Replacing the "25 Percent Rule" with Fact-Based Evidence, Part 2
by David Jarczyk
Yesterday we focused on using fact-based evidence for estimating a reasonable royalty rate. Today, let's dig deeper into the factors that determine comparable transactions and where to find intangibles license agreements.
After the appropriate intangibles have been identified and inventoried as the basis for matching comparable transactions, a pivotal next step is to identify what key factors of the subject situation or tested transaction affect comparability and, therefore, the final results. US Treasury regulations §1.482-(c)(iii) offers a useful description of the various factors that impact comparability, which are defined as:
- Being used in connection with similar products or processes within the same general industry/market;
- Have similar profit potential (this is difficult to quantify);
- Terms of transfer;
- Stage of development;
- Rights to receive updates, revisions, modifications;
- Uniqueness of the property;
- Duration of the license/contract/agreement;
- Risks assumed by the transferee (i.e. economic and/or product liability);
- Existence/extent of any collateral transactions; and
- Functions and/or services to be performed by each party.
Sourcing Intangibles License Agreements
Fact-based evidence in the form of license agreements exists for each type of intangible. However, finding a defensible set of comparable transactions from license agreements can be an arduous process, depending on the resource used. Sources can be classified into three main categories: government information databases (free), multi-purpose information databases (subscription-based), and royalty rate databases (subscription-based).
Government databases are often the most challenging resource for locating comparables, as these vast repositories were designed to accommodate a diverse audience seeking information for a wide range of purposes. In the US SEC EDGAR database, for example, the available information is indexed very broadly and the key attributes that could help an analyst find comparable transactions in license agreements are not easily searchable. Further, license agreements in EDGAR are not necessarily filed in one intuitive location, such as Exhibit 10 Material Contracts (as many analysts believe), which increases the risk of missing a pivotal comparable. Not surprisingly, many analysts consider government databases more time-consuming and less reliable than other sources of market comparable data.
Multi-purpose information databases offer another resource for locating comparable license agreements but, in general, are similar to government databases in terms of the broad organization of their data. While most multi-purpose databases will have more sophisticated search tools, both the manner in which the documents are indexed and the way the results are presented may not provide a clear and comprehensive fact pattern necessary for conducting a thorough comparables analysis.
Specialized royalty rate data providers offer another alternative information source and their tools and outputs tend to be aligned with the analyst’s specific needs when performing a license agreement search. Royalty rate data providers aggregate intangibles information and organize key terms into searchable attributes that can significantly streamline the search process. In addition to offering more sophisticated search filters, most royalty rate data providers will offer a summary of licensing terms and comparable criteria needed for each transaction matched within the defined search methodology. An example can be found here.
While summaries offered by royalty rate providers can offer a helpful snapshot of the license agreement, it is important to note that reading the full agreement text is a critical step in performing due diligence. In fact, reviewing all licensing terms contained in a license agreement document is the only way to validate that those terms fully support the factual profile of the subject situation or tested transaction. Reading the full text will also provide assurance that the document itself is usable, as some databases occasionally provide royalty rates from trade journals, financial newspapers or magazine articles gathered from unusable sources. Royalty rate comparables from unsubstantiated sources, such as newswire listings, cannot be used in court or with tax authorities unless backed up by a full text, corroborating license agreement.
Summary
Finding and analyzing fact-based evidence may provide the most defensible method for approximating reasonable royalty rates in the wake of Uniloc. There is a substantial repository of fact-based evidence available in the form of third-party license agreement data and documentation, and specialized royalty rate data providers can provide analysts with an efficient and reliable portal to finding representative transactions. As a result, when comparable transactions are identified and analyzed with a thorough methodology and comprehensive search process, fact-based evidence can support the resulting analysis with proof of thorough due diligence that can stand up in litigation matters.