Robert Goldscheider, a legendary solicitor, had coined the “25% Rule” for Royalty Rate determination in litigation cases in 1950. According to Goldscheider, the 25% Rule can be used in litigation cases as part of the two-stage process, wherein the defendant & plaintiff (collectively referred to as “Parties”) in the first stage determine Royalty as 25% of the operating profit (the “25% Threshold”). This is followed up with step two of upward/downward adjustments to the 25% threshold, depending on the bargaining power of each of the litigating parties.
The US court of law, in the case of GEORGIA-PACIFIC CORPORATION VS. UNITED STATES PLYWOOD CORPORATION (1970), had given a landmark judgement, proposing a framework of 15 factors, to be used for upward/downward adjustments to the 25% threshold. Robert did an empirical study of a series of commercial license arrangements which had been entered in past several years. Based on this study, Goldscheider was able to corroborate the 25% Royalty rate rule. In several of the past settled litigation cases, Robert found that the Court ruled Royalty rates were in the range of 12% of operating profit margin to 50% of the operating profit margins.
Upward/downward adjustments to the 25% Threshold
Courts comprehend a hypothetical situation that, had the licensor and licensee tried to legally negotiate a licensing agreement between them, who among them will have an edge over the counterparty, to negotiate better commercial terms in its favour? For instance, if the innovation (which is the subject matter of litigation) is resulting in enormous cost savings to the licensee, or if the innovation is ground breaking, such that it is capable of revolutionising the user industry, then obviously, the licensor will be having a strong bargaining power, and this should push the royalty rate in excess of the 25% Threshold.
In fact, in several extreme cases, like the one relating to “Standard Manufacturing Co vs. Department of Defence (USA)”, the revolutionary/ground-breaking nature of the patent/brand under dispute, the courts have gone ahead and awarded royalty payment to the innovator at close to 100% of the operating profit, on the sales made by the infringing entity. Courts have contended that when the product is ground breaking, the innovator has a very strong bargaining power in a licensing contract.
In the Indian context, several techniques are prevalent and used for triangulating and arriving at fair royalty rates. These techniques include the “25% Rule”, comparable transactions approach – where Courts look for comparable licensing contracts, which can be taken as the basis for determining fair royalty rate. With & Without Approach /Excess Profit Approach – where courts try to estimate the marginal profit that the defendant is able to earn due to the innovation which is the subject matter of litigation.
Indian Courts Perspective - Determining fair Royalty Rates
Royalty Rate Determination for Valuation of Brands / Patents in Litigation Cases 18 Patent disputes in India have witnessed a paradigm shift from being plain infringement suits to those involving a complex interface of patent and competition laws. These complex disputes are termed as Standard Essential Patent (SEP) suits whose jurisprudence has grown exponentially. India’s legal position on adjudicating such disputes has been evolving over time. Courts are following in the footsteps of their counterparts in developed jurisdictions and shaping their approach with the budding international scenario.
The effective approaches for Indian Courts to incorporate while dealing with reasonable royalty rate determination under SEP disputes include
(a) Incremental Earnings- Quantify the incremental profits that the subject IP generates through cost savings or a price premium. (When IP has not yet commercialized, estimates of cost savings based on prototypes or consumer research needs to be done)
b) The Profit Split- Using the EBIT as a starting point and unravelling the charge for tangible and other intangible assets will establish an excess margin. This margin then can be attributable to royalty rates based on qualitative or quantitative weightings of value drivers.
Conclusion
The 25% Threshold Rule is based on historical observations provides and useful guidance for how a licensor or licensee should consider negotiating a royalty payment. Richard Razgaitis, a leading consultant in the field of technology valuation, has identified six reasons for why the 25% rule makes sense.
Richard Razgaitis advocates that 75% of profit should be retained by licensee & 25% profit to be transferred to the licensor as Royalty because: a). It is considered an industry norm b) 75% of work and efforts needed to commercialized a product under patent needs to be done by licensee c) He who has the Gold makes the rule (Licensee’s dominate the market due to numerous investment alternatives) d) A 3x payback ratio is common i.e.; licensee retaining 75% profits by investing the rest 25% e) Technology is the one of 4 required steps of commercialization, other three being products manufacturing viability, actual manufacturing and selling efforts all of which rests on the heads of licensee (again a 3:1 risk reward relationship) and f). The ratio of R&D to profits usually is in the range of 25% to 33%.
The rule, whether used in litigation or non-litigation setting, provides a fairly reasonable tool to be augmented by a more complete royalty analysis. Georgia pacific factors are quite helpful in adjusting this simple 25% number up or down based on the number of qualitative assessments as delineated previously and have also been widely acknowledged by courts across the world in IP Litigation and Patent infringement case judgements.
By Rajeev Shah - Managing Director & CEO, RBSA Advisors
(The views expressed in the article are personal)
