Uniloc and the Demise of the 25 Percent Rule

This year’s Federal Circuit decision in Uniloc USA v. Microsoft has put an end to use of the so-called “25 percent rule” as a basis for determining reasonable royalties in patent infringement suits. The “25 percent rule” is a general rule of thumb that suggests, as a starting point in a negotiation, that a licensee would pay 25 percent of its expected profits as a royalty for products that incorporate the licensed intellectual property (IP). For decades, district courts allowed expert testimony on reasonable royalties in patent infringement suits to be based, at least in part, on consideration of the 25 percent rule. However, in Uniloc the Federal Circuit stated, “[e]vidence relying on the 25 percent rule of thumb is…inadmissible under Daubert and the Federal Rules of Evidence, because it fails to tie a reasonable royalty base to the facts of the case at issue.”

The 25 percent rule has had a number of proponents and was often used by experts in estimating reasonable royalty damages. An article published in 1997 by Degnan and Horton reported that about a quarter of respondents to a voluntary survey of licensing professionals used the 25 percent rule as a “starting point” in licensing negotiations. An article published in 2002 by Goldscheider, Jarosz and Mulhern argued that licensing and profitability data provided some support for the rule’s use, although they admitted, “there is quite a variation in results for specific industries….and [the 25 percent rule] should be considered in conjunction with other (qualitative and quantitative) factors that can and do affect royalty rates.”

In spite of its past use as a basis for patent damages opinions, the 25 percent rule has several serious shortcomings. First, there is no theoretical basis for the 25 percent rule. Economic theory provides no reason why technology should generally be worth 25 percent of the profits related to products embodying it. A simple technology that has many substitutes may be worth very little, regardless of the profitability of those products, while an enabling technology without viable substitutes may be worth much more than 25 percent of the profits from the covered products.

Second, there is very little published empirical data to support the rule. The 2002 study noted above purports to show an empirical basis for the 25 percent rule but presents data that appear to refute it. This study calculated the ratio of median royalty rates as a share of revenues to operating profit margins for firms in 15 industries. The study found that this ratio ranged from -3 percent to +493 percent, with only four industries out of the 15 examined having ratios between 20 percent and 30 percent. Moreover, the data presented in the study showed only a low correlation between royalty rates and operating profit margins on an industry-wide basis.

Third, damages experts in patent litigation have inconsistently applied the 25 percent rule. Some proponents of the rule have framed it in relation to the “whole arsenal” of IP embodied in a product, while others have claimed that it applies to the incremental contribution of IP to a product’s profitability. Proponents of the rule often cite it as one of many factors to consider in determining a reasonable royalty rate; in some instances, however, experts have used the rule as the primary basis for selecting a reasonable royalty.

The Court in Uniloc touched on many of these points in concluding that the 25 percent rule was no longer admissible as a basis for consideration by experts. Quoting from its recent decision in ResQNet.com v. Lansa, the Court stated that expert testimony on reasonable royalties “must carefully tie proof of damages to the claimed invention’s footprint in the market place.” The Court summarized, “…there must be a basis in fact to associate the royalty rates used in prior licenses to the particular hypothetical negotiation at issue in the case….The [rule] does not say anything about a particular hypothetical negotiation or reasonable royalty involving any particular technology, industry, or party.”

The Federal Circuit decision in Uniloc, along with other recent decisions addressing patent damages (e.g.,Lucent Technologies, ResQNet.com and Wordtech Systems), has made it clear that damages estimates must be tied to the facts in a case and be based on sound economic reasoning. Not only has the Federal Circuit disallowed the 25 percent rule, but it has indicated that use of “comparable licenses” will be given careful scrutiny as to the nature of the licensed technologies, the covered products, the conversion between lump-sum and running royalties, and the circumstances surrounding the negotiations.

An article published in the September 2010 issue of les Nouvelles, “Technology Royalty Rates in SEC Filings,” which analyzed thousands of technology license agreements, showed that royalty rates vary significantly depending on what rights, if any, are bundled with patent rights. For example, royalty rates in technology licenses for “bare” patent rights differ significantly from rates for licenses that include technological “know-how” or other rights. Royalty rates also vary based on the subject industry, whether the license was arrived at via settlement of litigation, and whether the licensor was a commercial or non-commercial entity, among other factors. Just as damages experts often have relied on the 25 percent rule without rigorous basis, many also have relied upon “comparable licenses” without investigating whether these licenses actually were comparable in these and other dimensions. The Federal Circuit’s recent set of decisions addressing reasonable royalties in patent infringement suits makes clear that future expert damages opinions must be carefully tied to the facts of the case, be based on properly selected comparable agreements, and be based on sound economic reasoning.

Thomas R. Varner, an EI Vice President, has experience in complex commercial litigation involving intellectual property, breach of contract, antitrust, and class action matters. He has also conducted extensive research in technology licensing across a wide range of industries. Dr. Varner authored the 2010 study published in les Nouvelles.