November 3, 2014
Valuation Strategies
By John C. Paul; C. Brandon Rash
Authored by John C. Paul and C. Brandon Rash
Patent portfolio valuation occurs in a variety of scenarios and for a variety of purposes including internal requirements, regulatory requirements, patent sales and acquisitions, patent licensing and litigation, and larger business transactions such as mergers, acquisitions, divestitures, investments, joint ventures, and other collaborations.
When valuing a patent portfolio, the discussion typically begins with the question of what is a reasonable royalty. An attempt is made to calculate a reasonable royalty based on a future revenue stream from licensing the portfolio to other industry participants, or on royalty rates used in comparable situations. And the discussion often ends there, when the valuation is conducted outside of the litigation context.
U.S. law entitles patent owners to appropriate compensation from those who use their rights, and that compensation should be no less than a reasonable royalty. As a result, it can be useful to consider other scenarios and theories in the valuation analysis. For example, if competitors are selling or are likely to be selling infringing products without a license, patent owners may be entitled to the profits they would have made if there had been no infringement. Although not always the case, the lost profits generally exceeds the reasonable royalty, often by a substantial amount.
To establish how such an alternative analysis of lost profits might affect the valuation of the patent portfolio, it must be ascertained whether lost profits are available under the relevant precedent, and if so, in what amount. This analysis varies and is highly case-specific, with numerous legal, economic, and technical issues to consider. It can be helpful to explore the facts and alternative valuation theories to avoid undervaluing a patent portfolio, and to reap the appropriate profits and returns on investments in research and development.
This article discusses legal considerations of the lost-profits analysis, including the availability of lost profits and their proper valuation, and how those considerations might affect the valuation of a patent portfolio in various scenarios.
U.S. patent law provides that, on a finding of infringement, the court must award the patent owner "damages adequate to compensate for the infringement, but in no event less than a reasonable royalty."1Adequate damages generally include any lost profits from lost sales and price erosion, as well as future lost profits.
To recover lost profits, patent owners must show a reasonable probability that, "but for" the infringement, they would have made the profits claimed to be lost and that those losses were reasonably foreseeable.2 Remote consequences, such as a heart attack of the inventor or a loss in value of common stock of the patent owner caused indirectly by infringement, are generally not considered reasonably foreseeable, and therefore would not be an adequate basis for lost profits.3
To show lost profits, the patent owner must reconstruct the market as it would have developed absent the infringing conduct and determine what products the patent owner would have sold and the profits on those sales.4 This reconstruction need not be perfect, and patent owners need not negate every possibility that the purchaser might not have bought the patent owner's product instead of the infringing one, or foregone the purchase altogether.5
However, the patent owner must show damages that are based on sound economic models and evidence, and not merely speculation or guesswork.6 For instance, the law of demand says that consumers will generally purchase fewer units of a product at a higher price than a lower price. If patent owners contend that they would have sold their products at a higher price but for the infringement, they must also present evidence of the amount of product they would have sold at the higher price.7
Courts give patent owners wide latitude to prove "but for" causation and entitlement to lost profits, but one common way is the four-factor test applied by the Sixth Circuit in Panduit Corp. v. Stahlin Bros. Fiber Works, Inc.8
This test requires patent owners to show:
1. Demand for the patented product.
2. The absence of acceptable noninfringing substitutes.
3. Manufacturing and marketing capability to exploit the demand.
4. The amount of profit to be made.9
Showing these four factors allows the court to infer that the lost profits claimed were caused by the infringing sales. The Panduit test assumes that the patent owner and the infringer sell products sufficiently similar to compete against each other in the same market segment. If the products of the patent owner and infringer are not substitutes in a competitive market, the Panduit test cannot meet the "but for" requirement.10 Lost profits may not be appropriate for nonpracticing entities, that do not seek to make and sell the invention.11
The patent owner must first show demand for the patented product, which may be either an infringing product or a product that directly competes with an infringing product. This first factor is often easy to show, since courts have considered a substantial number of infringing products to be sufficient evidence of demand. To satisfy this factor, patent owners need show only demand for the patented product, not particular features corresponding to claim limitations in the patent.12
Establishing the second factor, the absence of acceptable noninfringing substitutes, requires the patent owner to show that either (1) the purchasers in the marketplace generally were willing to buy the patented product for its advantages, or (2) the specific purchasers of the infringing product purchased on that basis. The mere existence of a competing product does not necessarily make it an acceptable substitute. If purchasers are motivated to purchase because of particular features available only from the patented product, competing products without such features may not be acceptable noninfringing substitutes.13
When the patent owner and infringer compete in the same market segment and sell substantially similar products, patent owners may satisfy the second factor with proof of their market share. Under this approach, patent owners may recover a percentage of lost profits from the infringer's sales equal to their market share in the relevant market segment, despite acceptable noninfringing substitutes, because the patent owners could still prove with reasonable probability the sales they would have made "but for" the infringement.14
If the patent owners show that other competitors in the market are likely infringers, the patent owners would be entitled to their shares of the market on top of their own and a correspondingly higher share of profits from the infringer's sales. When the patent owner and the infringer are the only suppliers of the patented product, it may be reasonable to infer that the patent owner would have made the sales made by the infringer, provided the other factors are met.15
The third factor, manufacturing and marketing capability, requires the patent owner to show that it could have made, sold, and distributed the quantity of infringing sales, in addition to its own sales.16 Manufacturing capability may be shown by having adequate manufacturing capacity, but may also be shown by the ability to subcontract a portion of the work,17 or by plant expansion to meet the increased demand.18 Marketing capability may be shown by establishing that the patent owner had an adequate distribution system and sales personnel. If the patent owner cannot show manufacturing or marketing capability for a particular market segment of the infringing sales, such as no sales capability in a particular segment or geographic region, lost profits may not be warranted for that segment.19
The fourth factor requires the patent owner to quantify the amount of lost profits. The amount may not be determined by mere speculation or guess, but it is enough if the evidence shows the extent of damages as a matter of just and reasonable inference, even if only approximate, and any doubts regarding the amount are resolved against the infringer.20
Calculating lost profits requires the patent owner to reconstruct the relevant market without the infringement and provide what its economic condition would have been in that scenario. This involves determining the incremental revenues generated from the lost sales of the patented or competing product and subtracting the incremental costs associated with those sales. Incremental costs would include the variable cost of each additional unit sold and any fixed costs that vary with the increased production, such as a facility expansion.21
If the patented feature is one of several features in an entire product, the patent owner must apportion the infringer's profits between the patented and unpatented features. Under the entire market value rule, however, the patent owner may obtain lost profits damages based on the value of an entire apparatus, including the unpatented features, if the patented feature creates the "basis for customer demand" or "substantially create[s] the value of the component parts."22 For the entire market value rule to apply, the patent owner must show that the value of the whole apparatus is properly attributable to the patented feature.
The entire market value rule also allows the patent owner to recoup lost profits on convoyed sales, which are sales of non-patented products that are sold with the patented products. Convoyed sales may be included where the non-patented and patented products "together were considered to be components of a single assembly or parts of a complete machine, or they together constituted a functional unit."23 Convoyed sales do not include non-patented products that have no functional relationship with the patented product and that may have been sold with the patented product only as a matter of convenience or marketing reasons. A functional relationship may not exist, for example, when independently operating patented and unpatented products are purchased as a package solely based on customer demand.24
In addition to lost profits from lost sales, a patent owner may also seek lost profits from price erosion, which requires the patent owner to show that, but for infringement, it would have sold its own product at a higher price.25 For example, entry of an infringing product into the market that forces the patent owner to offer discount rates or price concessions may result in price erosion,26 even if the infringing product was more expensive.27 Since a higher price presumably results in fewer sales, the patent owner also must present evidence of the amount of product it would have sold at the higher price, taking into account the nature of the market.
A patent owner may also recover future lost profits caused by the infringement. Given the inherent unknowns the future brings, however, the burden of proving future injury is higher than for past damages. A patent owner must present adequate evidence to enable the factfinder to estimate future losses responsibly and based on sound economic models and evidence, not pure guesswork.28 For example, a patent owner may show future lost sales based on actual pre-infringement and post-infringement growth rates, but speculative projections and bare testimony without evidentiary support are not sufficient.29
It may be useful for patent owners to apply the considerations that are routinely used in calculating lost profits in the litigation context to determine how lost profits affect the value of their patents outside of litigation, such as when they want to value the portfolio for purposes of internal valuation, sale, business acquisition, or licensing.
To recap, lost profits may be available where, "but for" the infringement, the patent owner would have made the profits claimed to be lost, which may be inferred from a showing that:
1. The infringing products directly compete with the patent owner's products.
2. There are no suitable non-infringing alternatives.
3. The patent owner had the manufacturing and marketing ability to fulfill the lost sales.
Thus, if the patent owner does not make or plan to make a competing product, lost profits may not be available, because the patent owner will have difficulty showing that, but for the infringement, it would have made the lost profits.
A lost-profits analysis may be useful for patent owners trying to determine the value of certain patents to their business. For example, based on the additional damages lost profits might allow, patents covering a higher-profit product line may be shown to be more valuable to the patent owner than patents for a lower-profit product line or patents unrelated to the patent owner's core business. Patents that cover both higher-profit and lower-profit product lines would possibly have a more complex and dynamic value if assessed under a lost-profits analysis.
A benefit of analyzing patents with a strong potential for lost profits damages is that it allows patent owners to take offensive steps to protect their businesses and to defend themselves, if a competitor brings its own action for patent infringement against the patent owner, and in cross-license negotiations in or outside the context of litigation.
Another aspect of the lost-profits analysis for an internal valuation involves properly structuring ownership of the patents to recoup the profits lost. Generally, one seeking to recover lost profits must have held legal title to the patent during the time of the infringement.30 This may be important, for example, where a patent-holding company owns the patents, and a sister corporation manufactures patented products under a non-exclusive license to the patents. In this scenario, to the extent these companies are separate corporate entities, they may not be able to recover lost profits of the manufacturer, even if they have a common parent corporation.31
Similarly, in the context of a joint venture including party A and party B, typically only the legal owner of the patents may be able to recover its share of lost profits. U.S. patent law allows joint ownership of the patents,32 which is one way the joint venture, or separate corporate entities, might be able to structure ownership to recoup the full lost profits. If party A's patents cover party B's activities but did not cover party A's activities before they joined together, a relationship that allows the joint venture to begin recouping party B's lost profits may add value to party A's patents.
Another situation in which a lost-profits analysis may be useful involves the sale of patents. The impact of lost profits in this scenario depends on the buyer and the nature of the sale. Even if the patent owner were able to collect lost profits, a buyer may not necessarily collect profits that the original patent owner lost by merely purchasing the patent. The patent owner, however, may as part of the sale assign the buyer the right to collect those past lost profits.33 In addition, the buyer may be able to collect profits lost since it owned the patent, assuming the buyer were able to show that "but for" the infringement it would have made additional profits during the period the buyer owned the patent.
Thus, valuing patents based on lost profits may be useful to patent owners for negotiating purposes when selling patents to a buyer that intends to use the patents to protect a highly profitable product line. There may be a scenario, for example, where the patent owner does not make any products that directly compete with infringing products or have the manufacturing or marketing ability to fulfill the lost sales, and thus, cannot recover lost profits. In this scenario, the patent owner may extract more value from the patent by selling it to a buyer who is able to recover lost profits after the purchase, since the patent may be more valuable to such a buyer. If in another scenario the patent owner has substantial past lost profits, assigning the buyer the right to collect those profits may also add value to the sale.
While the patent owner's ability to collect lost profits damages may not be relevant to a buyer of just the patent with no right to collect past damages, it may be relevant to a buyer of the patent owner's business and patents. By purchasing the business of the patent owner, the buyer would be able to collect profits the patent owner lost due to infringement. In this scenario, a lost-profits analysis might add substantial value to the sale. A lost-profits analysis may help the patent owner to decide which buyers to target and to show the increased value to the buyer.
The lost-profits analysis may also impact the value of patents in a licensing situation, for example, when the patent owner licenses the patents to an exclusive licensee. Like the patent owner, an exclusive licensee is entitled to claim lost profits.34 Similar to joint ownership of the patents, this gives separate corporate entities or two parties to a joint venture another way to structure a relationship to allow the recovery of lost profits.
Although non-exclusive licensees cannot recover lost profits, the potential for lost profits damages through litigation may assist a patent owner in negotiations with a non-exclusive licensee. For example, a viable threat of lost profits damages in litigation may encourage the non-exclusive licensee to negotiate without litigation. The lost-profits analysis, however, may have less of an effect on the valuation of patents where the patent owner is a non-practicing entity seeking only to license patents to non-exclusive licensees, since a non-practicing entity typically will not satisfy the requisite factors for lost profits, e.g., making and selling products that compete with the accused products.
Although reasonable royalties are typically discussed when valuing a patent portfolio, alternative theories such as lost-profits analysis can also play an important role in determining the true value. Patent owners may want to perform a lost-profits analysis as well as a reasonable royalty analysis, and compare the two. By also considering the lost-profits analysis, patent owners in various situations are more likely to be able to demand and extract the most value from their patents. Ultimately, incorporating a proper lost-profits analysis in appropriate circumstances creates a more sophisticated, dynamic valuation that accounts for variations in the marketplace and may lead to a more accurate and profitable result.
Endnotes
1 35 U.S.C. section 284.
2 Crystal Semiconductor Corp. v. TriTech Microelectronics Int'l, Inc., 246 F.3d 1336 (CAF. C., 2001).
3 Rite-Hite Corp. v. Kelley Co., 56 F.3d 1538 (CAF. C., 1995).
4 Grain Processing Corp. v. Am. Maize-Prods. Co., 185 F.3d 1341 (CA-F.C., 1999).
5 Datascope Corp. v. SMEC, Inc., 879 F.2d 820 (CAF. C., 1989).
6 Shockley v. Arcan, Inc., 248 F.3d 1349 (CA-F.C., 2001).
7 Crystal Semiconductor, note 2, supra. 575 F.2d 1152 (CA-6, 1978).
8 Rite-Hite, note 3, supra.
9 BIC Leisure Prods., Inc. v. Windsurfing Int'l, Inc., 1 F.3d 1214 (CA-F.C., 1993).
10 Hebert v. Lisle Corp., 99 F.3d 1109 (CA-F.C., 1996).
11 See however the discussion in Rite-Hite, note 3, supra., indicating that owners need not practice their invention.
12 DePuy Spine, Inc. v. Medtronic Sofamor Danek, Inc., 567 F.3d 1314 (CA-F.C., 2009).
13 Cohesive Techs., Inc. v. Waters Corp., 543 F.3d 1351 (CA-F.C., 2008).
14 BIC Leisure Prods., note 10, supra.
15 State Indus., Inc. v. Mor-Flo Indus., Inc., 883 F.2d 1573 (CA-F.C., 1989).
16 Datascope, note 5, supra.
17 Gyromat Corp. v. Champion Spark Plug Co., 735 F.2d 549 (CA-F.C., 1984).
18 Livesay Window Co. v. Livesay Indus., Inc., 251 F.2d 469 (CA-5, 1958).
19 Datascope, note 5, supra.
20 Lam, Inc. v. Johns-Manville Corp., 718 F.2d 1056 (CA-F.C., 1983).
21 State Indus., note 16, supra.
22 See discussion in Uniloc USA, Inc. v. Microsoft Corp., 632 F.3d 1292 (CA-F.C., 2011).
23 Rite-Hite, note 3, supra.
24 Am. Seating Co. v. USSC Group, Inc., 514 F.3d 1262 (CA-F.C., 2008).
25 Ericsson, Inc. v. Harris Corp., 352 F.3d 1369 (CAF. C., 2003).
26 Sanofi-Synthelabo v. Apotex, Inc., 470 F.3d 1368 (CA-F.C., 2006).
27 Kalman v. Berlyn Corp., 914 F.2d 1473 (CA-F.C., 1990).
28 Oiness v. Walgreen Co., 88 F.3d 1025 (CA-F.C., 1996).
29 Shockley, note 6, supra.
30 Arachnid, Inc. v. Merit Indus., Inc., 939 F.2d 1574 (CA-F.C., 1991).
31 Poly-Am., L.P. v. GSE Lining Tech., Inc., 383 F.3d 1303 (CA-F.C., 2004).
32 35 U.S.C. section 262.
33 Abraxis Bioscience, Inc. v. Navinta LLC, 625 F.3d 1359 (CA-F.C., 2010).
34 Rite-Hite, note 3, supra.
©2014 Thompson Reuters. Originally published by Valuation Strategies. This article is for informational purposes, is not intended to constitute legal advice, and may be considered advertising under applicable state laws. This article is only the opinion of the authors and is not attributable to Finnegan, Henderson, Farabow, Garrett & Dunner, LLP, or the firm's clients.
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