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Understanding the Difference Between Real-World Licenses and the Hypothetical License in Patent Damages Analysis

Larry Tedesco

Summary

  • A predominant method of calculating patent damages in intellectual property litigation involves the determination of a reasonable royalty through a “hypothetical negotiation” between the patent owner and the alleged infringer.
  • There are a number of differences between a hypothetical license and a typical real-world license, even when both are assumed to involve the same parties and a license to the patent or patents in suit.
  • Among the major issues often considered in an analysis of real-world licenses for insight into the hypothetical license are established validity and infringement, differences in license scope with respect to the patents or territories included, the timing of the license, and the volume of sales.
Understanding the Difference Between Real-World Licenses and the Hypothetical License in Patent Damages Analysis
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A predominant method of calculating patent damages in intellectual property litigation involves the determination of a reasonable royalty through a “hypothetical negotiation” between the patent owner and the alleged infringer. The negotiation of a license being considered is hypothetical because it never took place: The infringer is alleged to have used the licensor’s patented technology without negotiating a license for it.

There are a number of differences between a hypothetical license and a typical real-world license, even when both are assumed to involve the same parties and a license to the patent or patents in suit. Understanding and accounting for these differences correctly in a damages analysis can have a material impact on the reasonable royalty.

Among the major issues often considered in an analysis of real-world licenses for insight into the hypothetical license are established validity and infringement, differences in license scope with respect to the patents or territories included, the timing of the license, and the volume of sales, which are discussed in turn below.

Established Validity and Infringement

In real-world licensing negotiations, the licensee typically will dispute that the patents under discussion are valid and that the licensee’s products use its teachings. Actual negotiations, therefore, generally reflect a discount to deal with the licensee’s invalidity and noninfringement contentions. Consequently, it may be appropriate to adjust license rates negotiated in the actual world upward in the hypothetical negotiation to account for validity and infringement, which are typically assumptions a damages expert is asked to make. This logic is laid out by Stephen H. Kalos and Jonathan D. Putnam in “On the Incomparability of ‘Comparables’: An Economic Interpretation of ‘Infringer’s Royalties’,” 9 J. Proprietary Rights, no. 4, 2–5 (1997). For example, the authors of a 2004 Research Policy article note that the Wang Laboratories SIMM patent, which had been licensed for a 1 percent royalty prior to litigation, was licensed for a 3 percent royalty after a finding of validity and infringement in litigation. Edward F. Sherry & David J. Teece, “Royalties, evolving patent rights, and the value of innovation,” 33 Res. Pol’y, no. 2, 179, 189 (Mar. 2004). This comparison assumes that the royalty rates were applied to the same royalty base. The authors also suggested 50 percent as a reasonable adjustment, on average, to account for the risks of invalidity and noninfringement. Id. at 179. See also David J. Teece, “The ‘Tragedy of the Anticommons’ Fallacy: A Law and Economics Analysis of Patent Thickets and FRAND Licensing,” 32 Berkeley Tech. L.J., no. 5, 1489 (2018).

Courts have indicated that the value of a patent can increase as litigation risk is resolved. For example, the Federal Circuit has recognized that a patent may be less valuable at an earlier time in the litigation process when both parties generally have less information on validity and infringement. See, e.g., Spectralytics, Inc. v. Cordis Corp., 649 F.3d 1336, 1347 (Fed. Cir. 2011); see also Robocast, Inc. v. Microsoft Corp., 21 F. Supp. 3d 320, 334–36 (D. Del. 2014). The converse is that a patent may be more valuable as litigation progresses in ways that are favorable to the patentee.

Similarly, litigation risk could have a material impact on the rates paid in settlements. In a 2018 PricewaterhouseCoopers study, researchers found that patent cases that proceeded to trial were decided in plaintiffs’ favor about one-third of the time for the period from 1998 to 2017. Further, about 78 percent of cases were appealed for the period from 2007 to 2011. See PricewaterhouseCoopers, 2018 Patent Litigation Study (May 2018). Such statistics indicate that it may be appropriate to adjust royalty rates from settlement agreements upward for the likelihood of success in litigation to reflect the fact that the royalty rate in a hypothetical negotiation assumes a valid, infringed, and enforceable patent, and an infringing licensee willing to pay a royalty.

The degree of this upward adjustment can be determined to account for the degree of uncertainty that existed during the negotiation of the settlement agreement. For example, a settlement agreement negotiated while an inter partes review challenge to a patent is pending may be subject to greater uncertainty (and thus have been susceptible to a greater discount) than an otherwise comparable settlement agreement entered after a patent was challenged and an inter partes review board upheld the patent.

Narrower License Scope—Patent Count

A hypothetical license grants a license to the patents in suit only. However, many real-world licenses include a larger portfolio of patents. For that reason, when using a portfolio license as an input into the hypothetical license, it is necessary to consider the degree to which downward adjustments to actual-world licenses may be appropriate.

While parties in many technical industries regularly enter into licensing agreements for patent portfolios, specific patents in those portfolios, such as those asserted in lawsuits, tend to drive the negotiations, terms, and structures of those deals. Academic studies have found that the value of patents in a given portfolio tend to be skewed and that a few patents typically account for a large portion of the value of the overall portfolio. See, e.g., Dietmar Harhoff, Frederic Scherer & Katrin Vopel, “Citations, Family Size, Opposition and the Value of Patent Rights,” 32 Res. Pol’y, no. 8, 1343–63 (2003); Alfonso Gambardella, Dietmar Harhoff & Bart Verspagen, “The Value of European Patents,” 5 Eur. Mgmt. Rev. 69–84 (2008). Courts have acknowledged the skewed value of patents in portfolios in various decisions. See, e.g., Oracle Am., Inc. v. Google Inc., No. c10-03561 WHA (N.D. Cal. Mar. 13, 2012); In re Innovatio IP Ventures, LLC Patent Litig., MDL No. 2303, No. 11 C 9308, 2013 WL 5593609, at *8–12 (N.D. Ill. Oct. 3, 2013) (in which Dr. Gregory Leonard calculated the value attributable to Innovatio’s patents relying on the premise that the top 10 percent of all electronics patents account for 84 percent of the value in all electronics patents, which was accepted by Judge Holderman).

“Patent value skew” is a generally accepted concept in the patent licensing industry that not all patents in a portfolio are equally valuable—there is a “skew” in values among various patents. Judge Holderman accepted this principle in the Innovatio case, which dealt with standard essential patents. In re Innovatio IP Ventures, LLC Patent Litig., MDL No. 2303, 2013 WL 5593609.

Related empirical studies show that different patents have very different values, with some patents being of little or no value and some being extremely valuable. One study reviews the literature on this topic and summarizes the findings as “the distribution of individual patent value is extremely skew, generally more skew than a log-normal distribution. Most patents are worth very little, and a few are worth a lot.” Bronwyn H. Hall, The Use and Value of Patent Rights (U.K. Intellectual Property Office June 2009) (research paper prepared for the U.K. IP Ministerial Forum on the Economic Value of Intellectual Property, June 10, 2009). Another study estimates the distribution of patent values for a variety of industries. The median estimated value of a patent included in a study from the electronics industry was about $8,000. The 95th percentile of estimated patent value was about 50 times higher, at about $400,000. The 99th percentile of estimated patent value ($2,016,797) was nearly 250 times higher than the median. M. Schankerman, “How Valuable Is Patent Protection? Estimates by Technology Field,” 29 RAND J. Econ., no. 1, 94 (1998).

Based on my experience, negotiations often focus on a subset of patents necessary for the licensee to obtain operational and design freedom with respect to the patented technology. However, if a license is reached on a subset of patents, both parties will generally prefer to include the entire patent portfolio at issue to eliminate the risk of a future patent infringement dispute. Given these factors, the downward adjustment to actual licenses necessary to account for additional patents is often modest.

Narrower License Scope—U.S. Only

In a worldwide portfolio license, the parties typically agree to royalties that are payable for a number of patents, in a number of diverse jurisdictions, and for potentially infringing activities occurring in locations around the world. Unwired Planet Int’l Ltd. v. Huawei Techs. Co. Ltd. & Huawei Techs. (UK) Co. Ltd., No. HP-2014-000005 [2017] EWHC 711 (Pat) (Eng.).

As a result, the parties often take into account differences in global patent enforcement regimes and available remedies in specific countries and then settle on what could be considered a global “average” in terms of the royalty rate payable. But in the case of a hypothetical negotiation for patent damages purposes, only U.S. patents are at issue and only infringing activities in the U.S. are licensed.

Royalty rates payable for a U.S.-only license are typically higher than royalty rates payable under a global “average.” In Unwired Planet v. Huawei, both the plaintiff and the defendant agreed that if the license was for only one territory in a “major market,” then the “royalty rate should be higher than the benchmark (worldwide) royalty rate. That is because there are plainly significant efficiencies in global licensing.” While the parties disagreed on the specific amount of the royalty rate increase, the court found that it should be increased by 100 percent. In other words, the rate would be doubled. Id. at 122–23. Thus, it may be appropriate to consider whether the global average royalty rates in actual-world licenses should be adjusted upward for comparison with the hypothetical license.

Timing

It is widely accepted practice for patentholders to offer discounted rates to parties that reach agreement on a license more rapidly or take a license early in the lifecycle of an overall licensing program, or both. Those discounted rates reflect the lower costs thereby incurred by the licensor and the positive signals sent to the marketplace of other prospective licensees. Licensor companies also may grant lower rates to early adopters.

Volume

Licensors may offer lower effective rates to licensees that command a large volume of sales; licensors have several incentives for doing so, the following among them:

  • Gaining a large licensee without the need to initiate and complete litigation will generally send a positive signal to the marketplace of other prospective licensees.      
  • Conversely, large licensees that “hold out,” refuse a license, and force litigation will generally send a negative signal to other licensees—particularly to larger competitors.
  • All other things equal, larger licenses incur lower-percentage transaction costs than smaller licenses.
  • Gaining a large licensee, even at a discounted rate, has a larger positive impact on the licensor’s finances.

Each of these effects should be accounted for when analyzing licenses with large-volume licensees.

The views and opinions expressed in this article are those of the author and do not necessarily reflect the opinions, position, or policy of Berkeley Research Group, LLC, or its other employees and affiliates.