Replacing the "25 Percent Rule" with Fact-based Evidence, Part 1

by David Jarczyk

This two-part series explores new, defensible royalty rate search methods to replace the "25 Percent Rule."  Part one focuses on fact-based evidence.

Until recently, common practice and legal precedent had established the 25 percent rule-of-thumb (the “25 Percent Rule”) as an acceptable approach to approximating reasonable royalty rates that licensees would be willing to pay to licensors, based on profit, as part of a hypothetical arms-length negotiation.

On January 4, 2011, the United States Court of Appeals for the Federal Circuit changed that practice irrevocably when it deemed the 25 Percent Rule inadmissible during the Uniloc USA v. Microsoft patent infringement case.

In Uniloc, the court pronounced the "25 Percent Rule" a fundamentally flawed tool for determining a baseline royalty rate, and concluded that evidence supported by the "25 Percent Rule" was inadmissible in the case because it does not tie a reasonable royalty base with the factual profile of the case at issue. 

Uniloc sets a new precedent that more stringent analysis and documentation will be required to develop a position that can withstand this new level of scrutiny.  This decision also has global implications as it is likely to be considered in similar matters under the jurisdiction of country regulators (tax authorities) and global organizations such as the OECD.

Using Fact-based Evidence as an Alternative

In the wake Uniloc, it is clear that analysts will need to be as thorough as possible in performing due diligence to support their estimation of a reasonable royalty rate.  

Toward that end, a more defensible approach for determining reasonable royalty rates for infringement damages, for intercompany licensing, and for the transfer of intangibles may involve the examination of third-party license agreements that are sufficiently similar to the subject situation or tested transaction. 

Third-party licensing agreements may provide the most defensible source of fact-based evidence for several reasons. First, there is a substantial, publicly-available repository of representative license agreements in the US SEC, Canada SEDAR and other open information sources due to government regulations calling for public companies to file these material contracts. Second, an adequate percentage of these publicly-available license agreements offer non-redacted royalty rate information along with other licensing terms that are key factors of comparability such as licensing parties, product descriptions, territories and exclusivity. Third, the licensing terms within these license agreements can offer arms-length comparable transactions, which can present an unbiased model from which to determine a reasonable baseline royalty rate or set of royalty rates.

Finding Fact-based Evidence

When seeking fact-based evidence as the basis for estimating a reasonable royalty rate, defining your search methodology based on the functional profile of the tested transaction is a key factor in performing due diligence. 

Defining Criteria

A prudent first step in defining the criteria of the search methodology begins with the identification of all intangibles related to the subject situation or tested transaction.  Types of intangibles include:

  • Manufacturing intangibles such as patents, inventions, formulations, recipes, processes, technical information, designs, patterns, or know-how;
  • Marketing intangibles such as trademarks, trade names, trade dress, brand names, or service marks;
  • Copyrights and literary, musical, or artistic compositions;
  • Franchises (or business systems);
  • Methods, programs, systems, procedures, campaigns, surveys, studies, forecasts, estimates, customer lists, or training materials;
  • Software or source code; and
  • Intangible generating services: research and development, engineering, or marketing.
Tomorrow we will look at seeking comparability.