization began to accrue significance in the early 1960s and it presented a challenge to the U.S. Copyright office when the first registrations were submitted in 1964. Since that time, until the 1976 Copyright Act, the required registrations of software were accepted under the general assimilation of software as a “how to” book. The Act made it clear that Congress intended software to be copyrightable. Yet the very nature of software requires that copies be made in the ordinary course of using the software. First, the software is generally installed on the users’ computer system by copying it from a distribution medium (such as a computer disk, compact disk, or downloaded from the internet) on to a storage system (typically a hard drive). Secondly, another copy of the software is made to the computer’s memory in order to execute the software or, when viewing a page on a web site, a copy is transmitted (downloaded) to the computer’s memory and/or storage system.

Thus, in principle, the rightful possessor of software would generally be expected to be able to make copies, and Congress considered the need to set some limits to the exclusive right of copyright owners. Specifically, section 117 was added allowing, among other rights, the making of archival copies by the owner of a copy of a computer program. However, industry practice since the sixties had been to protect software through contractual means, i.e. by licensing instead of selling software. Thus, software copyright owners generally aim to limit copying by licensees, claiming they have not acquired the rights of an owner. One concern fueling this tendency is the principle of “first sale,” which generally limits the copyright owner’s rights to that first sale, but allows the buyer to resell the work without consideration being due to the author. Finally, the law does not distinguish between data and instructions when describing software only as instructions, where the former may well represent other types of information, including images.

Generally, when we think of copyright infringement, we think of somebody duplicating a work, either all of it or at least enough of it as to appropriate much of its value. Sometimes we even remember that a copyright can be infringed by publicly performing or displaying a work without permission, or by translating the work into another language or another form. But with software it is possible to infringe a copyright without copying all, or even a major part, of a work.

 

(1) Whelan v. Jaslow

The first appeals court to confront what copyright protects for a computer program beyond direct copying was the Third Circuit, in the case of Whelan Associates v. Jaslow Dental Laboratory. But the Third Circuit recognized that the dichotomy between idea and expression, codified in Section 102(b) of the Copyright Act of 1976, limits what might otherwise be found infringing. Jaslow argued that “the structure of a computer program is, by definition, the idea and not the expression of the idea, and therefore that the structure cannot be protected by the program copyright.” The mere idea or concept of a computerized program for operating a dental laboratory would not in and of itself be subject to copyright. Copyright law protects the manner in which the author expresses an idea or concept, but not the idea itself. Copyrights do not protect ideas – only expressions of ideas. There are many ways that the same data may be organized, assembled, held, retrieved and utilized by a computer. Different computer systems may functionally serve similar purposes without being copies of each other. There is evidence in the record that there are other software programs for the business management of dental laboratories in competition with plaintiff’s program. There is no contention that any of them infringe although they may incorporate many of the same ideas and functions. The ‘expression of the idea’ in a software computer program is the manner in which the program operates, controls and regulates the computer in receiving, assembling, calculating, retaining, correlating, and producing information either on a screen, print-out or by audio communication. The conclusion is thus inescapable that the detailed structure of the Dentalab program is part of the expression, not the idea, of that program.

(2) Kluge v Gentra

As we have seen in other cases, and other types of intellectual property, an important component or dimension of economic damages that can be recovered by plaintiffs are lost profits measured by a “reasonable royalty.” The determination of such royalty rate is not straight forward in most cases, and an expert’s experience is crucial to the determination of a suitable rate that does not fall into the trap of speculation.
An illustration of such a situation is the litigation involving Kluge Design, Inc. (“Kluge”), in relation to their intellectual property dispute with Gentra Systems, Inc. (“Gentra”) in 2003. In that case, the software involved was a specific type of embedded software, i.e., software incorporated into the circuitry of specific devices. The biggest challenge for the assessment of damages in this approach is to analyze a hypothetical situation without leading into speculation.
The analysis of a reasonable royalty typically begins by considering the range of royalty rates derived from a series of comparable arm’s length transactions in the marketplace. Naturally, however, few licensing agreements in intellectual property in general, and software in particular are perfectly comparable. Thus the appropriate comparable range can only be derived after an expert consideration of contextual factors such as the growth prospects of the device within which the software is used, in terms of the market dynamic and the competitive advantages the software may represent, exclusivity, scope of territory or application, among others. These additional factors allow the full range of royalty rate to be narrowed down to a more likely range where a hypothetical negotiation between willing buyer and seller would have taken place. In this case, the full spectrum of rates was found to range from a low of 2.5% of sales, to a high of 15.0% of sales. The more appropriate range for the case, however, was determined by the plaintiff’s experts to be 5.0% to 8.0%.

Furthermore, even a hypothetical negotiation has additional limits. The licensor cannot be assumed to be “willing” to enter into a transaction unless profitability meets the level of their full costs plus the prevailing market-driven profit. The licensee, on the other hand, must also find the license cost still allows for a reasonable profit. Within those limits, the negotiation ensues in the context outlined in the analysis of the royalty rates. Both aspects of the analysis are important to give a sound basis to the royalty rate conclusion, thus minimizing the risk of having the damages award dismissed on grounds of being speculative.

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Thus book authors would not be entitled to the additional market value of first editions re-sold at higher prices some time after publication. This is not expected to translate directly to software.

Trademark Damages After Mattel v MGA

The recent opinion from the Ninth Circuit Court of Appeals in the long-running Mattel v MGA Entertainment [Bratz(R)] case reiterates an important, and often overlooked, aspect of trademark damages calculations: the apportionment of damages attributable to the specific item of Intellectual Property at issue.  This aspect of trademark infringement damages is susceptible of being overlooked by plaintiffs’ experts focused of strictly proving lost revenue, and is of prime importance to defendants’ experts proving suitable deductions from revenue to derive lost profits.

This important topic is one of the three main points made in the Appeal Court’s opinion, which is discussed further in the IPmetrics website .  Other lessons for business are highlighted on the IPmetrics Blog.

Copyright Infringement Damages

What monetary damages can copyright owners be entitled to recover? Section 504(a) of 17 U.S.C. grants three types of damages remedies for copyright infringement:

1. Actual damages in the form of their lost profits in order to “repair” the damage;
2. The defendant’s profits to prevent infringers from benefiting from the illegal act, and;
3. Statutory damages, when unable to prove actual damages or profits and if the work is federally registered.

Other than in the latter case, the amount of damages has to be measurable, and the statutes and case law have established several criteria in this respect. If both defendant and plaintiff occupy the same market, courts tend to prefer lost sales measurements, not unlike trademark or patent infringement; otherwise, the courts tend to prefer a “reasonable royalty” or a “market value” test to determine the hypothetical fee that would have been received. Additional concepts of damages may apply too.

If the copyright owner has previously licensed a work, and the infringement occurs in the same market, the courts will likely use the prior license as a measure of actual damages. If the copyright owner never actually licensed its intellectual property in the same market, the value lost must be approximated from the infringer’s acts, and a ‘Reasonable Royalty’ calculated. A reasonable royalty has been defined as “the royalties customarily paid for the type of use to which the defendant has put the infringing material.” This may either be a lump sum or a royalty derived from profits, or a combination.

When neither proven lost sales (same market) nor previous licenses exist, the court may determine the copyright’s fair market value by employing a market value test; the value of a license that a hypothetical willing buyer would pay a willing seller. An important question here is whether or not a hypothetical negotiation is even likely. If not, then the court may look at alleged harm to the reputation of the copyrighted work, or to the “value of the use” if the copyright owner cannot prove lost sales or the infringer did not directly profit from the infringement (thus making royalty payments speculative).

In some other cases where the infringing use does not lend itself to a reliable valuation, the courts have compensated authors for the loss of the value to their professional reputations suffered by not being credited as the author of a particular work, as well as for the general loss of business good will accompanying the lack of attribution.

As far as the profits obtained by the infringer and attributable to the infringement, the statutes say that the copyright owner may be entitled to the profits attributable to the infringement, unless this is duplicative of the alleged lost sales.

The burden of proof of the revenues and the costs falls on the copyright owner and the alleged infringer respectively. The attribution of the profits to the infringing act is very specific. The infringed work may be intermingled with the infringer’s own original contributions and, in such a case; it can be very difficult for the court to separate the two. The court, therefore, has to rely on an apportionment of the profit but, if the distinction is not reliable, all of the profit is deemed to be attributable to the infringing elements.

The calculation of damages is, therefore, based on three principles:

1. Expert testimony is allowable;
2. Evidence only needs to be reasonably supportable, as opposed to mathematically exact; and
3. All doubts should be resolved in favor of the copyright owner.

Deductible expenses are generally recognized to include direct costs, and indirect operating costs, as long as they are proportionately attributable to the infringing product or service.

Finally, for works that have been formally registered within 90 days of publication, the copyright owner also has the choice of recovering damages amounts determined by statute. This recovery of specific amounts, instead of actual damages or profits, may be for $750, up to $30,000, with respect to any one infringed work. In cases of willful infringement, the court may increase this amount up to a maximum of $150,000, for each work. That is to say, the author of an infringed book can recover statutory damages of $30,000 regardless of how many copies were illegally printed and/or sold by an infringer.[1] In contrast to trademarks and patents, copyrights do not need to be registered to be protected, and registration formalities are only necessary to be eligible for statutory damages awards.

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[1] And if other infringements are later found, no further recovery can be claimed, as the award is limited by work, not by infringement.