Determining “Reasonable and Non-discriminatory” Royalties Law Seminars International

1. Determining “Reasonable and Non-discriminatory” RoyaltiesLaw Seminars International Aron Levko IP Practice Leader, Partner - Chicago

2. KEY POINTS • Why Royalties as a Measure of Damages • Comparison of Royalty Types • Reasonable Royalty Rate Determination • Non-Discriminatory Royalty Rate Determination • Appropriate Royalty Base

3. I. WHY ROYALTIES AS A MEASURE OF DAMAGES • 3 Primary Measures of Infringement Damages: 1. Lost Profits • awarded if patentee can establish that, but for infringement, patentee would have made infringer’s sales 2.Reasonable Royalty • measure of damages utilized when lost profits award proves inappropriate 3.Combination of Lost Profits and Reasonable Royalty • utilized when patentee can prove that it would have made some, but not all, of the infringer’s sales

4. I. WHY ROYALTIES AS A MEASURE OF DAMAGES (Cont.) Lost Profits v. Reasonable Royalty: Tests to Determine Appropriate Damage Measure • But For (Panduit Corp v. Stahlin Bros. Fiber Works, 1978; Paper Converting Mach Co v. Magna Graphics Corp, 1984; BIC Leisure Prod v. Windsurfing Int’l, 1993; Grain Processing v. American Maize,1999) • Reasonable Foreseeability (Rite Hite v. Kelly Co, 1995; King Instr Corp v. Perego, 1995) • Market Share Allocation (State Ind v. Mor-Flo Ind, 1989; Crystal Semiconductor v. Tritech, 2001) • Entire Market Value Rule (TWM Mfg v. Dura Corp, 1986; Stryker Corp v. Intermedics Orthopedics, 1995) • Discretionary Royalty (Stickle v. Hublein, 1983; Fromson v. Western Litho, 1988; Muhurkar v. CR Bard, 1996)

5. I a. BUT FOR Sufficient Financial Data? Absence of Acceptable, Non-Infringing Substitute? Adequate Manufacturing & Marketing Capabilities? Long Felt Need Satisfied by Patent? Yes Yes Yes Yes No No No No Royalties is the Measure of Damages Lost Profits is the Measure of Damages

6. I b. REASONABLE FORESEEABILITY Does Infringing Product Compete with Patented Product? Royalties is the Measure of Damages Does Infringing Product Compete with Non- Patented Product? No No Yes Yes Is the “But For” Test Satisfied? No Yes Lost Profits is the Measure of Damages

7. I c. MARKET SHARE ALLOCATION For Three or More Supplier Market: Does Patented Product Compete in the Same Market Niche? Does Patented Product have a Material Market Position? Is Price Inelastic? Yes Yes Yes No No No Lost Profits Royalties is the Measure of Damages Patent Holder Non-Infringers Non-Infringers Patent Holder Infringer Market Portion Not Captured by Patent Holder Lost Profits (Smaller Market) Non-Infringers Patent Holder Patent Holder Non-Infringers Infringer

8. I d. ENTIRE MARKET VALUE RULE For Royalty Analysis: Does the Patented Feature Define the Market for the Product? Does the Patented Feature Drive the Demand for the Product? Is the Patented Feature Integral to the Operating System? No No No Yes Yes Yes All Product Profits Considered in Royalty Analysis Product Profits Apportioned prior to Royalty Analysis

9. I e. DISCRETIONARY ROYALTY • Courts may determine royalty, beyond a reasonable royalty, to provide for adequate compensation from the infringement. • Award may be increased to as much as triple damages, attorney fees and prejudgment interest. • However, no punitive compensation may be provided in the royalty analysis just because an infringement is assumed.

10. II. COMPARISON OF ROYALTY TYPES Reasonable Non-Discriminatory RoyaltyRoyalty Objective -Adequate compensation -Increased sales for use of patent rights Competitive Strategy -Restrict access to IP -Compatible products Basis of Negotiation -Hypothetical -Consensus Considerations -GP factors, risk of LP -Contribution to pool Rights Provision -Naked license -Cross-License Bargaining Position -Willing licensor/licensee -Fair Economics -Comparable licenses, profit -Comparable licenses, split, alternative design cost pool rate

11. II a. BACKGROUND OF REASONABLE ROYALTY Title 35 U.S.C. 1. 154 (a) (1) – provides the right to exclude others from making, using, selling, having made or importing the invention. 2. 271 (a) – states that making, using, selling, having made or importing, without authority, infringes on this right to exclude. 3. 284 – calls for an award of claimant damages be adequate to compensate for the infringement, but in no event be less than a reasonable royalty.

12. II b. FUNDAMENTALS OF A REASONABLE ROYALTY • Objective: • To compensate a patent holder for an infringer’s unauthorized use of the patent holder’s property rights

13. II c. FUNDAMENTALS OF NON-DISCRIMINATORY ROYALTY • Objective: To increase sales by increasing compatible product offerings • Cross licensing technology and intellectual property rights in a non-discriminatory environment helps to: 1. Establish standards 2. Allow freedom to operate 3. Provide a broader market 4. Encourage technological progress 5. Create leverage Ultimately, this is an advantage to the manufacturer in acceptability of product design and advantages to the consumer in compatibility of product use.

14. III. REASONABLE ROYALTY RATE DETERMINATION • Georgia-Pacific Factors(Georgia-Pacific v. US Plywood, 1970) • Other Considerations (Honeywell v. Minolta, 1992) • Royalty Rate Calculations

15. III a. GEORGIA-PACIFIC FACTORS The 15 Georgia-Pacific factors act as a fundamental framework for calculating reasonable royalties, though the factors themselves do not prescribe any particular method for quantifying a reasonable royalty Factor Description Key Economic Consideration #15 Amount agreed by willing Hypothetical negotiation prior to infringement licensor and licensee with parties having full knowledge of facts #1/2/12 Royalties received and Relevant, comparable licenses and royalties paid by licensor/licensee; customary portion of profit or sales #3/4/5/7 Nature and scope of license; Commercial considerations established licensing policy; commercial relationship; duration of agreement

16. III a. GEORGIA-PACIFIC FACTORS Cont’d Factor Description Key Economic Consideration #6 The promotion of other Product interrelationships product sales #8 The established product Either past or projected profits of profitability patent holder and infringer #9/10/11 The advantages over older Importance of patented feature to product modes; benefits to the user; function and market attractiveness extent infringer made use #13 Profits attributable to the patent Relative contribution of patent compared to other resources provide by infringer #14 Opinion of qualified experts License negotiation practices and experience

17. III b. OTHER CONSIDERATIONS • Relativebargaining positions of the litigants, considering financial condition, next best alternative and sunk cost. • Reasonable anticipation of profits or losses as a result of entering into a license agreement. • Extent to which the infringement prevented the patent owner from using or selling invention. • Data outside of the hypothetical negotiation to complete the understanding of the litigants. • The nature of the market to be tapped, as well as the competitive position and strategies of the litigants.

18. III c. ROYALTY RATE CALCULATION – REASONABLE ROYALTIES • Market - Comparable license agreements * • Income - DCF, Analytic*, Profit split, Relief from royalty • Cost - Design around

19. III. d MARKET APPROACH - COMPARABLE LICENSE CONSIDERATIONS • Exclusivity • Field of Use • Geographic restrictions • Relative strengths of IP • Market share • Nature of market • Co-Promotion/marketing rights • Manufacturing rights

20. III e. INCOME APPROACH – ANALYTIC • New branded compound for off-patent pharmaceutical will provide five years of market share leadership • Management believes a 3% price premium can be sustained, net of advertising and promotion costs for five years. • 30% pre-tax discount factor (18% after tax)

21. III f. COMPARISON OF VALUATION METHODOLOGIES Discounted Cash Flow Relief from Royalty Cost Market • Strengths • Market considerations • Future Cash Flows • Strengths • Ownership • Future Cash Flows • Strengths • Ease of Use • Applicability • Strengths • Ease of Use • Applicability • Issues • Future potential • Market Considerations • Issues • Aggregation problems • Additional Investments • Issues • Comparables • Special considerations • Issues • Impact of discount rates • Additional Investments

22. IV. NON-DISCRIMINATORY ROYALTY RATE DETERMINATION • Pooling Arrangements • Royalty Rate Calculations

23. IV a. POOLING ARANGEMENTS • Patent holders’ property rights are consolidated into a central entity • This consolidation process results in the creation of the IP Pool • The central entity can be as simple as a cross-licensing contract in a bilateral agreement, or as significant as a separate corporate form (i.e. holding company, LLC, or partnership) for a multi-lateral agreement

24. IV b. POOLING ARANGEMENTS Examples: • Consortium members have equal access to each others’ patented technology at initial pooling date at little or no royalty – technology improvements available to other members at predetermined royalty rate – any new consortium members pay royalties on “base” technology and higher royalty rate on technology improvements. • Consortium members have equal access to each others’ patented technology under government funded R&D arrangement – allocation of R&D charges based upon value drivers such as revenues, with credits for resource contributions.

25. IV c. ROYALTY RATE CALCULATION – NON-DISCRIMINATORY • Standard royalty rate per patent/technology grouping ($1 per unit or 1% of net sales) • Lump sum payments (Annual R&D assessment or PV of royalties) • Comparable agreements (Market comparables or other consortium arrangements) • Return on investment (Hurdle rate on capitalized costs)

26. IVd. NON-DISCRIMINATORY ROYALTY RATE CALCULATION – STANDARD ROYALTY RATE • Pooling arrangement consisting of four consortium members, all of which have contributed property rights to the pool • The consortium members agree to a “membership” royalty rate of $0.50 for each net sale, and a “non-membership” rate of $5.00 for each net sale • Both members and non-members utilize Company A’s property rights, resulting in the following royalty revenue stream:

27. V. APPROPRIATE ROYALTY BASE • Does not include convoyed sales. • Reflects either a portion of the product or entire product encompassed by the patent. • Depends on the extent to which the patented feature drives the sale, is integral to the entire operating system or defines the market of the product (entire market value rule).

28. APPROPRIATE ROYATLY BASE - EXAMPLES Component - Intermittent windshield wiper Subsystem - Software for security clearance within financial transaction system Product - Angioplasty catheter Product Grouping - DNA testing kit (enzyme)

29. SUMMARY Reasonable and non-discriminatory royalty analyses: • provide compensation to infringed patent holder; • may result in significantly different rates; • reflect different purposes; • can be based on either similar or completely different approaches; and • are applied to similar royalty bases.