es nouvelleslesnouvelles.lesi.org/lesnouvelles2002/lesnouvelle... · tionship between real-world...

les NouvellesUse Of The 25 Per Cent Rule In Valuing IP

ROBERT GOLDSCHEIDER, JOHN JAROSZ & CARLA MULHERN

23

Brain Power — Use It Or Lose It BENNY BROWNE

Page 134

New Guidelines For Valuing “In Process” R & DTERRY ALLEN, JIM RIGBY

& RIZVANA ZAMEERUDDINPage 139

Technolgy Transfer In Brazil: A Guide To Licensing Foreign Technology In Brazil

CLARISSE ESCOREL & TARA PENNINGTONPage 143

Managing Intellectual Assets For Shareholder ValueBRIAN NAPPER & SHELLY IRVINE

Page 148

Licensing Of New Products: Determinants Of Royalty StructureTRICHY V. KRISHNAN & MURALI SANTHANAM

Page 155

Negotiation Strategies For Technology Acquistion Contracts JEFFREY J. BLATT

Page 173

Recent Decisions In The United States BRIAN BRUNSVOLD & JOHN PAUL

Page 176

Open Book — From Ideas To Assets Investing Wisely In Intellectual Property

JOHN RAMSAYPage 179

Volume XXXVII No. 4 December 2002

JOURNAL OF THE LICENSING EXECUTIVES SOCIETY®

Introduction

As the importance of intellec-tual property (“IP”) protec-tion has grown, so has the

sophistication of tools used to valueit. Discounted cash flow,1 capitali-zation of earnings,2 return on in-vestment,3 Monte Carlo simulation4

and modified Black-Scholes op-tion valuation methods5 havebeen of great value. Nonetheless,the fairly simple “25 Per CentRule” (“Rule”) is over 40 years oldand its use continues. RichardRazgaitis has called it the “most fa-mous heuristic, or rule of thumb,for licensing valuation.”6

The Rule suggests that the lic-ensee pay a royalty rate equivalentto 25 per cent of its expected prof-its for the product that incorporatesthe IP at issue. The Rule has beenprimarily used in valuing patents,but has been useful (and applied)

Use Of The 25 Per CentRule In Valuing IP

BY ROBERT GOLDSCHEIDER, JOHN JAROSZ AND CARLA MULHERN*

*Robert Goldscheider, Chairman, Interna-tional Licensing Network.John Jarosz and Carla Mulhern, Princi-pals, Analysis Group/Economics.We would like to thank the following in-dividuals for their hard work and usefulcomments on earlier drafts of this paper:Jaime Baim, Laura Boothman, Jeff Kinrich,Jennifer Price, Chris Vellturo and RobertVigil. The views expressed here are oursand do not necessarily represent those ofothers at the International Licensing Net-work or Analysis Group/Economics.

in copyright, trademark, trade se-cret and know-how contexts as well.Since the Rule came into fairly com-mon usage decades ago, times, ofcourse, have changed. Questionshave been raised on whether thefactual underpinnings for the Rulestill exist (i.e., whether the Rule hasmuch positive strength) such thatit can and should continue to beused as a valid pricing tool (i.e.,whether the Rule has much nor-mative strength).

In this paper, we describe theRule, address some of the miscon-ceptions about it and test its factualunderpinnings. To undertake thelatter, we have examined the rela-tionship between real-world royaltyrates and real-world industry andcompany profit data. In general, wehave found that the Rule is a valu-able tool (rough as it is), particularlywhen more complete data on incre-mental IP benefits are unavailable.The Rule continues to have a fairdegree of both “positive” and “nor-mative” strength.History of the Rule

One of the authors — RobertGoldscheider7 — did, in fact, under-take an empirical study of a seriesof commercial licenses in the late1950s.8 This involved one of his cli-

ents, the Swiss subsidiary of a largeAmerican company, with 18 licens-ees around the world, each havingan exclusive territory. The term ofeach of these licenses was for threeyears, with the expectation of re-newals if things continued to gowell. Thus, if any licensee “turnedsour,” it could promptly be re-placed. In fact, however, eventhough all of them faced strongcompetition, they were either firstor second in sales volume, andprobably profitability, in their re-spective markets. These licensestherefore constituted the proverbial“win-win” situation. In those li-censes, the intellectual propertyrights transferred included: a port-folio of valuable patents; a continualflow of know-how; trademarks de-veloped by the licensor; and copy-righted marketing and productdescription materials. For those li-censes, the licensees tended to gen-erate profits of approximately 20per cent of sales on which they paidroyalties of 5 per cent of sales. Thus,the royalty rates were found to be25 per cent of the licensee’s profitson products embodying the pat-ented technology.9

1. D.J. Neil, Realistic Valuation of Your IP,32 les Nouvelles 182 (December 1997);Stephen A. Degnan, Using Financial Modelsto Get Royalty Rates, 33 les Nouvelles 59(June 1998); Daniel Burns, DCF Analyses inDetermining Royalty, 30 les Nouvelles 165(September 1995); Russell L. Parr & PatrickH. Sullivan, Technology Licensing: CorporateStrategies For Maximizing Value 233-46(1996); Richard Razgaitis, Early-StageTechnologies: Valuation and Pricing 121-58 (1999).2. Robert Reilly & Robert Schweihs, ValuingIntangible Assets 159-66 (1999).3. Parr and Sullivan, pp. 223-33.4. V. Walt Bratic et al., Monte Carlo AnalysesAid Negotiation, 33 les Nouvelles 47 (June1998); Razgaitis, pp. 160-77.5. Dr. Nir Kossovsky & Dr. Alex Arrow,TRRU™ Metrics: Measuring The Value andRisk of Intangible Assets, 35 les Nouvelles 139(September 2000); F. Peter Boer, The Valuationof Technology: Business and Financial Issues InR&D, 302-06 (1999).6. Razgaitis, p. 96.

7. See, e.g., Richard S. Toikka, In PatentInfringement Cases, the 25 Per Cent RuleOffers a Simpler Way to Calculate Reason-able Royalties. After Kumho Tire, Chancesare the Rule Faces Challenges to itsDaubert Reliability, Legal Times 34 (August16, 1999).8. Robert Goldscheider, Litigation Back-grounder for Licensing 29 les Nouvelles 20, 25(March 1994); Robert Goldscheider, Royaltiesas Measure of Damages 31 les Nouvelles 115,119 (September 1996).

les Nouvelles December 2002 123

Mr. Goldscheider first wroteabout the Rule in 1971.10 He noted,however, that in some form it hadbeen utilized by valuation expertsprior to that.11 For example, in1958, Albert S. Davis, the GeneralCounsel of Research Corporation,the pioneer company in licensinguniversity-generated technology,wrote:

If the patents protect the Licenseefrom competition and appear to be validthe royalty should represent about 25%of the anticipated profit for the use ofthe patents.12

A form of the Rule, however, ex-isted even decades before that. In1938, the 6th Circuit Court of Ap-peals, in struggling with the prob-lem of determining a reasonableroyalty, heard expert testimony tothe affect that:

… ordinarily royalty rights to theinventor should bear a certain propor-tion to the profits made by the manu-facturer and that the inventor wasentitled to a ‘proportion ranging fromprobably ten per cent of the net profitsto as high as thirty per cent,’ whichshould be graduated by the competitivesituation.13

Regardless of its origins andauthor(s), the concept has aided IPvaluators for many years.Explanation of the Rule

In its pure form, the Rule is as fol-lows. An estimate is made of thelicensee’s expected profits for theproduct that embodies the IP at is-sue. Those profits are divided by theexpected net sales over that sameperiod to arrive at a profit rate. Thatresulting profit rate, say 16 per cent,

is then multiplied by 25 per cent toarrive at a running royalty rate. Inthis example, the resulting royaltyrate would be 4 per cent. Going for-ward (or calculating backwards, inthe case of litigation), the 4 per centroyalty rate is applied to net salesto arrive at royalty payments due tothe IP owner. The licensee/user re-ceives access to the IP, yet the price(i.e., royalty) it pays will still allow itto generate positive product returns.

The theory underlying this ruleof thumb is that the licensor and lic-ensee should share in the profit-ability of products embodying thepatented technology. The a prioriassumption is that the licenseeshould retain a majority (i.e., 75per cent) of the profits because ithas undertaken substantial devel-opment, operational and commer-cialization risks, contributed othertechnology/IP and/or brought tobear its own development, op-erational and commercializationcontributions.

Focus of the Rule is placed on thelicensee’s profits because it is the lic-ensee who will be using the IP.14 Thevalue of IP is, for the most part, de-

pendent upon factors specific to theuser (e.g., organizational infrastruc-ture).15 IP, like any other asset, de-rives its value from the use to whichit will be put.16

Focus also is placed on expectedprofits because the license negotia-tion is meant to cover forthcomingand on-going use of the IP.17 It is theexpected benefits from use of the IPthat will form the basis for thelicensee’s payment of an access fee.Past, or sunk costs, typically shouldbe ignored because a decision is be-ing made about the future.18 That is,what going-forward price results inthe product being a sound invest-ment? Any product in which theprojected marginal benefits exceedthe projected marginal costs shouldbe undertaken.

Focus is placed on long-run profitsbecause access to IP often will affordthe user more than just immediatebenefits.19 Focusing on a singlemonth or single year typically willnot properly represent the forth-coming and on-going benefits of theIP. In many occasions, it takes someperiod of time for a new companyor new product to obtain its opera-tional efficiencies and a steady state.Furthermore, up-front investmentsoften need to be amortized over theeconomic life of a product (not justits starting years) in order to evalu-ate properly the economic returnsto the product.

9. Robert Goldscheider, Technology Manage-ment: Law/Tactics/Forms § 10.04 (1991).10. Robert Goldscheider & James T. Marshall,The Art of Licensing – From the Consultant’sPoint of View, 2 The Law and Business ofLicensing 645 (1980).11. Robert Goldscheider, Technology Manage-ment: Law/Tactics/Forms §10.04 (1991).12. Albert S. Davis, Jr., Basic Factors to beConsidered in Fixing Royalties, PatentLicensing, Practicing Law Institute, 1958.13. Horvath v. McCord Radiator and Mfg. Co. etal., 100 F.2d 326, 335 (6th Cir. 1938).

14. In the reasonable royalty determinationin Standard Manufacturing Co., Inc. andDBP, Ltd. v. United States, both sides’experts focused on the patent holder’sprofit rate. The Court took exceptionnoting that defendant’s profits were a“more realistic and reliable estimation ofprofits which were to [the plaintiff] by theinfringement since they are derived fromthe actual sale of [the infringing product].”Standard Manufacturing Co., Inc. and DBP,Ltd. v. United States, 42 Fed. C1. 748, 767(1999). The Court noted that a variety offederal courts held the same, citing Mahurkarv. C.R. Bard, Inc., Davol Inc. and Bard AccessSystem, Inc. 79 F.3d 1572, 1580 (Fed. Cir. 1996)(district court did not err in calculatingportion of award when it initially usedinfringer’s profit rate); TWM ManufacturingCo., Inc. v. Dura Corp. and Kidde, Inc. 789 F.2d895, 899 (Fed. Cir. 1986) (affirming districtcourt’s computation of damages based oninfringer’s profits); Trans-World Manu-facturing Corp. v. Al Nyman & Sons, Inc. andAl-Site Corporation, 750 F.2d 1552, 1568(among factors considered in determiningreasonable royalty was the infringer’santicipated profit from invention’s use, andevidence of infringer’s actual profits probativeof anticipated profit.)

15. Baruch Lev, “Rethinking Accounting,”Financial Executive Online Edition, March/April 2002 Cover Story, http://www.fei.org/maggable/articles/3-4-2002.coverstory.cfm.16. In some circumstances, the licensor’sprofits may provide some guidance. That is,those profits may, in part, reflect his/herappetite for a license and those profits mayserve as a surrogate for missing or unknownlicensee profits.17. Razgaitis, p. 108. Fonar Corporation andDr. Raymone V. Damadian v. General ElectricCompany and Drucker & Genuth, MDS, P.C.d/b/a South Shore Imaging Associates,107 F. 3d 1543 (Fed. Cir. 1997). Hanson v.Alpine Valley Ski Area, Inc., 718 F.2d 1075(Fed. Cir. 1983).18. Richard Brealey & Stewart C. Myers,Principles of Corporate Finance, 123 (6thEd. 2000).19. Razgaitis, p. 108.

les NouvellesDecember 2002124

Finally, the Rule places focus onfully-loaded profits because theymeasure the (accounting) returns ona product. Gross profits representthe difference between revenuesand manufacturing costs. Grossprofits, however, do not account forall of the operating expenses asso-ciated with product activity. Thosecosts include marketing and selling(“M&S”), general and administra-tive (“G&A”) and research and de-velopment (“R&D”) expenses. Someof those costs are directly associatedwith product activity, others arecommon across product lines.

“Fully-loaded” profits account forthe fact that a variety of non-manu-facturing overhead expenses areundertaken to support the productactivity, even though they may notbe directly linked to certain volumeor activity levels. And such costs areoften driven by product activity.Failure to take into account theseoperating expenses may lead to anoverstatement of the returns asso-ciated with the sales of a product.

According to Smith and Parr:Omission of any of these [overhead]

expenses overstates the amount of eco-nomic benefits that can be allocated tothe intellectual property. In a compari-son of two items of intellectual prop-erty, the property that generates sales,captures market share, and grows, whileusing less selling and/or support efforts,is more valuable than the one that re-quires extensive advertising, sales per-sonnel, and administrative support.The economic benefits generated by theproperty are most accurately measuredafter considering these expenses.20

According to Parr:The operating profit level, after con-

sideration of the nonmanufacturing op-erating expenses, is a far more accuratedeterminant of the contribution of theintellectual property. The royalty forspecific intellectual property must re-flect the industry and economic envi-ronment in which the property is used.

Some environments are competitive andrequire a lot of support costs which re-duce net profits. Intellectual propertythat is used in this type of environmentis not as valuable as intellectual prop-erty in a high-profit environment wherefewer support costs are required. Aproper royalty must reflect this aspectof the economic environment in whichit is to be used. A royalty based on grossprofits alone cannot reflect this reality.21

Fully-loaded profits may refer toeither pretax profits or operatingprofits. Pretax profits are calculatedas revenues minus: 1) cost of goods,2) non-manufacturing overhead ex-penses and 3) other income and ex-penses. The historical relationshipsunderlying the 25 Per Cent Rule,however, have in fact been betweenroyalty rates and operating profits.22

The latter is revenues minus: 1) costof goods sold and 2) non-manufac-

turing overhead. Not subtracted outis other income and expenses. Inmany cases, these two measures ofprofit are quite similar; in othercases, they are not. Given that thevalue of intellectual property is in-dependent of the way in which afirm (or project) is financed,23 froma theoretical point of view, the op-erating profit margin is the correctmeasure to use.

Suppose that firm A and firm Beach have one piece of identical in-tellectual property and each manu-factures and sells one product thatembodies that intellectual property.The only difference between thefirms is that firm A is heavily fi-nanced by debt and firm B is not.Firm A would then have significant

20. Gordon V. Smith & Russell L. Parr,Valuation of Intellectual Property and IntangibleAssets, 362 (2nd Ed. 1994).

21. Parr, pp. 170-71.

22. Robert Goldscheider, Technology Manage-ment: Law/Tactics/Forms § 10.04 (1991),Razgaitis, p. 103.23. Brealey & Myers, Chapters 2 & 6.

Figure 125 Per Cent Rule Illustration - Revenue Side

Revenues

Cost of Sales

Gross Margin

Operating Expenses

Operating Profits

$100

$40

$60

$30

$30

$110

$40

$70

$30

$40

No Patent RevenueEnhancing Patent

25 Per Cent Rule

($40*25%)/$110=9.1%

Figure 225 Per Cent Rule Illustration - Cost Side

Revenues

Cost of Sales

Gross Margin

Operating Expenses

Operating Profits

$100

$40

$60

$30

$30

$100

$30

$70

$30

$40

No Patent Cost ReducingPatent

25 Per Cent Rule

($40*25%)/$100=10%


interest expenses to deduct from itsoperating profits resulting in pretaxprofit levels below operating profitlevels. Firm B does not have any in-terest expense to deduct. Thus, onan operating profits basis, firm Aand firm B would have equivalentprofit margins; but, on a pretax ba-sis, firm B would be considerablymore profitable. Application of the25 Per Cent Rule to operating prof-its would result in the same royaltyrate in the case of firm A and firmB; whereas, application of the Ruleto pretax profits would result in alower royalty rate for firm A. Sincethe underlying intellectual propertyand the products embodying it areidentical for both firms, one wouldexpect to obtain the same resultingroyalty rate. Thus, application of theRule to operating profits wouldyield the appropriate results.Illustration of the Rule

IP, like any asset, can be (and is)valued using three sets of tools.They are often referred to as the In-come Approach, the Market Ap-proach and the Cost Approach.24

The Income Approach focuses onthe returns generated by the userowing to the asset at issue. The Mar-ket Approach focuses on the termsof technology transfers coveringcomparable assets. The Cost Ap-proach focuses on the ability (andcost) to develop an alternative as-set that generates the same benefits.

The 25 Per Cent Rule is a form ofthe Income Approach. It is particu-larly useful when: 1) the IP at issuecomprises a significant portion ofproduct value and/or 2) the incre-mental benefits of the IP are other-wise difficult to measure.

IP is often priced based on the en-hanced revenues and/or reduced

costs that it generates versus thenext best alternative.25 The extent ofthat excess (or incremental value),holding all else constant, may formthe upper bound for the appropri-ate price.26

The 25 Per Cent Rule can be (andis) applied when the licensee re-ports product line revenue and op-erating profit data for the productencompassing the IP. It need not bethe case that the IP at issue be theonly feature driving product value.(In fact, underlying the Rule is theunderstanding that a variety of fac-tors drive such value.) That is whyonly a portion of the profits — 25per cent — is paid in a license fee.And that is why the appropriateprofit split may be much less than25 per cent of product profit.

The Rule also can be (and is) ap-plied when the licensee does not re-port profits at the operating profitlevel. (In fact, there are very few in-stances in which firms report prod-uct profits at such a level.) As longas product revenues and costs ofgoods sold are reported (i.e., grossmargins are available), the accoun-tant or economist can (and does)allocate common (or non-manu-facturing overhead) costs to theproduct line in order to derive op-erating profits.

The illustration in Figure 1 showshow the Rule is applied.

A patent may enhance or im-prove product revenues throughincreased prices (though that mayoccur with a reduction in volume27)or through increased volume. Thesecond column in Figure 1 illus-trates the impact of a revenue-en-hancing patent. Applying the 25 PerCent Rule to the expected operat-ing profits results in a royalty rateof 9.1 per cent.

A patent may also reduce prod-uct costs. Figure 2 illustrates that by

applying the 25 Per Cent Rule tosuch expected operating profits re-sults in a royalty rate of 10 per cent.

Valuators (and courts) who usethe 25 Per Cent Rule occasionallysplit the expected or actual cost (i.e.,incremental) savings associatedwith the IP at issue.28 According toDegnan and Horton’s survey of li-censing organizations who base aroyalty payment on projected costsavings, almost all of them pro-vide for the licensee paying 50 percent or less of the projected sav-ings.29 The apparent reasoning isthat such incremental benefitsshould be shared.

Splitting the cost savings by 75/25, however, may not be consistentwith the 25 Per Cent Rule. In Fig-ure 2, the incremental (or addi-tional) cost savings are $10. Splittingthat amount ($10) by 25 per cent,results in a running royalty rate of2.5 per cent ($10 x 25%/$100), whichis 1/16 of the new “product” prof-its, rather than 1/4. Applying theRule to incremental savings (or ben-efits) results in a running royaltythat is lower than that dictated bythe 25 Per Cent Rule. It may undercompensate the IP owner. The 25Per Cent Rule, in its pure sense,should be applied to fully loadedoperating profits, not to alreadycomputed incremental benefits.

Several courts have (implicitly)recognized the problem of splittingincremental benefits. In Ajinomoto,the district court wrote:

Although the ‘licensing rule of

24. Shannon P. Pratt et al., Valuing a Business:The Analysis and Appraisal of Closely HeldCompanies, 149-285 (3rd Ed. 1996); ShannonP. Pratt et al., Valuing Small Businesses andProfessional Practices, 507-524 (2nd Ed. 1993);Gordon V. Smith & Russell L. Parr, Valuationof Intellectual Property and Intangible Assets,127-136 (2nd Ed. 1994); Robert Reilly &Robert Schweihs, Valuing Intangible Assets118-203 (1999).

25. Paul E. Schaafsma, An Economic Over-view of Patients, 79 Journal of the PatentTrademark Office Society 251, 253 (April 1997).26. Jon Paulsen, Determining Damages forInfringements, 32 les Nouvelles 64 (June 1997).

27. Paul A. Samuelson & William D. Nordhaus,Economics 47 (17th ed. 2001). Crystal Semi-conductor v. Tritech Microelectronics International,Inc., 246 F. 3d 1336 (Fed. Cir. 2001).28. Standard Manufacturing Co., Inc. and DBP,Ltd. v. United States, 42 Fed. C1 748, 764-765(1999). Ajinomoto Inc. v. Archer-Daniels-Midland Co., No. 95-218-SLR, 1998 U.S. Dist.LEXIS 3833, (D. Del. March 13, 1998). Tights,Inc. v. Kayser-Roth Corp. 442 F. Supp. 159(M.D.N.C. 1977). Dow Chemical Co. v. UnitedStates, 226 F. 3d 1334 (Fed. Cir. 2000) Razgaitis,pp. 117-18.29. Stephen A. Degnan & Corwin Horton, ASurvey of Licensed Royalties,32 les Nouvelles 91, 95 (June 1997).


thumb’ dictates that only one-quarterto one-third of the benefit should go tothe owner of the technology … given[defendant’s] relatively low productioncosts and its belief that the sale of [theproduct] would increase [convoyedsales], the court concludes that [defen-dant] would have been willing to shareall of the benefit with [plaintiff] and that[plaintiff] would have settled for noth-ing less.30

Furthermore, in Odetics, the Fed-eral Circuit wrote that “one expects[an infringer] would pay as much asit would cost to shift to a non-infring-ing product.”31 And in Grain Process-ing, the Federal Circuit adopted thelower court’s reasoning that an in-fringer “would not have paid morethan a 3% royalty rate. The courtreasoned that this rate would reflectthe cost difference between (infringe-ment and non-infringement).”32

To the extent that incrementalbenefits (i.e., cost savings) have al-ready been calculated, any profitsplit applied to those may not beconsistent with the 25 Per CentRule. In theory, the licensee shouldbe willing to accept a royalty that isclose to 100 per cent (not 25 per cent)of the cost savings.Application of the Rule

The 25 Per Cent Rule is used inactual licensing settings and litiga-tion settings. Over the past three de-cades, a variety of commentatorshave noted its widespread use.33 Intheir survey of licensing execu-tives, which was published in 1997,Degnan and Horton found thatroughly 25 per cent (as a sheer co-incidence) of licensing organiza-tions used the 25 Per Cent Rule as astarting point in negotiations.34

They also found that roughly 50 percent of the organizations used a“profit sharing analysis” (of which

the 25 Per Cent Rule is a variant) indetermining royalties.35

A dramatic employment of theRule occurred in the early 1990’s inthe course of negotiations betweentwo major petrochemical compa-nies, respectively referred to as “A”and “B”. A was a leading manufac-turer of a basic polymer product(“X”), with annual sales of over $1billion. Its process (“P-1”) requiredthe purchase from B of an interme-diate compound (“Y”) in annualvolumes of over $400 million. Aowned a patent on its P-1 processto manufacture X, which would ex-pire in 7 years.

A developed a new process tomake X (“P-2”) to which it decidedto switch all its production of thepolymer concerned, essentially forcost reasons, but also because P-2was more flexible in producing dif-

ferent grades of X. P-2 did not in-volve the need to purchase Y fromB. Rather than simply abandon P-1,however, A decided to offer B theopportunity to become the exclu-sive worldwide licensee of P-1. Theargument was that such a licensecould be profitable to B because itwas a basic producer of Y (which Ahad been purchasing at a price con-taining a profit to B), and B couldthus manufacture X on a cost-effec-tive basis. Another attraction ofsuch a license would be that it couldcompensate B for the loss of its salesof Y to A.

B was interested to take such a li-cense to P-1, and offered to pay a 5per cent running royalty on its salesof polymer made in accordancewith P-1. A decided to test the rea-sonableness of this offer by apply-ing the 25 Per Cent Rule, a goodportion of which analysis couldemploy 20-20 hindsight. A under-stood the market for X, past andpresent, and had what it consideredto be realistic projections for the fu-ture. A had made such a study be-cause it intended to remain in themarket for X, utilizing P-2. A wasalso able to calculate pro-formaprofitability to B by subtracting B’smargin on its sales of Y to A for usein P-1.

This analysis revealed that Bshould be able to operate as a lic-ensee under A’s P-1 patent at an op-erating profit of 44 per cent. Ashared its fully documented analy-sis with B and asked “please tell usif we are wrong.” If not, A wouldexpect to receive an 11 per cent roy-alty based on B’s sales of X usingA’s patented P-1 process, based onthe 25 Per Cent Rule, rather than the5 per cent that was offered.

Following study of A’s workproduct, B (somewhat surprisedand reluctantly) agreed with A’sconclusion. B accepted these termsbecause B would still make a 33 percent operating profit under the li-cense, which was higher than B’snormal corporate operating profitrate. Over the remaining life of itsP-1 patent, this additional 6 per centroyalty amounted to added profit,

30. Ajinomoto Inc. v. Archer-Daniels-MidlandCo., No. 95-218-SLR, 1998 U.S. Dist. LEXIS3833, at 44 n.46 (D. Del. March 13, 1998).31. Odetics, Inc. v. Storage Technology Corp. 185F. 3d 1259, 1261 (Fed. Cir. 1999).32. Grain Processing Corp. v. American Maize-Products Co., 185 F. 3d 1341, 1345 (Fed. Cir. 1999).

33. Robert E. Bayes, Pricing the Technology, inCurrent Trends In Domestic and InternationalLicensing 369, 381 (1977). Marcus B. Finnegan& Herbert H. Mintz, Determination of aReasonable Royalty in Negotiating a LicenseAgreement: Practical pricing for SuccessfulTechnology Transfer, 1 Licensing Law andBusiness Report 1, 19 (June-July 1978).Lawrence Gilbert, Establishing a UniversityProgram, 1 The Law and Business of Licensing506.267 (1980). Robert Goldscheider & JamesT. Marshall, The Art of Licensing-From theConsultants Point of View, 2 The Law and Businessof Licensing 645 (1980). H.A. Hashbarger,Maximizing Profits as a Licensee, 2 The Lawand Business of Licensing 637 (1980). Alan C.Rose, Licensing a “Package” Lawfully in theAntitrust Climate of 1972, 1 The Law andBusiness of Licensing 267 (1980). YoshioMatsunaga, Determining Reasonable RoyaltyRates, — les Nouvelles 216, 218 (December1983). The Basics of Licensing: IncludingInternational License Negotiating Thesaurus,les 13 (1988). Edward P White, Licensing: AStrategy For Profits, 104 (1990). Martin S.Landis, Pricing and Presenting LicensedTechnology, 3 The Journal of Proprietary Rights18, 20-21 (August 1991). Wm. Marshall Lee,Determining Reasonable Royalty, les Nouvelles124 (September 1992). David C. Munson,Licensing Technology: A Financial Look at theNegotiational Process, 78 J.P.T.O.S. 31, 42 n.21(January 1996). Schaafsma, p. 251. Munson,Figuring the Dollars in Negotiations, 33 lesNouvelles 88 (June 1998). Robert Reilly &Robert Schweihs, Valuing Intangible Assets193-94, 503 (1999).34. Degnan and Horton, p. 92.35. Degnan and Horton, p. 92.


in fact, of several hundred milliondollars to A.

In Standard Manufacturing Co., Inc.and DBP, Ltd. v. United States,36 theU.S. Court of Claims employed atwo-step approach to determininga litigated reasonable royalty. Thefirst step involved an estimation ofan initial or “baseline” rate. The sec-ond step entailed an adjustment up-ward or downward depending onthe relative bargaining strengths ofthe two parties with respect to eachof the (15) factors described in Geor-gia-Pacific Corp. v. United States Ply-wood Corporation.37

The Standard Manufacturing Courtfound the application of the 25 Per CentRule to be an appropriate method fordetermining the “baseline” royaltyrate. And in support of its use of the25 Per Cent Rule, it cited defendant’sexpert’s (Robert Goldscheider’s)considerable practical experiencewith the Rule.38 The Court alsonoted that a number of other fed-eral courts had recognized that the25 Per Cent Rule is a “rule of thumb”typical in the licensing field.39 Forexample, the 25 Per Cent Rule hasbeen useful in situations where aparty analyzes its own IP for man-agement or tax reasons, or as partof a merger, acquisition or divesti-ture. The Rule has been employed

36. Standard Manufacturing Co., Inc. and DBP,Ltd. v. United States, 42 Fed. C1. 748 (1999 U.S.Claims LEXIS 11).37. Georgia-Pacific Corp. v. United StatesPlywood Corporation, 318 F. Supp. 1116(S.D.N.Y. 1970) modified and aff’d, 446 F.2d295 (2d Cir. 1971).38. Standard Manufacturing Co., Inc. and DBP,Ltd. v. United States, 42 Fed. Cl. 748, 763-64(1999 U.S. claims LEXIS 11).39. Ajinomoto Co., Inc. v. Archer-Daniels-Midland Co., No. 95-218-SLR, 1998 U.S.Dist. LEXIS 3833, at 052 n.46 (D. Del.March 13, 1998); W.L. Gore & Associates, Inc. v.International Medical Prosthetics ResearchAssociates, Inc., 16 USPQ 2d. 1241 (D. Ariz.1990); Fonar Corporation and Dr. Raymond V.Damadian v. General Electric Company andDrucker & Genuth MDS, P.C. d/b/a/ South ShoreImaging Associates, 107 F.3d 1543 (Fed. Cir.1997). See also, Donald S. Chisum, ChisumOn Patents, 7 § 20-03[3] [iv], 20-188, 20-189(1993 and Supp. 1997). Fromson v. WesternLitho Plate & Supply Co., 853 F. 2d 1568 (Fed.Cir. 1988).

Figure 3Licensed Royalty Rates (Late 1980’s - 2000)

Automotive

Chemicals

Computers

Consumer Goods

Total

35726890

1,533

No. ofLicenses

1.0%0.5%0.2%0.0%

0.0%

MinimumRoyalty

Rate

15.0%25.0%15.0%17.0%

77.0%

MaximumRoyalty

Rate

4.0%3.6%4.0%5.0%

MedianRoyalty

RateIndustry

Electronics 132 0.5% 15.0% 4.0%Energy & Environment 86 0.5% 20.0% 5.0%Food 32 0.3% 7.0% 2.8%Healthcare Products 280 0.1% 77.0% 4.8%Internet 47 0.3% 40.0% 7.5%Machine/Tools 84 0.5% 25.0% 4.5%Media & Entertainment 19 2.0% 50.0% 8.0%Pharma & Biotech 328 0.1% 40.0% 5.1%Semiconductors 78 0.0% 30.0% 3.2%Software 119 0.0% 70.0% 6.8%Telecom 63 0.4% 25.0% 4.7%

Figure 4Industry Profit Rates (1990 - 2000)

Automotive

Chemicals

Computers

Consumer Goods

Total

100126459544

No. of Companies

5.0%11.1%6.9%

11.0%

Wtd. Avg. Operating MarginIndustry

Electronics 425 8.8%Energy & Environment 767 12.2%Food 240 7.3%Healthcare Products 433 14.8%Internet 781 -13.5%Machine/Tools 174 7.9%Media & Entertainment 360 10.6%Pharma & Biotech 534 16.4%Semiconductors 207 17.4%Software 534 18.8%Telecom 627 14.2%

6,309 10.4%


as follows:• the remaining economic life of

the property being valued, whichmay be shorter than the remaininglegal life of any patents that may bepart of the analysis, is estimated;

• the operating profit rate ex-pected during each of such years isprojected and 25 per cent (or an-other rate considered appropriate inaccordance with the Rule) is appliedto each of the annual figures;

• a discounted cash flow analysisis performed, using an appropri-ate discount rate to convert futureflows into a current year lumpsum amount.

The rationale for this appraisalmethodology is that the plus or mi-nus 25 per cent apportionment is theprice of a reasonable royalty that theappraising party would be willingto pay for a license for this property,at that point in time, assuming thatit did not own it.

The Rule, whether used in litiga-tion or non-litigation settings, pro-vides a fairly rough tool to beaugmented by a more complete roy-alty analysis. The precise “split” ofprofits should be adjusted up ordown depending on the circum-stances of each case and relativebargaining positions of the twoparties.40 If a licensor comes to thebargaining table armed with a rela-tively strong arsenal of assets, itmay be entitled to 25 per cent, orperhaps more, of the pie. Corre-spondingly, a weak arsenal of as-sets supports a lower split. Indetermining the appropriate splitof profits, the factors established inthe Georgia-Pacific case are quitehelpful.41 In fact, many of the courtsthat have used the Rule in litigation

40. Robert Goldscheider, Litigation Back-grounder for Licensing, 29 les Nouvelles 20, 25(March 1994).41. Georgia Pacific v. United States PlywoodCorp., 318 F. Supp. 1116 (S.D.N.Y. 1970)modified and aff’d, 446 F.2d (2d Cir. 1971),the court set forth 15 factors that should beconsidered in determining a reasonableroyalty. See also, Stephen A. Degnan, UsingFinancial Models to Get Royalty Rates, 33 lesNouvelles 59, 60 (June 1998).

Figure 5Licensee Profits (1990 - 2000)

Automotive

Chemicals

Computers

Consumer Goods

Total

46

2023

No. of Companies

6.3%11.6%8.0%

16.2%

Licensee Wtd. Avg.Operating MarginIndustry

Electronics 30 8.8%Energy & Environment 14 6.6%Food 6 7.9%Healthcare Products 80 17.8%Internet 14 1.0%Machine/Tools 8 9.4%Media & Entertainment 3 -304.5%Pharma & Biotech 76 25.4%Semiconductors 16 29.3%Software 19 33.2%Telecom 28 14.1%

347 15.9%

Figure 6Royalty Rates and Licensee Profits

Automotive

Chemicals

Computers

Consumer Goods

Total

5.0%3.0%2.8%5.0%

4.3%

MedianRoyalty

Rate

6.3%*11.6%8.0%

16.2%

15.9%

AverageOperating

Profits

79.7%25.9%34.4%30.8%

Royaltyas % of

Profit RateIndustry

Electronics 4.5% 8.8% 51.3%Energy & Environment 3.5% 6.6% 52.9%Food 2.3% 7.9% 28.7%Healthcare Products 4.0% 17.8% 22.4%Internet 5.0% 1.0% 492.6%Machine/Tools 3.4% 9.4% 35.8%Media & Entertainment 9.0% -304.5%* -3.0%Pharma & Biotech 4.5% 24.5% 17.7%Semiconductors 2.5% 29.3% 8.5%Software 7.5% 33.2% 22.6%Telecom 5.0% 14.1% 35.5%

26.7%

* Fewer than 5 observations in data set.


have done so in the context of evalu-ating Georgia-Pacific factor #13 —“the portion of the realizable profitthat should be credited to the inven-tion as distinguished from non-pat-ented elements, the manufacturingprocess, business risks, or significantfeatures or improvement added bythe infringer.”Justification for the Rule

The Rule, based on historical ob-servations, provides useful guid-ance for how a licensor and licenseeshould consider apportioning thebenefits flowing from use of the IP.Somewhat untenable (and unreal-istic) is guidance that either the li-censor or licensee is entitled to allof the returns. No bargain wouldbe reached. Though a 50:50 start-ing split has a ring of a “win-win”situation, in fact, the evidence sug-gests otherwise.

Richard Razgaitis has identified 6reasons for why a 25/75 (starting)split makes sense.42 First, “that’s theway it is.” Numerous licensors andlicensees have agreed to a 25/75split. It is, according to him, the in-dustry norm. Second, typically 75per cent of the work needed to de-velop and commercialize a productmust be done by the licensee. Third,“he who has the gold makes therules.” Licensees have considerableleverage because of the numerousinvestment alternatives open tothem. Fourth, a 3-times payback ra-tio is common. Such is obtained bya licensee retaining 75 per cent ofthe return by investing 25 per cent.Fifth, technology is the first of the 4required steps of commercializa-tion. The others are making theproduct manufacturable, actuallymanufacturing it and selling it. Fi-nally, the ratio of R&D to profits isoften in the range of 25 to 33 per cent.Criticisms of the Rule

Despite (or perhaps because of) itswidespread use, the 25 Per CentRule has been criticized in severalways. First, it has been characterizedas a “crude tool” and as “arbitrary.”According to Paul Schaafsma:

42. Razgaitis, pp. 99-102.

Figure 7Distribution of Profit Splits - Licensee Profits

<0%

Nu

mb

er o

f In

du

stri

es

0%-20% 21%-40% 41%-60% 61%-80% >80%

109876543210

Figure 8Royalty Rates and Successful Licensee Profits

Automotive

Chemicals

Computers

Consumer Goods

Total

5.0%3.0%2.8%5.0%

4.3%

MedianRoyalty

Rate

11.3%*12.0%8.3%

18.4%

18.8%

AverageOperating

Profits

44.1%25.0%33.3%27.1%

Royaltyas % of

Profit RateIndustry

Electronics 4.5% 13.1% 34.3%Energy & Environment 3.5% 9.2% 38.1%Food 2.3% 14.2% 15.8%Healthcare Products 4.0% 18.5% 21.6%Internet 5.0% 10.4% 48.0%Machine/Tools 3.4% 9.6% 35.0%Media & Entertainment 9.0% -13.5%* -66.7%Pharma & Biotech 4.5% 25.8% 17.4%Semiconductors 2.5% 31.9% 7.8%Software 7.5% 25.1% 21.4%Telecom 5.0% 14.5% 34.5%

26.6%

* Fewer than 5 observations in data set.

Figure 9Distribution of Profit Split - Successful Licensee Profits

<0%

Nu

mb

er o

f In

du

stri

es

0%-20% 21%-40% 41%-60% 61%-80%

109876543210


again). Moreover, the Rule is not in-tended to be used in isolation. Thereare a variety of other tools thatshould be employed in any valua-tion assignment.

A second criticism is that the Ruleis “indefinite”. That is, should 25 percent be applied to gross profits, oper-ating profits, or some other measureof profits? According to William Lee:

The ‘25% rule’ is sometimes a littleindeterminate as to whether it refers to25% of net profit or 25% of gross profit(if you represent the prospective licen-sor, then of course you apply the 25%against anticipated gross profit; if yourepresent the prospective licensee, youcontend that the 25% applies to netprofit!). Note that the indefiniteness asto whether the ‘25% rule’ speaks to netprofit or gross profit brings it somewhatin line with the rule of thumb of 1/3 to1/4 of profit as a reasonable royalty asexpressed in [some publications].48

In fact, there is no indefiniteness.The Rule is based on historical ob-servations of the relationships be-tween royalty rates and operatingmargins.49 That is, rates often are 25per cent of operating margins. Andit is anticipated operating margins,according to the Rule, against whichthe profit split figure should be ap-plied. Applying it to another levelof profits may be valid and usefulin certain contexts, but such an ap-plication is not grounded in the con-cepts and facts surrounding the 25Per Cent Rule.

Third, some analysts believe thatthere is no indefiniteness and that,in fact, 25 per cent is meant to beapplied to a licensee’s gross profits.50

(Gross profits, again, represents thedifference between revenues andcost of goods sold. No deduction fornon-manufacturing overhead costsis included.) They criticize that ap-

plication because gross margin ig-nores a host of other relevant costs.Such analysts have concluded thatwhile the 25 Per Cent Rule is “simple”,“popular” and “easy to understand”, it“should be avoided.”51 Focusing ongross profits ignores “too many im-portant factors.”52

This criticism is specious, however,because the 25 Per Cent Rule is an al-location (or splitting) of operating prof-its. Explicit consideration is given toall of the costs, including non-manu-facturing overhead, that are neededto support a product or are driven bythe product. The Rule is not a split ofgross profits.

Furthermore, in their survey of li-censing executives, Degnan andHorton found that royalty ratestend to be 10 to 15 per cent of grossprofits.53 In other words, royaltyrates divided by gross margin issubstantially lower than 25 per cent.

In P&G Co. v. Paragon Trade Brands,54

the court cited testimony that theRule “is not really even useful as ageneral guide for deriving an ap-propriate royalty rate.”55 In part be-cause of that, the court wrote that it“will consider the [25%] Rule-of-Thumb analysis in determining theroyalty rate, [but] this approach willnot receive substantial weight.”56

Nonetheless, in its final royaltyanalysis, the court did write that“the [25%] ‘Rule-of-Thumb’ analy-sis provides an additional confirma-tion of the reasonableness of aroyalty rate of 2.0%.”57

A typical ‘rule of thumb’ … is for thelicensor to command 25% of the profit.While this … attempts to link the valueof the patent to the profitability of com-mercial exploitation, because it does notrelate to the value and degree to whichthe patent can exclude substitute prod-ucts and therefore command a patentprofit, it is little better than [an] ‘in-dustry norm.’ … Patented products addto [ ] economic profit the patent profittied into the ability of the patent to fur-ther exclude substitutes. … the portionof the total profit can vary greatly evenwithin a given industry. Adding thesevalues together, and multiplying by anarbitrary fraction to derive the value ofa patent is an exercise in arbitrary busi-ness analysis.43

According to Mark Berkman:[The 25 Per Cent Rule does] not take

into account specific circumstances thatwill determine the actual value of thepatent at issue. No consideration isgiven to the number or value of eco-nomic alternatives or the incrementalvalue of using the patented technologyover other viable alternatives.44

And Richard Toikka has ques-tioned whether, in litigation contexts,the Rule is reliable under Daubert v.Merrill Dow Pharmaceuticals45 andKumho Tire Co. v. Carmichael.46

The Rule, however, is one of manytools. Ultimate royalty rates oftenare higher or lower than 25 per centof fully-loaded product profits, de-pending upon a host of quantitativeand qualitative factors that can andshould affect a negotiation (or liti-gation). Even critics of the Rule haveconceded that, despite its “crude-ness”, it retains “widespread en-dorsement and use”.47 Part of thatis due to its simplicity and part ofthat is due to self-fulfilling proph-ecy (because of its simplicity, it hasbecome a norm and, because it is anorm, it is used over and over

43. Schaafsma, pp. 251-52.44. Mark Berkman, Valuing IntellectualProperty Assets for Licensing Transactions,22 The Licensing Journal 16 (April 2002).45. 509 U.S. 579 (1993).46. 526 U.S. 137 (1999).47. Schaafsma, p. 252.

48. Russell L. Parr, Intellectual PropertyInfringement Damages: A Litigation SupportHandbook 171 (1993).49. Robert Goldscheider, Litigation Back-grounder for Licensing, 29 les Nouvelles 20, 25(March 1994).50. Parr, p. 169. Berkman, p. 16. Gregory J.Battersby & Charles W. Grimes, LicensingRoyalty Rates: 2002 Edition 4-5 (2002).

51. Parr, p. 169.52. Parr, pp. 169-171.53. Degnan and Horton, p. 95.54. The Procter & Gamble Company v.Paragon Trade Brands, 989 F. Supp. 547 (D.Del. 1997).55. The Procter & Gamble Company v.Paragon Trade Brands, 989 F. Supp. 547, 595(D. Del. 1997).56. The Procter & Gamble Company v.Paragon Trade Brands, 989 F. Supp. 547, 595(D. Del. 1997).57. The Procter & Gamble Company v.Paragon Trade Brands, 989 F. Supp. 547, 596(D. Del. 1997). The expert’s “Rule-of-Thumb” analysis obtained a range of 1.975Per cent to 2.6 Per cent.


Fourth, it has been asserted thatthe Rule is inappropriate to use inthose instances in which the IP atissue represents a small fraction ofthe value residing in a product. Theauthors are sympathetic to the criti-cism. However, both the conceptsunderlying the Rule as well as theempirics supporting it recognize theflexibility of the Rule. The precisesplit should be adjusted up or downdepending on a host of factors, in-cluding the relative contribution ofthe IP at issue. Relatively minor IPoften should (and does) commanda split of profits lower than rela-tively important IP.

A final criticism of the Rule is thatit provides a rough or imprecisemeasure of incremental benefits. Acomplete (and accurate) incremen-tal analysis is preferred. None of theauthors disagree. The Rule often isan adjunct to other valuation meth-ods. And it is particularly usefulwhen helpful data on incrementalvalue are unavailable or limited.The 25 Per Cent Rule is a startingpoint to apportioning the profits.William Lee, both a critic and pro-ponent of the Rule, has noted:

…in most instances the rule-of-thumb of approximately 1/4 to 1/3 ofthe licensee’s anticipated profit to goto the licensor is a good starting placefor negotiations. Whether or not an-ticipated profit is expressed duringnegotiations, the effect of royalty onprofitability should certainly be in theminds of the negotiators on both sides.My experience, and apparently the ex-perience of others, tends to show thatmost successful licensing arrangementsend with royalty levels in this range.However, like all rules-of-thumb, cir-cumstances alter cases.58

Empirical Test of the RuleTo test the validity of the 25 Per

Cent Rule, we attempted to com-pare royalty rates from actual licens-ing transactions with the expectedlong-run profit margins of the prod-ucts that embody the subject IP. Wewere able to gather royalty rate data

from thousands of actual licensingtransactions.59 Because of the confi-dentiality of these licenses, alongwith a lack of access to expected (oractual) product profit rates, we wereunable to undertake a direct com-parison of product profit and roy-alty rates. We, therefore, examinedprofit data for two surrogates — lic-ensee profits and “successful” lic-ensee profits.

With the first proxy, we examinedthe profits for those firms in eachindustry that were involved in li-censing transactions. We used thoseprofit rates as a proxy for expectedlong-run product profits.

With the second proxy, we exam-ined “successful” licensee profits.We defined as “successful” those lic-ensees in the top quartile in their re-spective industries in terms ofprofitability. Presumably, these maymore accurately reflect the kind ofprofit rates that are generated byproducts that embody valuable IP.

For both proxies, we comparedmedian (or middle of the range) in-dustry royalty rates to weighted av-erage profit rates. Although weconsidered comparing medianroyalty rates to median profit rates,for some industries, median profitrates differed substantially fromweighted average profit rates due,at least in part, to the presence of asignificant number of small, start-up firms earning negative profitmargins. Given that the negativemargins earned by start-ups maynot be indicative of expected long-run profits, we examined weightedaverage profit margins (which givesthese negative profit margins rela-tively less weight).Royalty Rates

To obtain information regardingroyalty rates observed in actuallicensing transactions, we used

information provided by Royalty-Source.com, a searchable databaseof intellectual property sale and li-censing transactions, containing in-formation spanning the late 1980sto the present. From RoyaltySource,we obtained summaries of all avail-able licensing transactions involv-ing the following fifteen industries:

• Automotive• Chemicals• Computers• Consumer Goods• Electronics• Energy and Environment• Food• Healthcare Products• Internet• Machines/Tools• Media and Entertainment;• Pharmaceuticals and Biotech-

nology• Semiconductors• Software and• Telecom60

These licenses involved a varietyof payment terms — lump-sum, feeper unit and running royalties onsales. For ease of comparison, weconfined our analysis to the 1,533licenses that involved running roy-alties on sales.61

Figure 3 shows on an industry-by-industry basis, the information weobtained from RoyaltySource. Wehave reported minimum, maximumand median royalty rates. The me-dian royalty rate across all indus-tries was 4.5 per cent, thoughmedian rates ranged from a low of2.8 per cent to a high of 8.0 per cent.Industry Profits

We obtained financial informa-tion for the fifteen industries included

58. Lee, p. 2073.

59. We were unable to gather (or evaluate)information from proposed transactions thatwere never consummated. Presumably, inthose instances, IP sellers were asking formore than IP buyers were willing to pay. Wehave no a priori reason to think, however, thatexclusion of such “data” biases our results.

60. RoyaltySource database tracks licensingtransactions for other industries as well. Theindustry categories used here were developedby the authors and are somewhat differentthan the internal classification system usedby RoyaltySource.61. Data available to us from RoyaltySource.comdid not allow us to easily convert lump-sumor the per unit royalties into royalties perdollar, which terms were needed for testingour hypothesis. As a result, we excludedthose observations from our analysis. Wehave no a priori reason to think, however, thatexclusion of such data biases our results.


in our analysis from Bloomberg. TheBloomberg database provided fi-nancial data for the period 1990through 2000 for 6,309 companiesincluded in the fifteen industries un-der consideration. Figure 4 reportsboth the average operating profitmargin for each of the industries.Licensee Profits

Because total industry profits arenot a particularly close match toroyalty rates covering a limitednumber of companies, for our firstanalysis, we examined profitabilitydata for only those companies thatwere identified as licensees in thelicensing transactions database. Fig-ure 5 reports weighted average op-erating profit margins for each ofthe industries.Royalty Rates and LicenseeProfits

A comparison of royalty rates andlicensee profits provides some sup-port for use of the 25 Per Cent Ruleas a tool of analysis. Across all (15)industries, the median royalty rateas a percentage of average licenseeoperating profit margins, as shownin Figure 6, was 26.7 per cent. Ex-cluding the media & entertainmentand internet industries, the range

among the remaining industriesvaries from 8.5 per cent for semicon-ductors to 79.7 per cent for the au-tomotive industry.

In spite of the variation across in-dustries, the majority of industrieshad ratios of royalty rates to licenseeprofit margins of 21 to 40 per cent.Figure 7 shows a distribution of theratios across industries.Successful Licensee Profits

We also examined profitabilitydata for “successful licensees.” Wedefined those to be licensees withprofit rates in the top quartile foreach industry. We used these profitrates as a further-refined surrogatefor projected product profit rates.Royalty Rates and SuccessfulLicensee Profits

A comparison of royalty rates andsuccessful licensee profits appearsto, again, provide some support foruse of the 25 Per Cent Rule. Asshown in Figure 8, across all indus-tries, the median royalty rate as apercentage of average operatingprofits was 22.6 per cent. Excludingthe media and entertainment indus-try, for which only limited data wereavailable, the ratios range from alow of 7.8 per cent for the semicon-

ductor industry to a high of 48.0 percent for the internet industry.

Figure 9 reports the ratio distri-bution across industries and showsthat, again, the majority of indus-tries have ratios of royalty rates tosuccessful licensee profit margins inthe 21 to 40 per cent range.Conclusions

An apportionment of 25 per centof a licensee’s expected profits hasbecome one, of many, useful pric-ing tools in IP contexts.62 And ourempirical analysis provides somesupport for its use.

A comparison of royalty rateswith two proxies for expectedlong-run product profits (namely,licensee profits and “successful”licensee profits) yields royalty toprofit ratios of 27 per cent and 23per cent, respectively.

Although the data support theRule generally, there is quite a varia-tion in results for specific industries.As this variation makes clear, theRule is best used as one pricing tooland should be considered in con-junction with other (quantitativeand qualitative) factors that can anddo affect royalty rates.

62. Razgaitis, p. 118.


Based on a speech given by BennyBrowne at the LESI Conference, Osaka,Japan, on April 7th, 2002.

T his paper looks at brainpower and human relationsand how we can effectively

capture the brain power and how wecan use it for the benefit of mankind.So brain power, use it or lose it.

Over the last ten years we haveseen an enormous shift in impor-tance from tangible assets to intan-gible assets. For example, you’veseen people like Microsoft with amarket capitalization of many bil-lions of dollars, but when you actu-ally look at their hard tangible assetsthey are around 30% of the total soyou’ve seen a moving from tangibleto intangible assets.

There’s been a move from domes-tic to international focus through toglobal focus and from tangible as-set backed economies through to in-formation economies and that’sabout where we are now. So how dowe work with this and what do wedo about it?

Everybody knows that you canidentify and protect the traditionalintangible assets such as patents andtrademarks and copyrights to a cer-tain extent, but it’s much more dif-ficult to protect what is in the headof the knowledge workers, as theyare called.

I’d like to have a look at effectiveways of protecting the knowledgeand ensuring that the investmentin the workers’ heads is not lostto competitors.

A great Australian, Rupert Murdoch,the Executive Chairman of NewsCorporation, in October last year,gave the Inaugural Keith Murdochoration in Melbourne. His speech

Brain-Power—Use It Or Lose It!

BY BENNY BROWNE*

*Benny Browne is a partner in GriffithHack, Melbourne, Victoria, Australia.

was entitled, “Brain Power ShakeUp Urged.” You may think that thisapplies to Australia alone, but itdoesn’t. It really applies across theboard. This is what he said:

“Australia is steadily slipping inthe current race to create and attracthuman capital. We must realize thatthe financial assets of any countrycomprise less than 30% of the na-tional balance sheet. According tothe world’s foremost social scien-tists, 70% of the real value of anysociety lies in its human capital. Thekey to the future of any country isnot in its physical resources or in-dustrial capital, rather it is the hu-man capital which will fund thehealth and growth of nations in thenext 100 years.”

So having become very philo-sophical, let’s have a look at whatI’d like to cover. I want to have alook at:

What brain power is, or what I callbrain power.

• Why it’s important today.• How best to manage it.• Employer/employee loyalty.The problems that we have today

with accounting standards whichdon’t allow us to capture brainpower in balance sheets are:

• How you actually harness it,• How you protect it; and• Some emerging Australian

trends in the law as far as pro-tection is concerned.

Intellectual capital is what we aretalking about and it’s made up re-ally of four elements. They are:

• Brain power (which somepeople call human capital),

• Structural capital - for example,patents, trade marks,

• Customer capital, and• Other capital.To emphasize the importance of

Intellectual Capital I will relatewhat was told to me by the Chair-man of a public company, GeoffBrash, many years ago: The fourmost important things in a success-ful company are the shareholders,the customers, the suppliers andthe staff. In order to maintain thesuccess of the company, equal atten-tion must be paid to all four. WhatGeoff was saying, in essence, is thatwithout people a company couldnot be successful.

Brain Power consists of:• Competencies (your staff competencies), skills;• Knowledge and experience and

in particular how they havebeen applied to create valuefor others;

• What’s in the mind of the knowledge workers.Some years ago I was invited to go

to the Toyota factory in Melbournewhich is an enormous factory. It takesabout 3 hours to get around thewhole factory. The man who wasgoing to take us around the factorywas a retired employee and hadbeen with the company for some-thing like over 40 years. He hadnever had any position of extrememanagement responsibility, he hadbeen somebody who had workedhis way up but had never got to thevery top. And his job now was totake international and other visitorsaround the Toyota factory. I asked


my host, “Why is this man doingthis job?” and he said, “Because hehas been around for 40 years, heknows everything there is to knowabout this factory.” This is corporateknowledge at its best. It’s somethingwhich is being used in the best waypossible because this man can tellyou everything that’s happened inthe factory, how it has grown, whatthey do there, the introduction of ro-botics, etc. It’s really something veryimportant and Toyota saw it andpicked it up and worked with it.

Structural capital encapsulatesmethods that have been developed,systems and processes and personalnetworks. Karl Sveiby, a famouswriter in this area, describes struc-tural capital as that which is left af-ter the employees go home for thenight. So when the factory is empty,what’s left is the structural capital.

One of the biggest industries inthe world today, franchising, makesextensive use of structural capital.It is based around the licensing ofsystems, trade secrets and trademarks. But its principal focus is inthe licensing of systems.

Customer capital comprises thenumber and depth of personal cus-tomer relationships. These give riseto an organization’s reputation. Areference written by a customer ofan organization is always morevaluable than a reference written bythe organization itself. Shakespeare,in the play “Othello,” puts thesewords into the mouth of the charac-ter Othello: “He who steals my pursetakes nothing. ‘Twas mine, ‘tis his andhas been slave to thousands. Yet hewho robs me of my good name takesthat which not enriches him butmakes me the poorer indeed.”

And then there is other capitalsuch as things which we can’t touchbut we can identify them and see inthe form of patents, etc.

Question: So why is brain powerimportant?

Answer: Because it delivers re-sults and the results are what yousee around you in your office.

If your offices were stripped ofpeople there wouldn’t be one iotaof worth in the chairs and all the

other things. What’s in your officeis extremely important.

There is a Columbian universitywhich has conducted a study andthey say that the spending on intan-gible assets like R & D and em-ployee education results in areturn of 800% greater than anequal investment in new plants andequipment. Why? Well, new ma-chinery only allows incrementalimprovements but R & D and em-ployee education leads to innova-tion that creates revolutionary ideas.

There’s a body called the Confer-ence Board which has conducted asurvey of 200 senior executives, andthis survey shows that 80% of com-panies have some knowledge man-agement efforts under way. 60% ofthese senior executives use knowl-edge management enterprise wideand 60% expect to in five years, soit’s an increasing trend. Twenty fivepercent have a Chief KnowledgeOfficer or a Chief Learning Officerand 21% have a communicatedknowledge management strategy.

They have also reported the fol-lowing gains from KnowledgeManagement. Buckman Labs hasincreased its new product sales by50%, Dow Chemical has saved 40million dollars a year in the re-useof patents - they did a huge patentaudit and brought about this enor-mous amount of revenue saving.Ford Motor Company and BPAmoco saved more than US$600million in the past three years byemploying knowledge managementtechniques. Hewlett Packard re-duced its cost per call by 50%. RankXerox reduced its dispatches by15%. Roche can send out its prod-ucts for FDA approval six monthsfaster and Sequent registered 10%higher sales for new sales reps after6 months.

You’ll see adverts in the papersthese days, “Knowledge OfficerSought.” I saw one last year for avery big research and developmentcorporation in Australia called theCSIRO - they were advertising for aKnowledge Officer.

There is a body called Best Prac-tices LLC in the United States. Theysay that this is what ought to be hap-

pening: formally define the role ofknowledge in your business and inyour industry. All of us know it’sthere, but nobody has defined it.Understanding what knowledge inthe company is will allow you tofocus on finding and capturing in-tellectual capital and that will allowthe company to excel above others.

Divide the intellectual capital intothe strategic areas, for example:

• Brain Power,• Structural capital,• Customer capital, and• Other capital.Develop management systems

to assist in benchmarking efforts.You need to be able to measurethings because what gets mea-sured gets managed.

Turning next to the employer/em-ployee relationship. Employees arethe key to success to a company’s ex-ponential growth.1 It is absolutely es-sential to have employee/employerloyalty. Some years ago I was listen-ing to an audio tape of David Suzukiwho, most of you know, is the famousenvironmentalist and philosopherbased in Canada. He said a strikingthing, and I thought, this guy is good.He said, “Why is it that in our uni-versities we teach mathematics,we teach science, we teach arith-metic, reading and writing and yetnobody teaches relationships?”

In our lives we have constant re-lationship interactions with ourfamilies, with our outer families andwith other people, but nobodyteaches anybody how to relate. Andas a result, my bet is that therewould be a lot less dispute and warand so on in the world if relation-ships were better taught.

Bad employees, as everybodyknows, can cause a business to fail.Choosing an employee is somewhatlike choosing a house. When onechooses an employee, the interviewlasts perhaps an hour. When onechooses a house, the inspection lasts

1. Deal Consulting, “Creating EmployeeLoyalty.”


perhaps an hour. After that hour, onboth occasions, we make up ourminds as to whether to proceed ornot. People get employed it’s likebuying a house. Yes, in the employ-ment situation, there are things likesix months probation, but if therewere a better strategy to assess whatyou are taking on, the end resultwould be much better. It’s like amarriage, you need to know withwhat you are getting involved.

Bad employees obviously cancause businesses to fail and we’veseen that. I won’t mention anynames, but a very large accountingfirm in America springs to mind.

Mediocre employees. Well, thereare lots of people who fall into thiscategory. As Spike Milligan oncesaid, “In the army all you have todo is walk around with a broom inone hand and a piece of paper in theother and nobody will ask you whatyou are doing because you seem tobe employed.”

Good employees can really makea business go through the roof.

Now how do you keep the bestemployees in your business? Well,pay is something which is very im-portant, but it is not always the mostimportant. One of our employees inour law firm was working fromhome, he had a wife and a verysmall child and he wanted to spendtime with them. His productivity,when measured against his work atthe office, was much higher than ithad been before. He was at home inthe morning to play with his child.At ten in the morning, when thechild went back to sleep, he startedwork. Through a staggered work-ing hour day it turned out that hewas working many more hours andmuch more productively fromhome than he had been when work-ing all day at the office. So pay isn’talways the most important thing.It’s only a benchmark to value anemployee’s worth. It is important tonote, however, that wages belowmarket rate result in bad employ-ees. You get the worst employeesout of the pool.

Benefits provided by a companyoperate in a similar way to wages.

Some years ago I visited a companyin Australia called Southern DentalTechnologies. I was being shownaround the plant and talking to theManaging Director and asked him,“How do you keep the people inyour R & D section, you know youare in a very competitive business,what do you do to keep thesepeople?” And he said to me, “Youknow we sign confidentiality agree-ments, but they’re as good as thepaper they are written on. If some-body really wants to get out thereand break up your business, theywill.” And I said, “What do you do?”And he said, “We treat our employ-ees very well.” In this respect thebenefits provided by a company toits employees forms part of thisquestion: “How do you treat youremployees?” You’ll have to matchyour competitors, that’s obvious. Ifyou don’t, you’re not going to keepthe people.

Training. Training today is veryimportant because things are chang-ing so fast in the world, we’ve gotto have continuous training whichis dynamic and is exponential andallows employees to feel as thoughthey are climbing the career lad-der. The training shouldn’t be lim-ited to just technical sorts of jobskills, but it should be wider. Itshould include items such as likeforeign languages, computers andother types of courses, which in awider life sense will make the em-ployees better employees.

A learning environment wherepeople feel mentored. In a lot of thelaw firms, and I can really speakabout law firms because, as I saidbefore, I am a lawyer. There are em-ployees who, when you talk tothem, will say, “I really feel greatabout working here because I, as ajunior person, get to work with apartner and I really feel great aboutbeing in this company because I aminvolved in what’s going on. I getto work with the managers.”

Career plans. Obviously there aresome places where they’ve got ca-reer plans for their lowliest work-ers right the way through.

Evaluations and reviews. Now

these are very sensitive issues andsometimes they can cause a lot ofdamage, but they must focus on theindividual and how they fit into thecompany and not so much on whatthey are doing wrong. It’s not an-other one of those “OK, lets bashher/him” sessions. The reviewsshould be used as a method to keepgood employees and not to weedout bad ones.

Regular business meetings. Iknow of some firms which havemeetings where every one of the le-gal secretaries are brought into themeetings as well because they havea lot to contribute - they are impor-tant people. I have always main-tained that the garbage man whocomes around the streets early in themorning removing the garbage isone of the most important people,because without him we wouldhave this garbage stacked up every-where. Everybody in the whole chainis very important and they need toknow that, and they need to feel thatthey are very important. And obvi-ously if you recognize and rewardgood work, your employees are cer-tainly going to appreciate what youare doing for them and with them.You’ve got to provide good workingconditions because without goodworking conditions people will seethe green on the other side of thefence and will leave.

Now, I was talking about the ac-countancy problem before. Therehas been a move worldwide, glo-bally to allow human capital to berecorded on balance sheets of com-panies. I know a chap called SamKhoury, he is a LES member. He wasworking with Dow Chemical andhe did his doctorate on the valua-tion of what is in people’s heads.Being able to value what is inpeople’s heads is one thing, how-ever, unless that valuation can ap-pear on the balance sheet as anasset, it is worthless from a finan-cial point of view. Global account-ing standards are trying to get togrips with this but I don’t believe itwill happen in my lifetime. Thereare too many things which will miti-gate against it. In Canada there hasbeen the strongest push to try and


have this happen but even theyhave struck a blank wall.

Why have Brain Power valued onthe balance sheet? Because you cango to the bank and say, “I’ve got thisasset, I want a leverage against it.”Or, “I’m selling my company, I havethis asset and you will get the em-ployees, you will get the people togo with it.”

Harnessing it? Well, you heard itsaid before that intellectual prop-erty audits are valuable in identify-ing and harnessing brain power.However anecdotally, corporationsand government bodies pay verylittle attention to what the people dowithin the organization. By usingthe intellectual property audit it canbe pointed out to management whatthe corporation or governmentbody has in the form of brainpower, that it is an important as-set and that it must be nurtured.If a company develops a knowl-edge management system, it willcertainly help in harnessing it andbringing it to account. Obviously,if we could introduce new globalaccounting standards, that wouldbe great, but that’s on the wish listand it’s not something which is go-ing to happen over night.

Protecting it. One of the ways ofprotecting it can be in the form ofrestraint of trade. Now restraint oftrade will be a term familiar to thelawyers. All it means is that you sayto an employee you may not go outand work with a competitor for aperiod of time in a certain area.Those restraints are, in the westernworld at least, illegal and they canonly be made legal if they are rea-sonable in relation to how long,what geographic area and whattype of restraint it is. So there is away of protecting brain power, butit is still limited.

Restraining know-how. Now thisis a new phenomenon which hascome about over the last ten years.People in drafting contracts will tryand restrain know-how, and I mustsay that you will see later that thereis a trend where restraint of know-how is gaining some acceptance.

Garden leave. This is a really new

concept. For those of you who thinkthat it is something akin to gardengnomes in a garden, you are quiteright. It is paying an employee avery large sum of money to sit inhis or her garden and do nothing fora certain period of time. You will seelater that the Australian courts arewarming to this idea but it still hasnot met with total acceptance by theCourts. These trends through thecases show the following:

In 1972 there was a British case2

where a man was paid ten pounds,not to go out and compete. Withoutany hesitation the court just said,no, you can’t do it, you cannot tryand restrain a person from earninga living even though you have paidhim some money, it doesn’t washwith us, it is something you are notallowed to do. And the real irony inthis case was that the employee, af-ter the court ruled that he couldn’tbe restrained, sued the company forhis ten pounds because he said thatit still owed him the money eventhough he couldn’t be restrained.

There was a case in Australia in19913 which involved a companywhich was dealing with Taiwan.The company had an employeewhom they had signed up on anagreement that he wasn’t going tobe allowed to disclose the customerlists. Well the usual happened, andit happens all the time - he left thecompany and within a short time hejoined the competition and he hadall the information at his fingertips.His previous employer sued himand the company who was employ-ing him, alleging that the employeehad breached confidentiality. TheCourt held that it would allow a re-straint but for reasons which are notimportant here. There was an Act ofParliament in New South Waleswhich hadn’t been complied withproperly, so they didn’t enforce therestraint, but they were coming tothe view that this was a reasonabletype of thing to do, to protect thecompany’s goodwill.

In 1997 you had a similar type ofcase of Kone Elevators4 where a per-son who was a sales person withinthe company moved to anothercompany. Just before he left Kone,Kone scheduled the release of brandnew products which was attendedby the employee. Kone alleged thatthe employee knew exactly whatthose products were, having beeninvolved in the briefings. Further-more, the employee’s employmentwith a competitor would result indamage being suffered by Kone,were the ex-employee to divulge allthe new product information to thenew employer. The court held that,but for the fact that Kone had failedto comply with the New SouthWales Restraint of Trade legislation,it would have granted a restrainingorder. So the court there was say-ing if you had complied, we wouldhave allowed you to restrain him inthose circumstances.

The next case was one of ArnottsBiscuits.5 Arnotts is a very big bis-cuits manufacturer in Australia. TheManaging Director of Arnotts hadleft and he had been paid some-thing like one and a half times hisannual salary not to go and workfor a competitor. He left and,within the restraint period, joinedWeston Biscuits. Within days ofhim joining Weston, Arnotts wentto court seeking an injunction on thebasis that they had paid a signifi-cant amount of money so that theformer managing director wouldnot join a competitor. The courtwouldn’t stop the man from goingto Weston for reasons which are notimportant, but obiter the court com-mented that the concept of gardenleave was not a bad idea. If some-body has been paid a lot of moneynot to go and work then that per-son oughtn’t go and work, and thecourt stated that it would have en-forced this particular contractagainst the employee if the condi-tions in question had been compliedwith. Apparently he had signed up

2. Howard Hudson, 1972.3. Wright v. Gasweld, 1991.

4. Kone Elevators, 1997.5. Arnotts v. Weston, 1999.


for this deal with Arnotts during hisemployment rather than after hisemployment, so it seemed to be partof his employment contract andtherefore didn’t fall within the rea-sonable restraint.

The very last case is one which isa very recent case in Australia.6 Itwas a decision of the full FederalCourt. A confidentiality agreementwas challenged in the court as a re-straint of trade. Earlier we weretalking about trying to protectknow- how by confidentialityagreements. This confidentialityagreement had no ending date andwas completely disallowed by theCourt as an unreasonable restraintof trade. When the confidentialityagreement was read in a broadersense, the employee was to be re-strained from working at any timeand the court disallowed this. Yetthe Court indicated that restraintswhich are reasonable will be al-lowed, and really what’s reasonableis what is reasonable in the commu-nity at any given time.

The emerging trend in Australiaseems to be that the courts are com-ing to the view that garden leavemay well be an acceptable practiceand that know-how is not able to berestrained indefinitely through themedium of a confidentiality agree-ment. In my view, however, it is stillgoing to take a long time before weget to some decision which actuallypoints to garden leave and con-cludes that it, in itself, is satisfactory

So, in conclusion let me say thatI’ve taken you through some phi-losophy, taken you through a bit oflaw, and taken you through someadvice. In the end, if you don’t useyour brain power you will lose it.

6. Maggbury v. Hafele, 2001.


The world of licensing professionals is changing, withmore documentation and

analysis being required to arrive atthe values of intellectual property,especially for “In Process” R&D. Thisarticle will highlight some of the keypoints from the American Instituteof CPA’s (AICPA’s) Practice Aid,Assets Acquired in a Business Combi-nation to be used in Research and De-velopment Activities: A Focus inSoftware, Electronic Devices, and Phar-maceutical Industries.

Since the Enron scandal broke, au-ditors have been exercising extremecare when auditing a client’s finan-cial statements. In particular, audi-tors are examining off-balance sheetliabilities and the fair value measure-ment of assets included in the finan-cial statements more scrupulously.Although the fallout from the Enronscandal highlighted problems in fi-nancial reporting, other develop-ments have contributed to theperceived need for greater scrutinyin the financial reporting process.These other developments include:

•Changes in generally acceptedaccounting principles (GAAP) ap-proved in June 2001 – the Statementof Financial Accounting Standards(SFAS) 141, Business Combinationsand SFAS 142, Goodwill and IntangibleAsset Impairment;

•Changes reflected in SFAS 144,Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assetsto be Disposed of;

•The current Financial Account-ing Standards Board (FASB) projectconcerning the application of SFAS141 and 142 to non-profit organiza-tions; and

•The release of the AICPA’s Au-diting Standards Board exposuredraft of new auditing standards re-

New Guidelines ForValuing “In Process” R&D

BY TERRY ALLEN, JIM RIGBY AND RIZVANA ZAMEERUDDIN*

*Terry Allen, CPA/ABV, ASA and JimRigby, CPA/ABV, ASA are both Manag-ing Directors of The Financial ValuationGroup and are located in Kansas City,MO, and Los Angeles, CA, respectively.Rizvana Zameeruddin, MST, JD is a CPA,currently working on her LLM in tax, andteaches part time at DePaul University'sSchool of Accountancy.

lated to “fair value measurement.”The FASB is working on the ap-

plication of SFAS 141 and 142 prin-ciples to non-profit organizations.Research institutions, such as hospi-tals and universities, create and licenseintellectual property. Complicated is-sues arise from transactions involv-ing licenses for this intellectualproperty. The goal of this FASB projectis to clarify these complicated issues.

In January 2002, the AICPA’s Au-diting Standards Board released anexposure draft of new auditing stan-dards related to Auditing Fair ValueMeasurements and Disclosures. Thisexposure draft provides guidancefor auditing fair value measurementsand financial statement disclosures.“Fair value measurement” is the tech-nical accounting term for the valua-tion of intangible and tangible assetsfor financial reporting purposes.

On December 17, 2001, the AICPA,in conjunction with the Securitiesand Exchange Commission (SEC),released the AICPA’s Practice Aid,Assets Acquired in a Business Combi-nation to Be Used in Research and De-velopment Activities: A Focus inSoftware, Electronic Devices, and Phar-maceutical Industries. This PracticeAid devotes one chapter to valuing“In Process” R&D and, more impor-tantly, one chapter to auditing thevaluation of “In Process” R&D. Pre-viously, auditors only had to exam-ine the credentials of the valuationexpert. Now, this Practice Aid re-quires auditors to audit the valuationof the purchased R&D before they is-sue an opinion on the company’s fi-nancial statements.

Non-U.S. based readers are mis-taken if they believe that thesechanges do not affect them as well.The AICPA’s exposure draft – Au-diting Fair Value Measurements and

Disclosures – issued on January 15,2002 incorporated the InternationalFederation of Auditors’ exposuredraft on Auditing Fair Value Measure-ment issued in October 2001. A finaldraft of the international statementon fair value measurement will beissued by the end of this year andwill probably be adopted by the Eco-nomic Union in 2003. Fair valuemeasurement will clearly be an im-portant international issue in theimmediate future.

What does all this mean to man-agement? First, management musthave a better understanding of“value” in various situations, suchas buy/sell agreements, litigation,and financial reporting. Manage-ment also must have a better under-standing of who will be using thefair value measurements and whattheir different needs are. The usersof this information will include buy-ers, licensees, litigants, investors,regulators, and others. Second,when “research assets” are valuedfor financial reporting purposes,management can expect thoroughanalysis of internal financial records,memorandums, reports, projections,and other company representations.Furthermore, the valuer and auditorwill have extensive information re-quests (see Practice Aid, Exhibit 1 –Patent Information Request List).


Consequently, management willbe required to provide documenta-tion of their assumptions and claims.Financial record keeping will bemore extensive and the quality ofthese records will have to improve.Management will need to ensurethat their articles, presentations, re-ports, and revenue and cost projec-tions are consistent when presentedto different parties. They will haveto review the assumptions and pro-jections of external valuation ex-perts thoroughly.

The AICPA’s Practice Aid will af-fect the way management and re-search staff carry out their normalwork activities. Designed to be a“best practices publication,” thePractice Aid will affect valuationprocedures and methodology re-gardless of how value is defined. Thebiggest change dictated by the Prac-tice Aid is the requirement that au-ditors audit the valuation work,supporting values appearing in thefinancial statements. Previously, un-der SFAS 73, The Use of Experts, theauditor was merely required to ex-amine the valuation expert’s qualifi-cations and experience. Now auditorswill be required to do more researchwhen engaging experts. This addi-tional work will almost certainly re-sult in higher standards. The PracticeAid discusses the various docu-ments to be examined when the “InProcess” R&D is valued. It also in-cludes a sample valuation reportthat company management cancompare with the reports providedby valuation experts.

The Practice Aid highlights variousvaluation methods for “In Process”R&D, particularly, the relief-from-roy-alty method, the multi-period excessearnings method, and real optionmethods. The relief-from-royaltymethod discounts to a present value,the payments which would be re-quired if the R&D we re licensedfrom an outside party. Because thecompany owns the R&D asset, it hasthe right to manufacture and to sellproducts that incorporate the R&Dwithout having to pay a royalty feeto the developer. Avoiding a streamof royalty payments represents fu-ture cash savings, which have value

to the company. “A relief-from-roy-alty method may be appropriate forcertain categories of intangible assets.Trademarks and trade names, pat-ents, developed product technology,and base (or core) technology are allcategories of identifiable intangibleassets that frequently are licensed inexchange for a royalty payment.”1

The Practice Aid indicates that therelief-from-royalty method wouldrarely be appropriate in the valuationof specific “In Process” R&D projectsbecause royalty rates on similarprojects are seldom available.2 Themethod would be appropriate in cer-tain cases, such as the following:

•When the identifiable intangibleasset makes a contribution to thecompany’s cash flows that is com-parable to that made by a compa-rable licensed asset;

•When the identifiable asset canbe separated from other assets andit is practical and possible to licenseit separately;

•When the rights of ownershipcan be reasonably compared to therights under a license; and

•When the verifiable objective in-formation regarding royalty ratescan be obtained.

The second valuation method spe-cifically discussed in the Practice Aidis the multi-period excess earningsmethod. The multi-period excessearnings method is a specific appli-cation of the discounted cash flowmethod under the income method.3

It is known by various other namesincluding the discounted incremen-tal earnings method. This method isthe most common method used byvaluation experts in determining thefair value of intangible assets.

The principle behind the multi-period excess earnings method isthat the value of an identifiable in-tangible asset is equal to the presentvalue of the incremental after-taxcash flows attributable to that intan-gible asset.4 The net cash flows at-

tributable to the subject asset arethose in excess of fair returns on allthe other assets that are necessary tothe realization of the cash flows (thecontributory assets). These assets in-clude not only assets purchased inthe subject transaction, but also allassets required to realize the cashflows. The acquiring company mayalready own some of these assets ormay need to purchase them in sepa-rate transactions, if they are neces-sary to generate the expected futurecash flows.5

The real option method is the thirdmethod discussed in the PracticeAid. Although this method has notyet become widely accepted andapplications have not been standard-ized, interest is growing. The Prac-tice Aid indicates that real optionmethods are expected to supplementthe multi-period excess earningsmethod in the future.6

Real option methods have begunto achieve acceptance as a superiormethod for evaluating incomestreams subject to both uncertaintyand choice. In the discounted cashflow method, for example, whenusing very high discount rates (usu-ally with early stage research projectcash flows), the negative cash out-flows occur at the beginning of theestimation period (in which thepresent value interest factor is stillrelatively significant), and the posi-tive cash flows occur at the end ofthe estimation period (in which thepresent value interest factor has be-come exponentially lower), thus of-ten resulting in negative presentvalues. Management often will stillinvest in those projects because theyhave the choice either to stop invest-ing or to continue investing basedon either failing to reach, or reach-ing and exceeding certain targets atcertain time-based milestones. Theyare still willing, however, to investsmall amounts in a portfolio ofprojects (which can be discontinuedmidstream) in anticipation of the

1. AICPA Practice Aid, P. 13.2. Ibid, P. 14.3. Ibid.

4. Ibid.5. AICPA Practice Aid, P. 14.6. Ibid, P. 15.


occasional large return. A tradition-based observer might conclude thatmanagement has acted irrationallyto invest in a project with negativenet present value, while emergingtheory might suggest that the dis-counted cash flow method is accu-rate or incomplete when used in acircumstance of high risk and mul-tiple choice-points in the future.7

The use of real option methods hasyet to be embraced as a valuationtool, and although it deserves amention, the level of standardiza-tion among practitioners has not yetreached a point for inclusion in thePractice Aid.

The Practice Aid takes the positionthat intangible asset fair valuesshould include the present value ofthe expected tax payments made bythe asset’s owner and the tax ben-efits resulting from the amortizationof that intangible asset for incometax purposes. This position is instark contrast to the common beliefby many professionals that the fairvalue of the intangible asset does notinclude the amortization benefit.The inclusion of the tax effects in thevaluation is common in the incomeand cost approaches, but not themarket approach.8

Guidelines for Rates of Return tobe used in the valuation process arealso provided in tabular form in thePractice Aid on page 92. The TaskForce believes that venture capitalrates are the most appropriate rates

to use for “In Process” R&D valua-tions and as such, venture capitalcontinues to be an important sourceof R&D funding. The task force iden-tified two publications that provideguidance about the rates of returncommanded by venture capital in-vestors at various stages of anentity’s development. Those twopublications are:

•Plummer, James L., QED Reporton Venture Capital Financial Analysis(Palo Alto: QED Research, Inc.,1987).

•Scherlis, Daniel R. and WilliamA. Sahlman, A Method for ValuingHigh-Risk, Long Term Investments: TheVenture Capital Method (Boston:Harvard Business School Publish-ing, (1987).

The Practice Aid also focuses onthe analysis of Prospective FinancialInformation (PFI). An auditor is re-quired to obtain an understandingof the business purposes for an ac-quisition sufficient to enable him orher to evaluate whether the account-ing is consistent with the businesspurpose. In order to obtain this typeof information, the auditor usuallytalks to the company’s CEO andCFO, however, the auditor shouldconsider further discussions withthe marketing personnel familiarwith the acquiree’s products andmarkets, and also the R&D, produc-tion, and business development per-sonnel who are familiar with theproducts and product developmentplans related to the acquired tech-nology in order to gain additionalinsight. The auditor’s inquiries ofthe marketing and business devel-

opment personnel should provideinformation about: base (or core)technology, historical and existingproduct lifecycles and changes involumes and average selling pricesover those lifecycles, future prod-ucts and dependency of future prod-ucts on base (or core) technology,management’s technology develop-ment plans, capabilities of person-nel to conduct R&D, markets servedby the company and those it wouldlike to serve, competitive conditions,and regulatory requirements.9 Thislist, although extensive, is not fullycomprehensive; it is intended onlyas a guideline for auditors to helpachieve the level of understandingof a company’s business and to helpdesign effective substantive audit-ing procedures. The very nature ofacquired “In Process” R&D estimateis such that virtually every scenariowill be unique to each company andeach industry.

The elements of the PFI that re-quire verification will likely containa lot of estimates and assumptionsmade by management. The informa-tion to be verified includes, but is notlimited to revenue, cost of sales,sales and marketing expenses, gen-eral and administrative expenses,technical support expense, R&D ex-pense, tax expense, required levelsof tangible assets, and required lev-els of intangible assets. If the valua-tion specialist does not feel that heor she has received enough supportfor a particular PFI assumption, then

7. AICPA Practice Aid, P. 15.8. Ibid, P. 96. 9. AICPA Practice Aid, P. 147.

Stage of Development

Start-Up

First Stage or “Early Development”

Second Stage or “Expansion”

Bridge/IPO

Guidelines for Rates of Return

Plummer

50% - 70%

40% - 60%

35% - 50%

25% - 35%

Scherlis and Sahlman

50% - 70%

50% - 70%

30% - 50%

20% - 35%


he or she should review other clientrecords as well as external sourcesto support each material assumptionunderlying the specific elements ofprospective financial information.10

In preparing their PFI, a funda-mental point for corporate manage-ment is to not include synergies forvaluation of “In Process” R&D.The Practice Aid states that syn-ergies unique to the combined en-terprise should not be used inestimating the fair value of anyasset (individual) acquired. Ad-justments to the selected PFI canbe accomplished by revising therevenue growth or cost savingsrates from those used in the selectedPFI to those of market participants.11

Of the synergies that need to beeliminated, there are three maintypes: cost synergies, revenue syner-gies, and income tax synergies. Sincesynergies should not be included inthe valuation of “In Process” R&D, thePractice Aid provides examples ofhow to eliminate such synergieswhen making a valuation.12

Example–Eliminating Cost Syner-gies. Company A acquired CompanyX in a purchase business combina-tion. Selling costs for Company X are40% of revenues, and the rate repre-sentative of performance of marketparticipants is 30% of revenues. Dueto the unique size and efficiency ofits distribution channel, selling costsfor Company A are 20% (also the rateused by Company A in its PFI alter-native that was used to negotiate thefinal purchase price). Selling costs inthe PFI would be adjusted up to 30%,the rate representative of market par-ticipants, to eliminate a synergy spe-cific to the acquiring company.

Example–Eliminating Revenue Syn-ergies. Company A acquired Com-pany X in a purchase businesscombination. Company X’s productcomplements Company A’s prod-uct. Upon acquisition, Company A’scombined product offering will be

unique in the market, and CompanyA believes that it can derive 10%more in revenues from both prod-ucts than it or market participantscould if they were to sell either prod-uct on a separate stand-alone basis.The PFI should exclude all revenuesattributable to Company A’s pre-existing product, and the incremen-tal 10% increase in revenues derivedfrom Company X’s product, whichresulted from having a combinedproduct offering.

Example–Eliminating Income TaxSynergies. Company A acquiredCompany X in a purchase businesscombination. Company A cur-rently does not pay income taxesbecause of large net operating losscarryforwards. Company A doesnot expect to pay income taxes inthe foreseeable future due to thesize of the net operating losscarryforwards. In the PFI thatCompany A provides to the valua-tion specialist for use in valuing cer-tain assets acquired to be used inR&D activities, management ofCompany A does not include anyexpected income tax payments re-sulting from the cash flows attrib-utable to the acquired assets. Inother words, in the PFI prepared byCompany A’s management, thepresent value of the expected futurecash flows attributed to the acquiredassets is the same on a pretax basisas on an after-tax basis because noincome tax payments are expected.

The Practice Aid goes on to list in-formation that would be useful inevaluating the PFI assumptions.Such information includes knowl-edge of the business, due diligencestudies, research report of analysts,market research studies, historicalexperience with new product devel-opment activities of the acquiringcompany, offering memoranda,board of director materials preparedin support of the acquisition, devel-opment progress subsequent to the

acquisition, and forecasts providedto lenders.13

The Practice Aid advises thatmanagement’s expectations shouldbe tested based upon internal bud-gets, technology developmentplans, materials presented to theboard of directors in support of theacquisition and other corporatedocuments, including website con-tent and press releases.14 Even withall the information gathered andanalyzed, additional analytic proce-dures may still be required, there-fore, the information developed inperforming the preliminary proce-dures set forth above should beused to tailor further substantiveprocedures and evaluate the reason-ableness of the results.15

As the auditors’ responsibilitiesincrease, they will require more in-formation from the owners or buy-ers and sellers of the “In Process” orcompleted R&D. The auditor shouldconsider whether the preliminaryvaluation is unreasonable consid-ering the knowledge of the acquir-ing company’s business and thebusiness purpose of the acquisi-tion. That consideration includesan assessment of whether the keyassumptions appear reasonablebased on the auditor’s knowledgeof the business and the “In Process”R&D projects.

There are newer, and more strin-gent requirements of licensing pro-fessionals including a trend towardsmore documentation and analysis toarrive at the values of IntellectualProperty especially “In Process”R&D. The AICPA Practice Aid helpsassist the licensing professional inbetter understanding these require-ments as they pertain to the valua-tion of “In Process” R&D. It isintended only as a guide however,and an in depth review of the Prac-tice Aid is highly recommended.16

10. AICPA Practice Aid, P. 72.11. Ibid, P. 75.12. Ibid. 13. AICPA Practice Aid, P. 152.

14. Ibid, P. 148.15. AICPA Practice Aid, P.148.16. The Practice Aid can be purchased on thewebsite www.CPA2Biz.com, AICPA’s jointventure.


Introduction

In the modern economytecnology has undoubtedlybecome an essential tool to en-

able a country to achieve a certainlevel of development. Investmentin technology not only enhancesand encourages scientific re-search but also makes the coun-try a more attractive market forforeign investments. In addition,technology development im-proves the quality and speed ofindustrial production constitutinga vital element for an emergingcountry like Brazil, enabling itproperly to supply its internal mar-ket and to face its internationalcompetitors. In this perspective,the selling, transfer or even “rental”of a specific technology throughthe so-called Technology TransferAgreements is seen in Brazil as animportant economic and commer-cial negotiation which must bothobserve the applicable laws and beregistered at the Brazilian Patentand Trademark Office (BPTO).

In Brazil, the acquisition of tech-nology from developed countriesis commonly used by national com-panies to make themselves morecompetitive and better able to facethe international market. Accord-ing to BPTO data base, in 2001 itsTechnology Transfer Board has reg-istered 2,020 technology agree-ments, representing 20 per centmore than the previous year. Thetotal amount of royalty remittancesabroad for technology transfer was11 percent higher in the year 2000than in 1999 when they reached theequivalent of US$1.987 billion. Ac-cording to the Brazilian CentralBank US$ 2.207 billion was remit-ted abroad in 2000 as a result oftrademarks, patents, franchise and

Technology Transfer In Brazil:A Guide To Licensing ForeignTechnology In Brazil

BY CLARISSE ESCOREL AND TARA PENNINGTON*

*Clarisse Escorel ([email protected]) is an associate attorney withMomsen, Leonardos & Cia, in Rio deJaneiro, Brazil.Tara Pennington is a law student fromUniversity of San Francisco School of Law,and spent a five-week internship withMomsen, Leonardos & Cia during Mayand June, 2002. This article takes into con-sideration changes in the law up to Au-gust 31st, 2002. The authors would liketo express their gratitude to Gabriel F.Leonardos, partner of Momsen, Leonardos& Cia, for his support in the conceptionand realization of this article.

other kinds of technology transferagreements.

The majority of agreements re-corded at the BPTO in the year 2000were technical assistance agree-ments basically in the fields ofchemical products manufacture(11%), metallurgic (10%) and auto-motive (8%). In 1998 and 1999 thescenario was not very different. Thegrowth of remittances for technicalassistance during the last decade canbe explained by the privatizationtrend that took place in Brazil andthe opening of the internal marketfor foreign investments mainly inthe telecommunication, transporta-tion, electricity and fuel sectors. Itis reasonable that the foreign inves-tor wants to bring technicians fromoverseas in order to implementproperly new methods and equip-ment. Nevertheless, it would not beaccurate to consider that in suchcase Brazil was acquiring technol-ogy from abroad. The genuinetransfer of technology may be veri-fied in agreements like a trademarkand patent license agreements aswell as technology supply and fran-chise agreements wherein there is atraining and learning process bylocal technicians.

The BPTO has 32,000 registrationsof technology agreements since1972. However, it should be notedthat the effective technology trans-fer character of such agreements isnot necessarily as huge as it seems.As mentioned herein above thegreat majority of agreements re-corded at the BPTO are technicalassistance and related ones whereinthe technology transfer contentmust be carefully examined.

The real technology transfer canbe found in patent license and tech-nology (know-how) supply agree-

ments and is extremely valuable forBrazil not only because it providestechnology modernization for thelocal industry but also in view of thecorresponding payment of royal-ties. The royalties are calculatedwith basis on the net sales of thegoods produced by the licensee uti-lizing the technology and, therefore,if there are no sales, which add tothe gross domestic product, thereare no remittances abroad, estab-lishing a mechanism in which anyamount paid to the licensor is theresult of licensee income that wouldnot exist if there were no technol-ogy license.

In view of the above introductoryscenario, the purpose of this articleis to provide a general overview oflicensing in Brazil and to offer ad-vice on how to minimize unneces-sary delays or rejection of thecorresponding technology transferagreements. Law nº 9,279/96, whichtook effect in 1997, is the intellectualproperty law that governs trade-marks, patents and licensing, that is,the registration of technology trans-


fer agreements in Brazil. Eventhough this law constructed aframework for technology transfer,foreign parties planning to licensetechnology in Brazil should beaware that in order to update andto respond to first world countries’developments in this field the coun-try is constantly improving its in-tellectual property system. Theeffect of this rapid change is that theBPTO often creates new rules,sometimes even non-written ones.As a result, registering technologytransfer agreements in Brazil cansometimes be an unpredictable andfrustrating experience. However, asBrazil gains momentum and poweras a developing nation, it is crucialfor parties seeking to license tech-nology on a global scale to under-stand the Brazilian approach totechnology transfer.

The Brazilian Patent and Trade-mark Office (“BPTO”), known inBrazil as the National Institute ofIndustrial Property (“INPI”), is thelargest intellectual property office inLatin America. The BPTO is respon-sible for registering all patents,trademarks and technology transferagreements. Royalty-bearing tech-nology transfer agreements shouldbe submitted for review to theBPTO. The BPTO may request ad-ditional information or clarificationon the filing, and, in some cases,may reject the filing entirely. Exceptin the latter situation, the agreementwill eventually be recorded with theBPTO, the effect of which is to per-mit it to be enforceable against thirdparties, accrue royalties and receivebeneficial tax treatment. Followingthe agreement registration beforethe BPTO, the certificate of recordalissued by such office must be filedat the Brazilian Central Bank (BCB)for the royalty payments to be au-thorized.

Part I of this article sets forth thefive different types of technologytransfer agreements recognized bythe BPTO and the documents re-quired for each filing. Part II pro-vides an in-depth explanation of thedifferent types of agreements, ac-crual and payment of royalties aswell as tax implications for licens-

ing foreign technology. Part III is acase study that illustrates a typicalforeign technology licensing trans-action between a Brazilian partyand a foreign party and discussesthe registration of the resultingtechnology transfer agreementswith the BPTO.I. Technology TransferAgreements Recognized by theBPTO and General FilingRequirements

The BPTO recognizes five types oftechnology transfer agreements:patent license agreements, trademarklicense agreements, technology sup-ply (know-how) agreements, tech-nical assistance agreements andfranchise1 agreements. Parties in-terested in licensing foreign tech-nology in Brazil, whether they areBrazilian or foreign, must file a tech-nology transfer agreement for regis-tration with the BPTO. On average, ittakes the BPTO 40 days to reviewand record an agreement. Once theagreement is recorded at the BPTO,it is enforceable against third par-ties, royalty payments are remissible(as long as the procedure at the BCBis successful) and the Brazilian partybecomes eligible to claim the royaltypayments as tax-deductible items.

All technology transfer agree-ments and accompanying docu-ments must comply with the BPTOregistration requirements. The rulesindicate that: (i) representatives ofeach party must initial all pages ofthe agreement and sign the finalpage; (ii) foreign parties shouldhave the agreement notarized by anofficial Notary Public; (iii) the sig-nature of the Notary Public must belegalized by the nearest BrazilianConsulate; (iv) two witnesses of anynationality or domicile must signthe last page of the agreement; and(v) each witness must list their fullname, address and nationality.

Apart from submitting the agree-ment for review by the BPTO, theparties must file several other docu-

ments. If the agreement is betweena Brazilian party and a foreign partyor between two Brazilian parties,they must submit: (i) a simple Por-tuguese translation of the agree-ment – a translation by a publicsworn translator is not required; (ii)the forms entitled “Requerimentode Averbação” and “Ficha Cadastrode Entidade” completed by the Lic-ensee/Recipient or by their attorneys;(iii) a receipt verifying payment ofthe official filing fee; (iv) a powerof attorney signed by the legal rep-resentative of either Licensor/Pro-vider or Licensee/Recipient; (v) acopy of the bylaws of the Licensee/Recipient; and (vi) a letter ad-dressed to the Technology TransferDepartment of the BPTO briefly ex-plaining why the parties enteredinto the agreement. In the event thatboth parties to the technology trans-fer agreement are foreign, the par-ties should submit: (i) the originalversion of the technology transferagreement; (ii) a notarized copythereof; (iii) its translation into Por-tuguese; (iv) the receipt verifyingpayment of the official filing fee; (v)a power of attorney and; (vi) a peti-tion to be prepared by its attorneys.

In many cases, the parties willneed to file more than one type oftechnology transfer agreement. De-pending on the type of technologythat is being transferred, the BPTOmay only approve limited paymentof royalties. Parties who file a patentand a trademark license agreement(when the trademark identifies thepatent), a trademark and a know-how agreement (when the trade-mark identifies the know-how), apatent and a know-how agreement(when the know-how is necessaryin order to effectively use thepatent) or all three agreements maynot be able to request separate roy-alty payments for each agreement.The BPTO views the above pairs ofagreements as dependent, meaningthat one agreement is considered tobe a consequence of the other. FromBPTO perspective, it would be un-fair for the licensee to have to makeseparately royalty payments foreach portion of an overarching busi-ness operation. Therefore, royalties

1. Franchising is regulated in Brazil by Lawnº 8,955 of 1994.


paid on one type of technology pro-vide consideration for use of theother. For example, a franchiseagreement incorporates the corre-sponding trademark because thetrademark is considered to be in-cluded in the agreement as a neces-sary tool for the franchiser. BrazilianFranchising Law includes trade-mark use into franchise agreementsbecause it would be unfair to re-quire the licensee to pay separatelyfor the use of the trademark when afranchise and the correspondingtrademark are inextricably linked.

An exception to this rule is whena party files a know-how agreementin conjunction with a technical as-sistance agreement. In that situa-tion, royalties are payable on bothagreements despite the fact thatthey relate to the same subject mat-ter because technical assistance andknow-how have separate functionsand are considered as not depen-dent on each other. Another excep-tion is if a party can demonstratethat a patent and a know-how canwork well separately and are notnecessarily connected to each other,in which case it may be possible tocollect royalties for each agreement,subject to approval by the BPTO.II. Explanation of the Five Typesof Technology TransferAgreements

The five types of technologytransfer agreements have some dif-ferences in terms of filing require-ments, tax treatment and royalties.Parties interested in prompt regis-tration with the BPTO should takecareful note of these differences toexpedite the approval process.A. Patent License Agreements

Parties who wish to license apatent issued by or pending withthe BPTO must file a patent licenseagreement. The agreement shouldclearly set forth the application orregistration numbers of the patentor patents and their respective titles.

Brazilian law permits accrual ofpatent royalties if the patent to belicensed is still pending with theBPTO. However, royalty paymentsmay not be remitted until the patent

registration process with the BPTOis complete, that is, when the corre-sponding patent certificate is is-sued. While the application ispending with the BPTO, royaltypayments may be deposited in anescrow account until the patent reg-istration process is finalized and theBCB authorizes the remittance. Af-ter receiving approval from both in-stitutions, the payments can beremitted to the Licensor. The Licen-sor can continue to collect royaltiesas long as the patent and, thereforethe agreement, is in force. The expi-ration term of a patent in Brazil is20 years.

The Brazilian tax ordinance, nº436 of 1958 of the Treasury Minis-try, governing technology transferagreements, established deductibil-ity ceilings for payments flowingbetween companies that have a par-ent/subsidiary relationship. Theceilings are a designated percentageof the net sales made by the Lic-ensee of the products or servicesusing the licensed patent, trade-mark or technology. For related par-ties, the maximum amount that maybe paid by the Brazilian party to theforeign licensor is exactly the tax de-ductibility ceiling which ranges be-tween 1% and 5% for patent licenseagreements. On the other hand, ifno ownership interest exists be-tween the parties, there is no tax de-ductibility ceiling imposed on theroyalty payments owed by Licenseeto Licensor. It should be noted thatthis policy creates a disincentive forboth Brazilian and foreign partiesconsidering a technology transfertransaction because of the negativetax implications for the Braziliancompany and the payment caps theforeign company will have to ac-cept. The tax ordinance, in effectsince 1958, reflects a quite old pro-tectionist mentality being a clearexample of the Brazilian govern-ment’s resistance to totally embracethe globalization of business.B. Trademark LicenseAgreements

Trademark license agreementsstating the trademark application orregistration number should be filed

with the BPTO. The approximatelength of time between the filing ofa trademark application and the is-suance of a trademark registrationis two years. There is an importantdifference in the treatment of royal-ties for trademarks and patents inBrazil. Whereas a patent licenseagreement may accrue royalties assoon as the patent application isfiled with the BPTO, a trademarkmust be registered with the BPTOfor royalties to accrue. This differ-ence is explained by the attributiveprinciple, a legal concept embracedby Brazilian law. Brazil follows the“first to file” system which dictatesthat priority rights to a trademarkare given to the first individual tofile the trademark with the BPTO.This system is different from the“first to use” system adopted by theUnited States, whereby trademarkrights are given to the first party touse the trademark, regardless ofwhich party initiates the registra-tion process. In Brazil, an applicanthas no property rights over a trade-mark until it is officially registered,that is, when the corresponding cer-tificate is issued by the BPTO. Incontrast, a patent affords the inven-tor an immediate property interest.Trademark royalty payments maybegin only after the registration pro-cess is complete, and payments maycontinue as long as the trademarkregistration is in force. Trademarksare valid in Brazil for a period of 10years and are renewable by thetrademark owner for subsequent10-year periods.

Trademark license agreements aresubject to lower deductibility ceil-ings than patent license agreements,as the tax deductibility ceiling ontrademark license agreements is al-ways 1 per cent.C. Technology Supply Agree-ments (Know-How Agreements)

Technology supply agreementscover the acquisition of know-howdestined to the manufacture of in-dustrial products and services. Thistype of agreement differs frompatent license agreements insofar asthe recipient has, in principle, theright to use the know-how royalty-


free upon expiration of a term thatis usually of five or ten years, de-pending on whether the agreementis renewed. The reason behind thisdifference is that the BPTO viewstechnology supply agreements asequivalent to a sale of technologywhile patent and trademark licenseagreements are considered agree-ments for rental of technology.Know-how licenses trigger pay-ments for a term of no more thanfive years, after which time re-newal for an additional five-yearperiod is conditional upon a show-ing that the technology has beenupdated enough to merit continuedpayment of royalties for a secondfive-year term. Thus, upon expira-tion of a term of either five or tenyears, the BPTO considers that therecipient owns the technology forwhich he had paid.

Know-how agreements receivethe same tax treatment as do patentlicense agreements, and the deduct-ibility ceiling ranges between 1 percent to 5 per cent of the net sales.D. Technical Services (Assis-tance) Agreements

Parties supplying and executingspecialized services for which pay-ment is to be received should file atechnical services agreement withthe BPTO. Typical activities coveredby this type of agreement are trans-fer of technical information, plan-ning and programming methodsas well as searches, studies andspecialized projects on how to per-form the services and operate thetechnology. In evaluating this typeof agreement, the BPTO requiressubmission of a detailed schedulesetting forth the qualifications of thetechnicians, their hourly labor rates,and total number of hours worked.The payment term under this typeof agreement may be fixed either asa lump sum or as a series of pay-ments as long as the BPTO receivesa schedule explaining the break-down of fees. In addition, the BPTOshould be notified of the time pe-riod during which the services willbe rendered. In the event that theservices are performed before theagreement and a schedule is filedwith the BPTO, the parties should

include the starting and endingdates of the services.

If a technical services agreementis filed in connection with a patentor trademark license agreement,the tax deductibility ceiling ap-plies, limiting the royalty pay-ments remissible to the foreignparty. However, if the technicalservices agreement is the onlyagreement to be filed pertaining tothe foreign technology, Brazilianlaw does not impose a tax deduct-ibility ceiling on the payments.E. Franchise Agreements

The sole franchise agreement rec-ognized by Brazilian FranchisingLaw nº 8955 of December 15, 1998is the “business format franchise.”This type of agreement covers thetemporary acquisition of rightswhich involve the licensing of abusiness method that usually in-cludes the license of trademarks andthe supply of technical assistanceservices in combination with someother related technology transfer.This type of agreement is subjectto the same tax regulations as theother agreements, but the deduct-ibility ceilings may be more flex-ible regardless of whether theparties maintain a parent/subsid-iary relationship.III. Case Study

The following example demon-strates a business transaction thatwould necessitate multiple filingswith the BPTO. A new Americancompany (“Licensor”) launches abusiness manufacturing and sellingwidgets in the United States. It im-mediately decides to expand itsmarket to Latin America, specifi-cally to manufacture and sell thewidgets in Brazil. After consultingwith its attorneys and some Brazil-ian business connections, it locatesa Brazilian party (“Licensee”) thatis interested in manufacturing thewidgets. The Licensor agrees totransfer its technology to the Brazil-ian company in exchange for roy-alty payments. Not only does theLicensor need to file a know-howagreement to cover the technologyit supplies, it also must file a tech-nical assistance agreement to cover

the process of teaching the Brazil-ian workers on the manufacture ofthe widgets through the knowledgeof foreign technicians. In addition,the Licensor files patent and trade-mark license agreements authoriz-ing and regulating the Licensee’suse of the patent and trademark.Because all of the agreements relateto the same operation, royalty pay-ments for the use of each piece oftechnology will probably not beapproved by the BPTO.

The Licensor should first contactcounsel that is either located in Bra-zil or is extremely familiar with theBPTO and its licensing procedure.In order for the patent and trade-mark to be enforceable in Brazilagainst potential infringers, the Li-censor should file patent and trade-mark applications with the BPTO.The applications should be filed assoon as possible after the widgetbusiness first begins in Brazil sinceroyalties related to a patent licenseagreement may begin to accrue asof that date. If the patent applica-tion process runs smoothly, thepatent certificate should be issuedin approximately two years. Sincethe Licensee will be using thepatent during that time, the Licen-sor may request that the Licenseedeposit the patent royalty pay-ments in an escrow account forremittance following registrationof the patent. Royalties do not ac-crue regarding the trademark untilthe corresponding trademark regis-tration has been granted.

While the patent and trademarkapplications are pending, the par-ties can execute and file the technol-ogy transfer agreements so that theLicensor or Licensee, depending onwhich party has rights of enforce-ment, can enforce the patent andtrademark against any third parties,royalties can be payable to the Li-censor and the Licensee can receivetax benefits. The BPTO would prob-ably refuse to approve royalties foreach agreement because the entiretransaction relates to the manufac-ture and sale of the same widgetscovered by the patent application.

For example, the BPTO may onlyapprove royalties on the patent, and


those royalties will be calculatedbased on a percentage of the netsales of widgets made by the Lic-ensee. Because the parties do nothave a parent/subsidiary relation-ship, there is no tax deductibilityceiling imposed by the government.The Licensor has more flexibility todesignate the percentage of sales itwishes to collect as royalties, and,subject to BPTO approval, the Lic-ensee can claim that entire amountas tax-deductible. After the BPTOapproves the patent and patent li-censing agreement, the BCB willauthorize the proposed royalty pay-ments. The BCB normally requiresapproximately two weeks to autho-rize the remittance of royalties. Af-ter this process is complete, theparties should be sure to notify theBPTO of any name, address or own-ership changes.Conclusion

While Brazil has not yet perfectedits intellectual property system, tre-mendous progress has been madein recent years, especially with thenew Intellectual Property Law, Lawnº 9,279/96. As one of the most im-portant developing countries, cer-tainly the most relevant economy inSouth America and together withMexico the most important in LatinAmerica, effective technology trans-fer is paramount to Brazil’s upwardmobility in the international intel-lectual property arena and to glo-bal expansion of businesses.


A History of the IntellectualAsset Management (“IAM”)Movement

T he evolving technology-based economy of the 1990s,characterized by shorter

product cycles, rapid infiltration ofe-commerce and an increase in pat-enting activity, brought forth a shiftin strategic thinking for many com-panies. In 1982, only 32% of the av-erage company’s asset base wascomprised of intangible assets. To-day, this figure is over 70% andgrowing.1 Realizing this trend, andseeking competitive advantage dur-ing this time of change, firms beganto focus on how to generate addi-

Managing Intellectual AssetsFor Shareholder Value

BY BRIAN NAPPER AND SHELLY IRVINE*

*Brian Napper, Partner,Deloitte & ToucheShelly Irvine, Senior Manager,Deloitte & Touche

tional value from these intellectualassets. The focus of this article is toillustrate the short-term financialbenefits and long term strategic andcompetitive advantages that a firmwill realize from having an inte-grated and focused IAM program.It will provide the reader with a ba-sic understanding of IAM and offertools to begin company-wide imple-mentation of an IAM program.

A company’s intellectual assets in-clude not only its intellectual property(“IP”) patents, copyrights, trademarksand trade secrets – but also other codi-fied or intangible knowledge such asknow-how, contracts, processes andprocedures, licenses and non-com-pete agreements. More broadly de-fined, intellectual assets include acompany’s branding, human capital,such as a skilled workforce, and the

relationships it has with customers,suppliers and distributors, widelycalled intellectual capital.

The focus on intellectual assetsevolved not only from a changingeconomy, but also from a changinglegal environment. In 1982, theCourt of Appeals for the FederalCircuit (“CAFC”) was created in theUnited States and had an immedi-ate and positive impact on ownersof intellectual property. Statisticsshow that prior to the CAFC’s cre-ation, approximately 70% of patentschallenged in the U.S. federal courtswere overturned, compared to ap-proximately 20% after its creation.2

Further, in 1998, the CAFC ruledthat business processes are patent-able, a move that generated sig-nificant patenting activity withinindustries such as banking and fi-nancial services, which rely on pro-prietary methods and processes forcompetitive advantage. Coupledwith the favorable legal environ-ment for intellectual property own-ers was the exploding rate at whichpatents were being applied for andgranted in the 1980s and 1990s.

With the focus on intellectualproperty in the legal and technicalcommunity, many companies suchas Dow Chemical, Hewlett-Packardand IBM became pioneers in intel-lectual asset management withwell-run and highly publicized pro-

1. Harvard Business Review, Jan-Feb 2000.

2. North Carolina State University Study,http://www4.ncsu.edu/~baumerdl/504.01%20PPT%20Notes/504.01%20Ch.%208.ppt.

IntellectualProperty

IntellectualAssets

IntellectualCapital

Patents

Trademarks

Trade Secrets

Trade Names

Copyrights

“Codifie

d” Knowledge &

Know-How

Contracts

Permits

Licenses

Non-Competes

Human Capital

Organizational C

apital

Customer C

apital

Distrib

utor

Supplier


SystemIntellectual assets shape every

part of an organization. As illus-trated below, each division or dis-cipline within a company plays akey role in IAM, and as such, effortsto implement an IAM programmust be coordinated on all fronts.

Whether used as a defensive oroffensive tool, IAM provides signifi-cant benefits to a company in termsof revenue enhancement, cost re-duction and strategic advantage.The benefits to be gained from IAMare not going unnoticed in the mar-ketplace. Between now and 2005,more than 50% of companies in the

pharmaceutical, aerospace, infor-mation technology, consumer goodsand biomedical sectors will imple-ment systems to better manage theirintellectual assets.4

Revenue EnhancementIAM facilitates revenue enhance-

ment through licensing income, fo-cused and maximized research anddevelopment (“R&D”) expendituresand strategic alliances/joint ven-tures, among others. Worldwidepatent licensing grew to well over$100 billion in 1998 and is expectedto reach half a trillion dollars annu-ally by 2005 as companies search fornew revenue streams by expandinglicensing programs.5 Companiessuch as IBM and Rambus haveturned their patent portfolios intoprofit centers through strategic li-censing of their intellectual prop-

grams. Each of these companies hasexperienced the benefits of IAM interms of revenue, cost savings andstrategic advantage. For example,IBM, with its immense patent port-folio and focus on out-licensing, hasreportedly managed to generate an-nual revenues in excess of $1.2 bil-lion from licensing. Dow Chemicalhas integrated IAM into every facetof its business, using its intellectualassets not only to generate revenueand cost savings, but also to guidethe company into strategic markets,protect its position in certain mar-kets and generate more focused andefficient patenting. IAM can benefitnot only large companies with well-established intellectual assert port-folios, but companies of any size,industry or stage of development.

An increase in companies’ alli-ance activity throughout the 1990shas also created a demand for IAM.Intellectual assets have become thecurrency of choice in connectionwith strategic and joint venture al-liances between companies withinthe same industry, or often withinmultiple industries. It is estimatedthat businesses conducted throughalliances accounted for 3-5% of anaverage company’s revenues in1990. That figure stands at 20% in2000 and is expected to reach 40%by 2010.3 IAM is critical to maximiz-ing a company’s position withinthese increasingly important alli-ances, as well defined, protectedand valuable intellectual propertyoften forms the basis and businessjustification for such endeavors.Benefits of an Effective IAM

3. EIU Global Executive Survey.

4. Gartner Group.5. “The Basics of Financing IntellectualProperty Royalties, Part III: What is theMarket” by Licent Capital, July 2, 2001 at http://www.cafezine.com/index_article.asp?deptId=3&id=412.

R & DInnovation meets

market needs.

PersonnelPeople are a key

intellectual asset. Afirm must provide thetools and incentivesto maximize their

value.

MarketingBrands, trade names

and trademarksprovide competitive

advantage.

LegalEnsures that valuableassets are identified

developed andprotected.

Finance/Accounting

Maximize intellectualasset value through

capital budgeting, R&Dallocation, financial risk

analysis andmeasurement andreporting tools.

Patent Number

1,000,000

2,000,000

5,000,000

6,000,000

Granted

1911

1935

1991

1999

Elapsed Time

122 years after first patent

24 years after patent 1,000,000




tries in which the patent is pros-ecuted. In a company with thou-sands of patents filed in manycountries of the world, this expensecan represent a significant portionof a company’s R&D budget. Costsavings are achieved by continuallyevaluating the patent portfolio andidentifying and pruning patentsthat are non-core to the business,not protecting a market or technol-ogy area and are not viable for out-licensing, as well as controllingwhat is patented in the future.Companies that are able to deter-mine effectively which inventionsare not worth patenting (no busi-ness purpose) or are better kept asknow-how or trade secrets (suchas processes or formulas) will bebetter positioned to focus their R&Dand patenting efforts on the mostprofitable markets and products.For example, Dow Chemical foundthat by pruning its portfolio andreducing its patenting activitythrough a focus on strategic patent-ing, it not only reduced costs, butalso secured a stronger, more man-ageable portfolio of assets. Simplyby eliminating the patents that hadlittle business value, Dow estimatesthat it saved more than $40 millionin maintenance costs (filing fees,taxes, etc.) over a five-year period.6

Companies can also reduce tax li-ability through focused managementof intellectual assets. For example,creating an entity focused primarilyon managing a company’s intellec-tual property and then licensing theintellectual property back to theusers of the assets can be advanta-geous from a management effi-ciency and tax perspective. FurtherIP may be donated, which can re-sult in tax credits for the donator.DuPont’s 1999 donation of $64 mil-lion worth of intellectual propertyto three universities (University ofIowa, Virginia Polytechnic andPenn State) was one of the largestto date, prompting other companiesto consider the benefits of intellec-

tual asset donation.Strategic Advantage

IAM has many strategic benefitsthat depend largely on the goals andvision of the company. For innova-tors, patents and other intellectualproperty can be used to protect andto defend existing markets and tosecure key future markets. Earlyrecognition of emerging markets ortechnology needs may allow a firmto gain competitive advantage bypatenting or exclusively licensingcornerstone technologies (buildinga “patent wall”) or by erecting bar-riers to entry in strategic technologyareas. For example, a medical de-vice company recently recognizedthe value of innovative technologyapplicable within its industry sev-eral years before the market wasready for the technology and ac-quired rights to the technologythrough a license agreement. Thiscompany took the up-front financialrisk that the need would material-ize and the strategy was advanta-geous in that it realized an increasedmarket share and the ability to ex-clude potential competitors.

The strategy of market penetra-tion is often accomplished throughwidespread out-licensing in emerg-ing industries and establishing stan-dards to achieve “network effects”for technology. Microsoft used thisstrategy to set a de-facto standardfor its Windows operating system.For strategies that include “skim-ming” markets and establishing apricing premium, intellectual assetscan be use to increase brand valueand awareness and customer loy-alty. Still other strategies, includingcost leadership and operating excel-lence, can be achieved by develop-ing or in-licensing processes andmanufacturing know-how whichcan be used to increase productiv-ity and to provide a competitive costadvantage.Other Benefits

In certain cases, intellectual prop-erty and royalty streams may beused to secure funding. For ex-ample, one start-up software com-pany recently used its proprietarytechnology and patent portfolio to

erty, both within their core indus-try and outside of it. Licensing ishighly profitable, with net profitmargins generally over 90% on li-censing revenues.

Understanding, organizing and ef-fectively managing the company’sportfolio of intellectual assets willincrease the return on R&D dollars,facilitate spending of precious R&Ddollars on high-value projects andidentify and eliminate unwarrantedR&D expenditures. A thorough re-view and clustering of a company’sintellectual assets will reveal 1)which products and technologiesare strategic and core to the businessversus those which are non-core; 2)those which are used to generaterevenue versus those that are onlydefensive; and 3) establish a tech-nology roadmap to help guideproduct development and funnelresources to high value projects.Companies that are nimble enoughto make wise resource allocationdecisions for innovative products inkey markets will bring technologyto market faster than their rivals,increasing market share and en-hancing long-term shareholdervalue.

Mining a portfolio for unused orunderutilized assets that may con-tribute to the development of newproducts or services is an importanttool for generating incremental rev-enue. For example, a well-knownchemical company traditionally fo-cused on consumer products butwith a compound applicable in themedical industry (but no process ormanufacturing capability to exploitit), entered into a joint venture witha company who possessed thecomplementary capabilities to com-mercialize a product within themedical industry. It was a low-risk,high value project that ended upgenerating substantial, unplannedand highly profitable revenue forboth entities.Cost Reduction

Over the life of a patent, a com-pany will spend between $250,000and $1 million per patent on pros-ecution and maintenance expenses,depending on the number of coun-

6. 2001 Conference on Intellectual AssetManagement; June 26, 2001 speech by RickGross, Dow Chemical Company at the DrakeHotel, Chicago.


As a first step, firms consideringimplementing an IAM system musthave support and buy-in from up-per management and each of thebusiness units, otherwise the IAMprocess will stall and implementa-tion throughout the organizationwill be problematic. We have foundthat an immediate showing of fi-nancial success can facilitate suchbuy in. Many companies experienceshort-term success by mining forpatents that are easily marketableand quickly licensed to generateroyalty income. Other companiesidentify intellectual property thatare candidates for donation or builda spin-off business around intellec-tual property. Still others conductroyalty audits of previous licenseesto generate revenue. These types ofactivities generate a fast return, andwhile just the tip of the iceberg,demonstrate the financial impact ofIP to the company, thereby facilitat-ing management buy in.Organize

Once management has agreed tocommit resources to an IAM pro-gram, the first step is to take inven-tory and understand the universe ofintellectual assets owned by thecompany. Not surprisingly, many ofthe companies for which we haveconsulted have only a cursory un-derstanding of their intellectual as-sets and often valuable patents andknow-how sit unexploited withinthe firm. Typically this gatheringprocess begins with in-house coun-sel, who should have an under-standing of the company’s issuedpatents, patent applications, licenseagreements, trademarks, copy-rights, trade secrets and inventiondisclosures, or at least know who toapproach to obtain such informa-tion. In many cases it is also neces-sary to speak with the inventorsthemselves to understand in-pro-cess R&D that may have potentialvalue, but that has not yet beencodified in the form of a patent orpatent application (e.g., know-how,blueprints, processes and proce-dures, etc.). Even abandoned R&Dprojects may be candidates forscreening and organization. Andthis concept can be extended to even

non-high tech companies, such ascomputer/video game software de-velopers and abandoned artwork.Once the universe of information hasbeen identified and assembled, itneeds to be carefully organized andclustered for evaluation.

At this stage, a basic electronicIAM database should be imple-mented. There are several companiesthat sell software for managing pat-ents and other intellectual assets, suchas First to File and Dennemeyer andCompany, but at this stage, simplycapturing the information in a da-tabase, such as Microsoft Access,should be sufficient. The companymay wish to transition to a more so-phisticated management systemonce the framework for the IAMprocess has been established andthe process is up and running. In ad-dition to an electronic database, thecompany must also maintain well-organized paper files documentingall the information related to theintellectual assets, including in-vention disclosures, market andtechnology feasibility studies,prior art searches, PTO applica-tions and correspondence, etc. Thefields and information containedwithin this system will dependlargely on the next step in the IAMprocess, portfolio screening.Develop Team and Screen

Once the company has identifiedthe intellectual assets it owns or hasrights to and the basic informationrelated to the assets assembled in acentral database (e.g., asset descrip-tion/patent #, title, abstract, file/record date, issue date, inventor,etc.), a cross-functional team com-prised of in-house (or external) le-gal counsel, technical/engineeringand business unit level managers(marketing and executive) must beassembled to screen, categorize andassess the intellectual assets. Hav-ing these diverse perspectives iscrucial to understanding the legalprotection and enforcement issuesrelated the intellectual asset, and thetechnical feasibility issues and busi-ness level knowledge of markets,customers and competitors. Acquir-ing the long-term dedication andtime commitment from this team is

secure $10 million in financing.Well-known IP financing transac-tions include that of Calvin Klein,which used its IP to back a $58 mil-lion bond. Similarly, David Bowie’scopyrights were used to secure $55million in financing.7 Monetizing in-tellectual assets is an emerging prac-tice that is well suited to bothstart-ups and established compa-nies alike.

Litigation issues uncovered as aresult of the IAM process can havea substantial financial impact (somepositive and some negative) on acompany. Almost 50% of attorneyspolled in a recent survey believethat intellectual property litigationwill be the hottest legal practice areain the next 10 years.8 As such, acompany must guard against in-fringement and also ensure that itis not infringing on its competitors’technology. During the IAM pro-cess, a company may uncover apatent that can be asserted againsta competitor. On the contrary, itmay discover products that it as-sumed were covered by patents, buton second glance may be question-able and at risk for a lawsuit by acompetitor.Implementing an IAM SystemManagement Buy-In

The ultimate goal of a firm fo-cused on its intangible assets is tointegrate IAM into every facet of thebusiness and to use it not only toproduce immediate financial gain,but also as a strategic guide to gen-erate long-term value for the com-pany. This is not accomplishedovernight and the system must bebuilt from the ground up. Compa-nies such as Dow Chemical and HP,who implemented IAM programsmany years ago, are still working toachieve full integration of intellec-tual asset management into all as-pects of their respective businesses.

7. “The Basics of Financing Intellectual PropertyRoyalties, Part III: What is the Market” by LicentCapital, July 2, 2001 at http://www.cafezine.com/index_article.asp?deptId=3&id=412.8. PR Newswire; June 15, 2000.


(at a high level) and the firm has asense of the relative value of the in-tellectual assets, a thorough assess-ment can be made. This assessmentshould begin with the same IAMteam that was assembled to organizeand to screen, but will likely requireadditional input from inventors/en-gineers, marketing personnel or evenindustry/technology experts outsideof the company. While screening theportfolio for value opportunities, theteam should ask the following typesof questions:

1. What patents or technologyareas/know-how can be licensed?When licensing, a company shouldconsider whether the technology iscore to the business or product linesand if it is being used to protect acertain market or product. There arereasons to license core technology,including licensing to establish astandard or licensing to a companybetter equipped to maximize thetechnology’s value (well knownbrand name, larger distribution sys-tem), but these types of decisionsmust be rigorously analyzed and val-ued. On the other hand, if the patentor technology is not strategic to thebusiness, there may be an opportu-nity to license, sell or donate, eitherwithin the industry or outside.

Companies license for many rea-sons, including as a strategy topenetrate a market or establish astandard, using licensing purely togenerate income or licensing toform a strategic alliance to penetratenew markets or geographic areas.One basic way to identify licensingopportunities for technology out-side of a company’s core area is tolook at the patent classes estab-lished by the PTO during the filingprocess. The PTO classification mayprovide a roadmap to look for po-tential licensing opportunities. Li-censing of important technologyoutside of a core business was illus-trated by the aerospace and defenseindustries in the 1990s, which havesince realized that much of the tech-nology they developed, for exampleGPS, is applicable to consumerproducts. In such a situation, licens-ing to non-competitors outside ofthe company’s core business is rela-

tively low-risk.Another strategic reason to li-

cense, often to competitors withinthe same industry, is to establishcross-licenses for freedom to de-sign. Especially common withinthe semiconductor and computerhardware industries, cross-licens-ing to a competitor may not onlystrengthen resources available toa company, but it can also be adefense against litigation.

Trademark licensing is a revenue-generating opportunity many com-panies overlook. For example,Calvin Klein, an apparel companywith a strong and recognizablename in clothing, has parlayed thatsuccess into many areas includingperfume, makeup, shoes and sun-glasses, among others, generatingsubstantial licensing income. Trade-mark licensing can be risky, how-ever, since quality control may bedifficult when using outside manu-facturers and dilution of the valueand prestige of the mark can occur.

2. What can be commercialized?The company should search for anyoverlooked “gems” in the portfoliothat might be well-suited for a jointventure or strategic alliance. A com-pany with potentially valuable in-tellectual assets, but lacking someof the complementary assets to ex-ploit it, may be able to partner withanother company to generate an en-tirely new business opportunity. Al-ternatively, there may be a viableinvention that can be developed inhouse which fell through the cracksand will be discovered during theIAM process.

3. Are my technology rights be-ing enforced? Multi-million dollarawards for patent infringementare common and companies whoare not actively policing their intel-lectual property may be forgoingnot only sizeable damages awards,but also market share and custom-ers. Along the same lines, the com-pany should explore whether anylicenses or development agree-ments in force need to be auditedfor royalty compliance.

4. Does the company have patentsthat are about to expire or deemed

also essential, as they will likely beresponsible for maintaining the sys-tem, reporting and disseminatingresults, appointing “special teams”to carry out directives and coordinat-ing across business units and func-tions. The majority of companies thathave been highly successful at IAMhave either hired dedicated resourcesor carved out job responsibilities forexisting employees, with the sup-port of management, for executionof the IAM initiative.

Prior to screening, the teammust establish well thought-outand useful criteria for categorizingthe patents. There is no standardrule-of-thumb and criteria selectionwill differ depending on the type oforganization and the industry. Forexample, a semiconductor companymay screen its patents based on thefollowing criteria:

•Industry code (IPC code as cat-egorized by the U.S. Patent &Trademark Office)

•Technology family or businessunit

•Core/non-core•Defensive/“in-use”

•Licensed out9

•Products which use or rely onthe patents

•Potential value of patent at highlevel review (low, medium,high)

•Age of patent•Strength of patentAs new patents, invention disclo-

sures and know-how are added toa company’s base of intellectual as-sets over time, they must be subjectedto the screening process. This processwill result in centralization and ahigh-level ranking/prioritization ofIAM efforts to facilitate the next taskin the IAM process, assessment.Assets

Once the intellectual assets havebeen clustered, screened and ranked

9. A company may want to create a separate,but linked, database to track licensing activitysince it will require different information,including fields for tracking royalty paymentdue dates, milestones, payments received,and auditing procedures, among others.


ties of the competition can be a valu-able piece of the IAM process andwill identify market trends, productideas, partners or joint venture op-portunities, and potential licensingopportunities (either out or in-licens-ing). One important way to gain in-sight into what the competition isdoing is to monitor and analyze pat-enting activity and trends in the in-dustry. Monitoring the competition’spatenting activity gives substantialclues as to where the market isheaded and, if monitored, can helpa company to secure rights in cer-tain areas and to “head the compe-tition off at the pass”. Anotherrevealing analysis used to identifycompetitors or potential competi-tors is to look for companies whosepatents cite the same prior art asyour company’s patents – they arelikely in a similar market space ordeveloping competencies that maycompete in your market niche andshould be watched. These companiesmay also be potential licensees foryour company’s technology, or evenpotential partners. Other sources ofcompetitive intelligence include pub-lications, press releases, conferences,hiring activity, joint ventures and li-censing arrangements, contracts andtrade associations.

During this process a firm willlikely uncover many opportunitiesto generate value from its intellec-tual property. However, focusing ona handful of key prospects to beginwith is important. A firm shouldstart with these “fast track” oppor-tunities initially, to solidify manage-ment buy-in and increase the chanceof success.Extract Value

Once the IAM team has identifiedthe “fast track” opportunities re-lated to its intellectual assets, itshould embark on several tasks.First, a company must develop arealistic timeline for completing theidentified opportunities. Second,the group must establish a due dili-gence and negotiation team for anypotential targets it has identified forlicensing. This team must be pre-pared to discuss issues such as ex-clusivity, scope of license (both

low-value and should be disposedof? As discussed earlier in this ar-ticle, patents are expensive tomaintain. Patent pruning can savemoney, and if a patent is about toexpire and/or it is not being usedin a core product or market, it maybe worthwhile to let it expire. Simi-larly, patents can be donated forsubstantial tax write-offs, not tomention the goodwill associatedwith a donation. This is often anarea that can generate conflictwithin an organization at the busi-ness unit level and even betweeninventors themselves. Inventorsand business unit leaders are, bynature, proud of the patents thatthey have produced, and care mustbe taken to ensure that pruning ofpatents and other intellectual assetsdeemed as low-value is carried outin a diplomatic and non-demoraliz-ing fashion. Creating a criteria reliedupon to decide whether patent aban-donment should be explored is im-portant to standardizing this process.

Consideration must be given toaligning employee incentives andgoals with the strategic objectives ofthe company. For instance, a firmthat is focused on patent pruningand patenting only strategic, coreideas, must be careful not to pro-vide the wrong incentives (such asgenerous financial awards to in-ventors who file or issue a patent,regardless of its potential value),but instead structure incentivesthat are tied to the value or poten-tial value of a patent or technol-ogy. On the other hand, companieslike Hewlett-Packard and IBM areamong the leaders in the industryfor the number of new patentsgenerated, and have generous re-wards for inventors who file and is-sue patents, often regardless of theperceived value.

5. What are my competitors do-ing? An underlying factor in the as-sessment process is the ability tounderstand not only your own com-pany and its intellectual assets,product and market strategy andvalue enhancing opportunities, butalso to understand those of yourcompetitors. Monitoring the activi-

geographic and product coverage),terms and enforcement. Third, thegroup needs to establish a team tosearch for potential joint venture orstrategic alliance partners for intellec-tual assets identified as suitable forpartnership. Fourth, the companyshould perform a valuation of eachopportunity to come up with a real-istic idea of what each option isworth, especially if there are severalrevenue generating opportunities forone group of intellectual assets.Maintenance and Reporting

The IAM process does not endhere. In fact, it is by its very nature,evolutionary. Monitoring and ex-tracting value are continual pro-cesses that must be maintained andtracked as the company, its technol-ogy and the marketplace evolve.Any licensing arrangements en-tered into by the company shouldbe monitored through royalty au-dits to ensure compliance. Jointventures or commercialization ef-forts must be tracked and the com-pany must make certain (throughvarious non-disclosure agree-ments), that its intellectual prop-erty is protected - especially whendealing with outside parties. IAMrequires both discipline and cre-ativity to ensure that maximumvalue is being derived from thecompany’s intellectual assets.

As with any business within acompany, results of the IAM pro-gram must be measured and dis-seminated to demonstrate its valueto management. The IAM team thathas been responsible for imple-menting the IAM process shouldalso establish quantitative andqualitative criteria by which to mea-sure results. Measurement tools aretypically unique to the organizationand must be easily understandableby management (visual tools, in-cluding charts and graphics, are of-ten helpful to easily disseminateinformation). Some common mea-surement tools include:

•Intangible value as a percent ofmarket value

•Patents issued compared topeers and industry


•R&D expenditures and returnon assets

•Licensing income•Human capital (headcount)•Customer base•Product base•Frequency of new product intro-

ductions/time to marketanalysis

•Strength and age of the patentportfolio

•Patents issued compared to salesgrowth rate (are the patentstranslating into revenue?)

ConclusionA company that understands not

only its own intellectual asset posi-tion but also the position and focusof others in the market, and usesthis information to gain strategic ad-vantage and long-term growth, hasachieved the goals of a successfulIAM program. The benefits of IAMwill permeate a company - fromrevenue enhancement and cost sav-ings to motivating researchers andinventors and attracting talentedpeople- all of which generate share-holder value in the long run. Usingthe tools outlined above, a companycan begin to develop a systematicapproach to managing its intellec-tual assets within the firm to gener-ate immediate short-term financialgain, and also to maximize its com-petitive position for long-term futuregrowth. Over time, a well plannedand supported IAM program willbecome embedded in the company’sculture, day-to-day operations andprocedures and employees will beginto think strategically with regard tointellectual assets throughout all fac-ets of the organization.


1.0 Introduction

“R oyalty” is the compen-sation paid by users toowners of Intellectual

Property Rights (IPR). Owners ofIPR who have, in varying degrees,the “right to exclude” others frompracticing the subject matter ofthose rights, be it patents, copy-rights, trademarks or trade-secrets,forego that right in return for theroyalty. Theoretically, the licensormay seem to have the unfetteredright to dictate the royalty chargedto the licensee.1 If only this weretrue, it would reduce the innumer-able hours spent by executives andattorneys at license negotiationtables. Judges required by law to de-termine “reasonable royalty”2 wouldnot “find it a difficult judicial chore,seeming often to involve more thetalents of a conjurer.”3 The proposi-tion that the owner is unlikely to beable to exploit fully his invention allby himself and hence would seek tocollaborate with others may seem tosuggest that the contribution of thelicensee is more decisive. Extendedlogically, the licensee should havethe prerogative to decide the royalty.The fallacy is immediately apparent

Licensing Of New Products:Determinants Of Royalty Structure

BY TRICHY V. KRISHNAN* AND MURALI SANTHANAM**

*Trichy V. Krishnan is a professor at RiceUniversity in Houston, Texas.**Murali Santhanam is ContractAdministrator for Datasoft Consult-ants, Inc. of Houston Texas.

– the need for licensee’s input in thecommercialization process is onlysecondary to the invention. Said dif-ferently, the product4 is the primaryfocus of every enterprise and theprocess by which it is put in thehands of the customer becomes asecondary focus, although both areneeded for a commercial success.Moreover, since every licensee’sbusiness does not stop with theproduct-under-focus alone, hisquest in seeking maximized returnsin his overall business would in-volve factors inconsequential to thesuccess of the focal venture.

Our premise that the licensor orthe licensee has the exclusive privi-lege of determining the royalty isfaulty. Clearly, the answer lies in be-tween these two extremes. The licen-sor and the licensee make valuablecontributions in crafting the successof a venture and consequently havea hand in determining the royaltypayable to the licensor. It is ratherobvious that the licensor and lic-ensee are both essential parties to thesuccess of a venture and hence bothshould play an important role indefining the royalty. However, whatis not obvious is how much effortshould each put in to make the ven-ture a success, which makes it diffi-cult to decide on the royalty. Combinethis with other issues in negotiationand we quickly end up having a li-censing process involving the par-ticipation of professionals fromvarious fields – management, mar-keting, finance and law. Hence, it isno wonder that in many licensingnegotiations, royalty is the most de-bated and the least conceded – it couldeven be labeled the crucial compo-nent. After all, the licensor and lic-ensee work for a piece of the pie,each vying for a lion’s share of it.

Royalty determination may not bea big issue in case of products thatare already producing royalty rev-enue streams. Here, the licensormay be able to draw upon the exist-ing licenses in order to license fur-ther as long as there are no pendingdisputes on this. Similarly, if the lic-ensee is already licensing productssimilar to the focal product, he willbe able to find precedents and de-termine royalty. In the case of newproducts, however, neither the li-censor nor the licensee would haveprior models to draw upon. Royaltydetermination would then becomea very challenging issue in thosecases. In this research, our focus ison the royalty determination fornew products.

Why new products? Introducingnew products is probably the bestway to grow and to achieve marketleadership for any company. In fact,it has been shown that only thosecompanies that derive over 50% oftheir sales from the new productsintroduced in the past five years arevery successful. Smart companiesfind it prudent to invest lots ofmoney in new products in spite ofpotential cannibalization of theirexisting products because the com-petition is so severe that if theydon’t, somebody else will. Further,without new products in place, thecompanies will resort to price warsleading to profit erosion, thus lettingcustomers enjoy all of the surplus.In short, new product introduction

1. A patent empowers the owner to exactroyalties as high as he can negotiate with theleverage of the monopoly. Brulotte v. Thys Co.,379 U.S. 29, 33 (1964)2. Patent Act states that the court shall awardthe claimant damages adequate to com-pensate for the infringement, but in no eventless than a reasonable royalty for the usemade of the invention by the infringer. 35U.S.C. § 284.3. Fromson V. Western Litho Plate & Supply Co.,853 F.2d 1568; 7 U.S.P.Q.2d 1606 (1988).4. We use the word in its most genericsense – it encompasses everything thatcarries IP protection and is offered forpublic consumption.


is probably the best way to growvolume and profits, and hence it ishere to stay. On the other hand, mar-kets for many products have be-come so complex and so saturatedthat the consumers do not feel anynatural need for any new product.5

This in turn implies that in the caseof many new products that bom-bard the market every year “theworld does not (any longer) beat apath to the doorway of the inven-tor.”6 Hence, to market a newproduct successfully, participationof various other entities in theeconomy is needed. But, as ex-plained before, in licensing newproducts the royalty determinationbecomes a very tricky and thornyissue because of the need for astrong marketing push.

One way to structure the problemof royalty determination is to lookat the objectives of the whole pro-cess. There are two broad objectivesin general. The main objective in aroyalty negotiation is to make the li-censor and the licensee perceive theresulting royalty to be a fair alloca-tion of the profit of the proposedenterprise, thereby motivating eachto work towards success of the ven-ture. The other objective in royaltynegotiation is to make as far as pos-sible the royalty more a function ofrational issues than a function of “ir-rational” forces such as the raw mar-ket power or legal power of theparties in negotiation. These twoobjectives can be achieved if andonly if both the licensor and the lic-ensee clearly understand what ittakes to make the product a com-mercial success and how mucheach needs to contribute towardsit. This is because the success is not

achieved in one step, nor guaran-teed upfront7. In fact, if one analyzesthe various new product ventures,it can be observed that while someof the failures can be attributed tolow demand per se for the products,many of them can be attributed topoor marketing strategies deployedby the firms offering those products.In other words, the success of a newproduct is not as much a functionof inherent need for the product asit is of how the company under-stands or develops that need, de-vises an appropriate marketing plan(i.e., a well-laid out set of appropri-ate marketing strategies) to reachthe consumers, educates and con-vinces the customers about how theproduct fulfills that need.8 Hence, totackle the problem of royalty deter-mination one must first identify asmany of those various underlyingmarketing strategic factors as pos-sible, quantify them and relate themto the eventual market success.Once these factors are identified,then by ascertaining the contribu-tion of the licensor and the licenseeto each of those factors, he can de-vise a scheme that uses this infor-mation and apportions the profitsfrom the venture to the licensor andthe licensee.

A framework to help one deter-mine royalty in such a systematicand scientific manner is necessaryfor another reason also. In litigation,once infringement has been proved,the courts are called upon to ascer-tain damages payable by the in-fringer to the owner of the IP rights.In patent law, the damages can belost profits or an amount not lessthan the reasonable royalty. Courtsstruggle with the task of ascertain-ing “reasonable royalty,” which is theminimum that should be awarded tothe patentee. The courts concur thatthey had to use the judge-createdmethodology described as “hypo-

thetical negotiations between will-ing licensor and willing licensee.”9

Although the courts have devisednumerous methodologies to ascer-tain the “reasonable royalty,”10 aclose examination shows that theyare not very helpful in the case ofnew products. Thus, we find that arationalistic model that would facili-tate royalty determination is re-quired from both business and legalpoints of view.

Thus, our main objective in this re-search is to develop a frameworkthat can facilitate the determinationof royalty structure in the case ofnew products, where the licensorprovides the product and the lic-ensee provides everything else thatis needed to bring the product to themarketplace11. As mentioned before,this requires identification of thevarious factors involved with suc-cessfully marketing the new prod-uct. The first step to uncoveringthose factors is to understand whattype of novelty the new productbrings to the market. This is dis-cussed in Section 2. Specifically, weexplain how to define novelty in anew product and its implications formarketing strategy. We next explainin Section 3 how the novelty factoraffects the consumer adoption pro-cess, which in turn determines themarket potential and the salesgrowth dynamics of the new prod-uct. We also describe a process withthe help of which one can make aconnection between the marketingefforts and the resulting salesgrowth. In Section 4, we describehow the various marketing strate-gic factors described in the previoussections can prove vital in address-

5. In contrast, in the early part of the 20thcentury, the products were so sparse thatconsumers gobbled up whatever came to themarket, which tendency prompted Ford todeclare, “I can give you car of any color aslong as it is black.” Put simply, we have, as asociety, evolved from a seller market to abuyer market.6. Miller v. Daybrook, 291 F. Supp. 896 (W.D.Ohio 1968).7. The success rate of new products isaround 20% only, on an average acrossmany industries.

8. It should be noted that although anexcellent marketing plan by itself cannotmake a success out of a “bad” product,absence of a sound marketing plan will surelymake even a “good” product fail.9. Fromson, 853 F.2d 1568, 1569; 7 U.S.P.Q.2d1606, 1608 (1988)

10. One court has provided a list of factorsthat need to be considered in arriving at thereasonable royalty amount. Georgia-PacificCorp. v. United States Plywood Corp., 318 F.Supp. 1116 (S.D.N.Y. 1970)11. We do realize that many other factorssuch as finance, raw material, research anddevelopment are needed to commercializea product idea. However, we focus only onone aspect, namely marketing, in ourresearch, since this is the most critical andleast understood, in our opinion, of all thecommercialization factors involved withnew product introduction. We also believethat the other factors are easily quantifiable.


ing the legal considerations in-volved in royalty negotiations andarrangements. In Section 5, we con-clude the paper giving directions forfuture research.2.0 New Product and Noveltyin a New Product

Before taking up royalty negotia-tion for a new product, it is very im-portant to understand what effortsare needed to market the product.The first step in understandingthose marketing efforts is to explorethe type of new product we aredealing with. This is the subject ofthis section.

Consumer’s adoption or rejectionof a new product basically dependson the type of novelty the consumersees in the product, and the market-ing efforts expended in projectingit to him. The word “novelty”should not be construed as referringto new physical feature in the prod-uct nor in the sense it is commonlyunderstood in patent law. It pertainsto the novelty in the utility the con-sumer will achieve from consumingthe new product.12 A careful analy-sis of the various new products willindicate that there are basically twotypes of new products: breakthroughproducts and brand line extensions.Breakthrough products typicallychallenge an existing usage behav-ior and bring about a permanentchange in how consumers deriveutility from the activity concerned,while brand line extensions tend tofit into the existing consumptionpattern without necessitating anymajor change in the lifestyle or con-sumption behavior. We call theformer type “eagles” and the brandline extensions “birds.” We will nowdescribe these in detail.2.1 Eagles (Break-ThroughProducts)

Breakthrough products includedishwashers and washing machinesin the 1950s and 1960s, camcorders,personal computers and cellularphones in the 1980s, and DVD play-ers, robotic home appliances andportable digital assistants in the1990s. These eagles dramaticallychanged the lifestyles (at home orwork) and/or the consumption be-

havior of the consumers – Walkmancan be considered a good example.Initially people ridiculed the idea oflistening to music with the speak-ers inside their ears! Companies inthe U.S. refused to distribute or li-cense this product from Japan.Later, over a period of time, con-sumers discovered that Walkmancould add tremendous utilities –provide entertainment during theirjogging and walks, make theirtravel (train, bus and air) less mo-notonous, make their music listen-ing experience more private, makelistening to music less intrusive toothers, and allow them to listen totheir music whenever and whereverthey wanted. Once the consumersstarted realizing these additionalutilities for the surrounding activi-ties, the sales of the Walkman tookoff in an unprecedented fashion. Itis important to note that this break-through product changed not onlythe consumption behavior and util-ity of the focal process (i.e., listen-ing) but also those of many otherprocesses (ex: the exercising andjogging process) it impacted. Theoverall utility for the consumer in-creased so substantially because ofthe adoption of the Walkman that iteventually made consumers ex-claim, “How did I ever live withoutthis product?”13

Eagles create a need (and thus anew market) and over time elevateit to a necessity. The need intensi-

fies as consumers find utility notjust from its obvious immediate usebut from the increased utilities theyderive from some of the surround-ing activities as well, and thischanges the overall consumptionbehavior of the consumers. Many atime, as we noted in the case ofWalkman, it may be a while beforethe additional utilities of the eaglesare recognized for their worth.Hence, the adoption of some ofthese eagles among customers willbe gradual rather than spectacular.Thus, some eagles will have spec-tacular immediate growth whileothers will have delayed growth.We will call those with spectacularadoption as “swoop eagles” andthose with gradual adoption as “cir-cling eagles.”

Clearly, eagles don’t emerge veryoften since they require confluenceof many factors – technologicalbreakthrough, a strong vision of theinvestor and the company investingin it, and huge investment of re-sources – for their development.Further, it is not unusual to findhuge investments made to move theproduct from drawing board to pro-duction plant and perfect the com-mercial production of the prototype.To ensure maximum return for theirhigh and risky investment in eagles,companies adopt two methods.First, since these products generallypossess strong IPR, companies seekpatents for them. They would haveone or more patents covering them(at the very least, patents would bepending approval before a host ofcountries) – product, process or de-

12. For example, many consumers do notknow how a cell phone works to appreciatethe technical marvels in it, but they do likethe new convenience it offers in terms of‘staying in touch’ any time, any place.13. There have been quite a few products thathave evoked similar consumer response.Notable products are - Dish Washers (freedup time and energy for housewives andmade things less messy), B&W Televisions(self-explanatory), Cellular telephones(made communication time and locationfree, and made it portable), Microwaveovens (enabled part of the cooking and re-heating easier and quicker), Cameras (recordprecious moments in personal and publiclife), Instant cameras by Polaroid (self-explanatory), Digital cameras, Over-nightcourier service started by FedEx (enabledmail delivery a lot quicker, safer andanytime), Copiers (self-explanatory), andCamcorders (self-explanatory).

14. There is abundant dissemination ofinformation relating to IP protection andalmost all companies and individuals arealive to the risk of not seeking proper formof protection for their “product” (we use thisword in its generic form as referring to allvarieties of things ranging from patentablethings to copyrightable works to know-howworthy of trade secret protection). We do notanticipate a situation where a product islaunched without any form of IP protectionprocess in place. In the case of patents, thereare certain statutory “bars” which thelicensor has to be aware of. There is aninviolable time line that he has to strictlyadhere to, failing which the invention will beheld non-patentable.


sign.14 Second, it has become com-mon these days for companies tomaintain the know-how and othersensitive details as trade secrets.This is because companies are notconfident that certain proprietaryinformation command patent pro-tection. Hence, rather than riskingdisclosure in patent applicationsand later having those claims de-nied by the Patent Examiners,companies prefer to keep themconfidential and rely on the pro-tection afforded by the trade secretlaws. If some claims are rejected butyet the patent is granted, the entireapplication is published and thecontents of the rejected claims alsobecome public. It is only necessaryto take all reasonable steps to ensurethat the proprietary information iskept secret to continue to enjoy theprotection afforded by trade secretslaws. It should be kept in mind thatwhether a new product will be aneagle or not depends not on whatthe company desires or expects it tobe but on what the consumer de-rives from it.

In the case of products that com-mand copyright (e.g., movies,computer software, music, etc.), assoon as the “ideas are fixed in atangible medium,” protection isafforded. There are some creationslike computer software that can besubject of both a patent and acopyright. The decision to elect foreither or both forms of protectionis again a matter for legal advice,and deliberation.2.2 Birds (Brand-LineExtensions)

Birds do not produce sweepingchanges in the existing consumerbehavior. They simply bring in anincremental utility, perhaps to a par-ticular segment of the consumers, intheir consumption process. Theyhave a minimal effect on the utili-ties derived from other activities ofthe consumer. Examples of brandline extensions are yogurt with cof-fee flavor, liquid detergent, off-beatmovies such as Home Alone andTitanic, HDTV, a new TV with a big-ger screen, a new cell phone withtwo additional features, lemon fla-

vored potato chips, a new perfume,another game show on the TV, etc.

Unlike eagles, which create andthereby dominate a new huge mar-ket that survives for a long time,birds capture a small fraction of theexisting market they target. How-ever, some birds hit a jackpot. Con-sider the baking soda toothpasteintroduced by Arm & Hammer, anew entrant in the toothpaste mar-ket. The incumbents (P&G, Colgate-Palmolive, and others) didn’t payattention to this bird, but within ayear, A&H baking soda toothpastecaptured such a sizable marketshare that all the players hurriedlyintroduced their own baking sodaversions. It will be hard to believethat any expert would have pre-dicted such an outcome.15 Thus,among the bird type of new prod-ucts, some birds produce eagle-likeeffects, raking in huge returns thatare often unexpected, even by thecompanies introducing them. Wewill distinguish the two categories,calling them “birds” and “dom-

birds” (Dominating Birds).It is important to realize that

while eagles create a new market,these dom-birds do not create anynew market but by meeting an ex-isting need (or a latent need)16 moreeffectively or efficiently17 they wresta huge market share away from al-most every existing brand in the cat-egory. They do not enlarge theoverall market but redistribute theexisting market share points.18 Thedom-birds upset the market struc-ture and come to occupy the firstbranch of decision-making in manyconsumers’ minds (see Figure 1). Ifwe define the market structure (orconsumer choice structure) in a cat-egory, we will find that dom-birdscreate a new branch somewherenear the top of the tree while other

15. Similar are the stories of Tide (liquiddetergent introduced by P&G), Sanex(dermo-protectant liquid soap introduced bySara-Lee in Europe), Sensor (razor introducedby Gillette), “Who wants to be a Millionaire”(game show by ABC) and Minivan (in-troduced by Chrysler with its brands DodgeCaravan and Plymouth Voyager).

Figure 1.

16. Baking soda toothpaste and dermo-protectant liquid soap are examples of thistype.17. Efficiency can be achieved with respectto any resource base including time,money and effort. Microwave-safe foods areexamples of time-based efficiency, Lexus,being an almost Mercedes class (at a far lessprice), is an example of money-basedefficiency, and walk-behind lawnmowerwith power push is an example of effort-based efficiency.18. Minivans are a case on point. The minivantook away share from subcompact, compactsand other station wagons.

Size (fl. oz.)

Consumerdecision tree(an example)

Ultra detergent

Liquid PowderForm

Brand AllSurfTide

Consumer Decision Process

25 50 100


birds simply fit in to one of the lowerbranches (see Figure 2 for exampleof such a structure).

Although we could successfullydifferentiate a bird from a dom-bird,19 it is very difficult to predictwhether a brand-line extensionwould turn out to be a bird or a dom-bird. We can only probabilisticallysay whether a bird would be a birdor a dom-bird in the market, the restis mostly happenstance.

While it is easier to develop a bird,it is possible that some birds mayrequire more resources than oth-ers.20 Further, it may not be veryevident whether minor alterationsin product features or changes incomposition are patentable. It couldbe a very cost intensive effort to findout whether or not the “result” ispatentable. Even if it is found to bepatentable and a patent is obtained,the claims may be very narrow. Thecriteria for grant of copyright arehowever less rigorously structuredand hence copyright protection maybe available.21 Hence, the companiescannot expect to use patent protec-tion to recoup their investment, ifany. They typically resort to two av-enues. First, they market the prod-uct so quickly and so intensivelythat the other companies take timeto catch up. Second, major marketplayers use their existing trade-marks to offer some sort of protec-tion for the birds. If companies carrymarks that would ordinarily be con-sidered merely descriptive and un-worthy of trademark protection,

they can sometimes acquire a “sec-ondary meaning,” which connectsthem to particular goods or ser-vices.22 Even new entrants can ac-quire trademark registration basedon intent to use the mark if it is lateractually used in commerce within sixmonths (extendible for an additionalperiod of six months).23 Avoiding orpreventing customer confusion is apriority in trademark law and hencethe launchers would be able to usethe tools of trademark law to pro-tect the birds. In our coffee flavoredyogurt example, the first entrantwould register not only its name(e.g., Yofee) but also its color com-bination and picture in the productpackaging (coffee seeds floating inwaves of yogurt).

Thus, we can say that new prod-ucts can be classified as belongingto one of the four types: swoopeagles, circling eagles, dom-birds,and birds. This takes us to the nextquestion - How can this classifica-tion help us in understanding theconsumer adoption dynamics of anew product? This is the topic of thenext section.

3.0 Novelty in a New Product(Consumer Adoption Dynam-ics and Market Level SalesGrowth) Marketing EffortsEffectiveness

As stated earlier, success of a newproduct can be said to be deter-mined by two main factors, namely,the product per se (product novelty,quality, design, reliability, whetherit meets a need, etc.) and the mar-keting efforts.24 In the previous sec-tion, we focused on the novelty ofthe new product. Now, we will lookinto the marketing efforts in detail.Typically, a licensee draws a market-ing plan, which is a blue print thatanalyzes the efforts needed, the lev-els required, and the time line overwhich the efforts need to be put in.Since the end objective of expend-ing these efforts is to enable con-sumers’ acceptance of the product,the best way to determine the con-stituents of the marketing plan is to“reverse engineer” the whole pro-cess - start with the consumer andexplore what would make him

Figure 2.

19. When the Minivan was introduced, LeeIacocoa, the CEO of Chrysler Corp, observedthat it was a big gamble because the com-pany’s fate was tied to the success of theminivan. Although the gamble paid offhandsomely, his statement at the time of orjust before launch, exemplifies the difficultiesin predicting success potential of birds. Otherexamples are the baking soda toothpaste andthe liquid soap (Sanex) introduced in Europe.20. For example, the development of theliquid detergent by P&G might have con-sumed more resources than the developmentof, say a new yogurt with a different fruit orflavor or texture.21. Copyright protects the “expression” andnot the “idea.” Even if the underlying ideasare the same, if the form of expression is shownto be different, copyright will be granted.

24. Marketing efforts include various factorssuch as knowledge of the market, iden-tification of proper target markets, type ofdistribution support offered, communicationmessage and media used, price charged,resources and commitment expended inexecuting the marketing plan, and types ofstrategies employed to tackle competition.

Size (fl. oz.)

Ultra detergent

Liquid PowderForm

Brand AllSurfTide

Birds vs Dom-Birds

25 50 100

New Product

Dom-Birds

Birds

New Product

22. Secondary meaning is present when, adescriptive mark has “become distinctive ofthe ... goods [or services] in commerce. [15U.S.C. § 1052(f)].23. 15 U.S.C. § 1051 (b).


adopt the product. Sections 3.1 and3.2 are devoted for this.

There is another reason why it isimportant to understand the con-sumer adoption dynamics for a newproduct and its implications formarketing strategy. Companies thathandle all the activities from prod-uct manufacturing to marketing,such as P&G, generally have the in-frastructure to provide many ofthese marketing efforts and alsohave the competence to identify theoptimum mix of these factors for agiven new product. When suchcompanies develop and market anew product, they will tune their ex-isting resources to suit the newproduct and there is no need toidentify the relative contribution ofthe novelty and the marketing ef-forts in the eventual success or fail-ure achieved. However, in case oflicensing, where the licensor andlicensees are two different entitiesseeking their own profit maximiza-tion objectives, the licensor is at adisadvantage because he cannot ac-tually observe the marketing effortsthat might be deployed by the lic-ensee. There is a possibility ofmoral hazard, i.e., the licensee hasan incentive to put in the market-ing efforts in such a way and mea-sure that the outcome would bemore beneficial to him than to thelicensor. A product licensor wouldhave two major concerns – whetherthe licensee expends the requiredmarketing efforts and whether theefforts so expended produce the de-sired results. The consumer adop-tion analysis will identify a set ofbasic marketing effort requirementswhich can then be used by the licen-

sor to cross check the extent and ef-fectiveness of the licensee’s market-ing efforts.25 In fact, such a set ofbasic requirements can also be usedas a common ground by both licen-sor and licensee to start their nego-tiation process.26

Currently, licensing Agreementsusually incorporate either a “bestefforts” clause or a “minimum per-formance” guarantee. The former isused in situations where there hasbeen a course of dealing between theparties and mutual trust has devel-oped or when the parties are notable to decide upon a definite mixand probable extent of efforts. Thelatter is adopted in situations wherethe licensor has a fair grasp of thethreshold efforts needed and looksto the licensee to exceed or at leastput in the bare minimum. Partiesshould be cautious not to use eitherof these clauses as a substitute fordetails in a licensing agreement butas a residuary clause that will serveas a fallback in case of omissions. Aprudent approach would be tospecify, as far as practicable, thevarious efforts expected from the lic-

ensee. In litigation for breach of“best efforts” or “minimum perfor-mance” clause, courts are likely tofirst look to objective criteria con-tained in the license.27

Before we proceed further, it hasto be noted that for expositionalease we are abstracting away fromother issues such as the marketingcompetency of the company con-cerned,28 competitive factors29 andnetwork externalities.30 Thus, we re-strict our focus to only those standalone new products that do not haveany competition in the market nowand in the near future, and we alsoassume that the potential licensingcompanies have sufficient market-ing savvy.3.1 Adoption Decision Process

Consumer decision process inadopting a new product has mul-tiple stages that we call AKCUD.They are:

Awareness stage – consumercomes to know about the product’sexistence;

General Knowledge stage – theconsumer develops an initial inter-est in the product;

Conviction stage – the consumerseeks, collects and analyzes specificrelevant information and gets con-vinced about the product’s utility;

Uncertainty reduction stage – theconsumer gets over his misgivingsabout a product’s performance andpossible side effects; and

Adoption stage (makes a decisionto adopt).

We will now discuss each of thefive stages in detail. The AKCUD31

discussion will bring out the needfor different types of marketing ef-

25. There are many marketing research toolsavailable that can be used to test and measurethe impact of various marketing efforts. Forexample, impact of advertising can be testedthrough measuring, in a sample customerbase, how many of them remember theadvertisement and the product.26. The fact that the various marketing effortsare inter-dependent and that they assumedifferent levels of importance for differentnew products make it difficult, if not im-possible, to draw out a complete marketingstrategic plan for introducing a given newproduct. Hence an ongoing discussion on thisissue is critical.

27. A discussion of the interpretation of the“best efforts” clauses in many cases can befound in David Bressman et al., AvailableRemedies for Dispute Resolution in Internationaland U.S. Trademark Licenses, in The New Role ofIntellectual Property in Commercial Transactions377, 380-81 (Melvin Simensky & Lanning G.Bryer eds., 1994)28. A concerned licensor would typically ask‘how experienced is the marketing de-partment of the company to handle a newproduct?, how comfortable the company iswith the target customer?’ For our researchpurposes, we assume that the companiesinvolved in licensing have a good marketingdepartment that is experienced enough inboth the areas in the sense that majormarketing blunders are less likely to happen.A simple example of such blunders is stockinga product in Foley’s when the intended targetcustomer is a WalMart shopper.29. We also assume that the new productconcerned here has IP protection and henceto that extent the competitive factors do notplay any major role. We are conscious offactors like the scope of the claims coveringthe new products, the ease or difficulty withwhich claims can be designed around, andthe validity of the patent claims have adefinite bearing on the royalty. The successor otherwise of a product is dependent onthese factors and our classification of productsinto four categories is based on the showingin the market by the product.

30. The utility of products such as telephones,fax machines and application softwareprograms to an individual depends to a largeextent on how many others have adopted theproduct. For some products such as TV, theutility increases as more channels andprograms are offered. These effects are callednetwork externalities.31. A similar “chain” concept one can find inany marketing textbook is AIDA, whichindicates Awareness, Intention, Decision andAdoption stages. However, the AKCUDchain we propose here is more suitable forour purposes.


forts for the different types of newproducts we discussed in Section 2.Stage 1. Awareness

A swoop eagle or a circling eagleis more likely to be quickly spottedand noticed by the consumers thana bird or a dom-bird. Consumerswill become immediately aware ofan eagle when they get exposed toit, while they may not actively reg-ister the existence of a bird or a dom-bird unless they are exposed to it ina persistent fashion.32 In the case ofa swoop eagle or a circling eagle, theproduct’s novelty will be enough tocreate awareness, and sometimeeven excitement, if a minimum levelof advertisement is done to makethat exposure. Swoop-eagles gener-ate free PR and word of mouth thatwill further reduce the need for afull-blown advertising campaign.Apparently, the novelty factor playsa big role in catching and retainingthe consumer attention. The lower

the novelty (as in a bird or a dom-bird scenario), the greater are themarketing efforts (advertising, dis-play in retail stores, promotions,PR efforts etc.) needed, especiallyin generating awareness. Note,however, that in the case of a cir-cling-eagle, since it takes time forconsumers to appreciate the over-all utility increase the productbrings to them, certain additionallevel of marketing efforts (i.e., thanthose for swoop-eagles) are neededat this awareness stage so that theykeep it registered in their minds al-though they are less likely to ac-tively move to the next stage. It isimportant to note that in all the fourcases, the awareness level needs tobe measured frequently throughmarketing research tools to keeptrack of the product diffusion pro-cess and the effectiveness of market-ing campaign.

There is another dimension in thisawareness creation stage. Some-times, even a new swoop eagle orcircling eagle may go totally unno-ticed if it addresses a non-main-stream activity of target customers.33

Although it is safer to make a caseby case determination it can be gen-erally stated that consumers are alsoless likely to notice novelty in low-cost products of common use andmore likely in the case of durablegoods.34 The obvious reason forthis divergence in consumer be-havior is that there is considerablymore involvement in the purchas-ing process in the case of durablesthan in the case of non-durableconsumer goods.

In summary, how important anew product is from the consumer’sperspective determines how far theconsumer will be ready to pay at-tention to it or to the marketing ef-forts supporting it. Since birds, to

begin with, do not have much tooffer they are least likely to gain anyground if the product is in a lowpriority category. By the same token,the success of eagles also cannot beassured in such a category. Both thelicensor and the licensee shouldhave a clear sense of how importantthe particular activity is, which thenew product addresses, in the glo-bal picture, i.e., in the overall life orwork style of the customer. If it is avery low priority activity for theconsumer, more and perhaps differ-ent marketing efforts (repeated ad-vertising, direct mail campaigns,direct sales force, booths in confer-ences, etc.) need to be employed tocreate a good level of awareness inthe market.Stage 2. General Knowledge

In the post-awareness stage, con-sumers will immediately be able tomake out how “birds” and “dom-birds” work and what they do. It isbecause those products fit in withthe existing life style (ex: liquid de-tergent or HDTV or teeth-whiteningtooth-paste) and they seem to pro-vide a higher or a slightly differenttype of utility to an existing activity(i.e., to washing or watching TV orteeth brushing). Consumers can, ontheir own, gain a high level of gen-eral knowledge about the product,without the licensee investing anyefforts in creating it. The product,perhaps with an apt name or a smartpackaging or both, will speak for it-self. Usually, birds and dom-birdsare often a result of market feedbackfrom consumers, retailers and dis-tributors and hence, marketing ef-forts do not play any major role inconveying to the consumers any

32. When introducing their new product,Robotic lawnmower, a company based inIrvine, Texas, spent minimum efforts inadvertisement. Houston had this product ona couple of bill-boards and for a short timeon radio. Four other cities had this producton TV (just one channel) for a month. In othercities, it was in magazines for a longerduration but many people became quicklyaware of the product’s existence though notsufficiently enough to buy it. A similar thingcannot be expected to happen with, say, awalk-behind lawnmower with a new cuttingblade.33. An automobile company will be moreinterested in improvements made in asteering box or suspension design than inimprovements made in bolts and nuts. If abolt manufacturer is interested in getting theattention of the car manufacturers towards anew bolt, the changes brought forth in thenew bolt should be exceptionally great. Onthe other hand, even not-so-major im-provements made in suspension or tires willimmediately grab the attention of the carmanufacturers. Rohm and Haas, the chemicalgiant, tried to sell a new cleaning agent forsmall workshop machines, but couldn’tsucceed in informing, educating and con-vincing the potential customers since thecleaning agent is a very low priority item intheir purchase decision process. Similarly, asmall company came up with a new shock-pad for the construction industry, butcouldn’t make the product a success becauseit lacked resources to market this low priorityitem (i.e. from consumer point of view). Thisis true for household items as well.

34. A toothbrush is least likely to get theattention of the customers unless it reallyinvolves, for example, a stunning new designor very high life expectancy. The “lifeexpectancy wars” fought by the batterymanufacturers is another example. On theother hand, a new type of mattress introducedby, say Sealy’s, will get the attention fromthose shopping for a mattress.

35. Take the digital camera - potentialconsumers quickly become aware of itsexistence, but what the product can do vis-à-vis a regular camera and how it works(internally and from the consumer usagepoint of view as well) are not generally wellknown.36. This is the reason why market researchfor eagles and late-soaring eagles will bemisleading in many cases. Consumers willfind it difficult (and perhaps will be un-willing) to assess the new utility it providesand hence any response from them will behighly misleading.


general information about how theproduct works.

In the case of swoop eagles, con-sumers will be highly aware of theproduct’s existence but will gener-ally lack knowledge on its predictedcapabilities. Often, the utility to begained is new, un-researched (in themarket) and not immediately relat-able to anything that the consumeris well accustomed to.35 This is be-cause the consumers tend to visual-ize or perceive eagles within anexisting framework that has largelybeen built on the prevailing mind-set, life-style and societal infrastruc-ture which the new breakthroughproduct seeks to differ from or chal-lenge and change (recall Walkmanexample).36 If lack of such a generalknowledge is wide spread anddeep, the eagle will become a cir-cling eagle. In the case of swoopeagle and circling eagle, the market-ing efforts should be effectively de-ployed to build a high level ofknowledge about the product’s useand usage in the target market.Without such focused efforts, con-sumers will be left with only in-terest and curiosity about theproduct and will lack the “push”and enthusiasm to move further inthe AKCUD chain. The product’scomplexity (ex: multi-functionality)or user-friendliness will also be afactor in this marketing effort.37

Marketing efforts for knowledgediffusion can take many forms, de-pending upon the product type andthe target market. They includesales force directly contacting pro-fessionals (doctors, lawyers andplumbers), company reps meetingB2B clients through teleconferenc-

ing and industry wide conferences,retailers employing workshops andkiosks, web sites providing all de-tails, clever TV and print advertis-ing, to name a few.38

In the case of late-soaring eagles,the initial interest will be very lowand so the marketing efforts have tobe carefully planned taking into ac-count the evolution of the needs.One suggestion is the use of thechasm model proposed by Moore(1995).39 However, both the licensorand the licensee have to practice pa-tience and carefully keep track of thedevelopments; otherwise, the prod-uct will never soar at all.Stage 3. Conviction

After gaining a general knowl-edge about the new product, a po-tential consumer is likely to askquestions such as “What does it dofor me?” “What is the utility I gainfrom using the product?” “Can I getan idea about the $ value of that util-ity to me?” This is where the mar-keting efforts need to be really smartsince they can make the biggest im-pact. Basically, the licensee shouldbe able to create a lasting impressionin a consumer’s mind - how exactlythe consumer should perceive thenew product and its functions, valueits utility and compare it with a like-product, etc. This positioning cam-paign is the best marketing tool thatthe licensee has to “manipulate” theconsumer in order to make himthink about the new product in theway he and the licensor want himto think. If this is done successfully,the consumer will get convincedabout the utility he could derive

from the product and move on toadopt it.

This is difficult to achieve in abird, which is just a brand line ex-tension. This is because the consum-ers have a good general knowledgeabout what the product does andhence the licensee has to concentrateupon the increase in the utility thathis product can bring about. Thisincrease could be expressed in termsof effectiveness, efficiency or both(ex: less color fading in case of a newcolor-guard detergent, more movielike experience in case of a new bigscreen TV). The unknowns are thedegree to which the consumerwants to get accustomed and startbelieving in the additional attributeand the amount of value he may at-tach to the extra utility. The goal ofthe positioning exercise will be tomake consumers believe that thenew product would really providea sizable incremental utility in theactivity (think of whitening tooth-paste) and that the incremental util-ity will be beneficial to him.40 Thelicensee should be creative in coin-ing and communicating the position-ing theme to the target consumers ina credible manner.41

The positioning exercise is equallyimportant for swoop eagles and cir-

37. Multifunctionality refers to inclusion ofmany features in the product. User-friendlinessrefers to the ability of the product to make apotential adopter understand its essentialfeatures on his own.38. Since the attention span of consumers toTV ad is very limited, it may be sometimescounter productive to indulge in any know-ledge enrichment exercise through this media.39. The book Crossing the Chasm by GeoffreyMoore (published by HarperCollins Publishers,1999) makes some interesting suggestions on this.

40. Authentic claims (Crest toothpaste’s tartarcontrol property approved by FDA, Oatsreduces risk of heart attack) or importance ofthe utility to a sizable number of consumers(viagra, liquid form of detergent) can make abird into a dom-bird. It is possible for a birdin a consumer durable category (Lexus,HDTV) or an industrial durable (forklift truckor a new copier machine meant for smallbusiness units) to use what is called a price-performance criterion, which basically helpsthe consumer quantify in monetary terms theutility of the new product with reference tothe product being replaced. We will discussmore on this later infra note 50.

41. The positioning point has to be finelydefined for a bird. Otherwise the new productwill not get differentiated from the existingproducts and this will make the consumerwonder “Why do I care about anothershampoo?” The important thing to note is thatthe consumers will hardly make any attempton their own to notice and appreciate thedifference. Since birds are not likely to benoticed or taken seriously in one attempt, afrequent and consistent communication of thepositioning is needed.42. One can harp on the positive factors (ex:very fast download through DSL) or negativefactors (ex: how a slow download wouldhurt).43. A quick reading of the book Break-throughs by P. Ranganath Nayak and John M.Ketteringham of Arthur D. Little (publishedby Mercury Business Books, 1993) willillustrate this point. Provides is not just over-night delivery but freedom from planning 3days-ahead for some mailing and an additional3 days for the activity concerned! This“convenience” makes consumers allocate theirtime to the various activities much moreeffectively and efficiently.


cling eagles but the challenge hereis different. The consumers shouldbe educated on everything the prod-uct can do for him. The licensee hasto come up with creative content42

and an apt way to deliver it in or-der to convince the consumer aboutthe product. It is vital to bring theconsumer to a different level ofthinking and convince him on thenew type of utility the productbrings to him, both for the immedi-ately recognizable activity and otherrelated activities (ex: camcorder,Walkman).43 Since a considerablechange in behavior (with respect toconsumption of the relevant activi-ties) is required of the consumer inorder to appreciate and assign somevalue to the new product’s utility,the potential consumer has to beconvinced with respect to those ac-tivities in a changed surrounding.Once informed, the consumers willget the message quickly and re-peated communication is not re-quired, and the resources can beallocated elsewhere. Further, witheagles, the word of mouth is likelyto play a much greater role in con-vincing the consumer about the newutility it brings forth. In essence,what the licensee needs to do in caseof eagles is light a carefully selectedsplinter and the fire will hopefullyrage on.

In case of a late-soaring eagle, thisexpected change in behavior isharder to convey44 and hence it maybe that the consumers themselves

will discover those changes overtime.45 Quite often, not much can bedone by anybody in the case of late-soaring eagles. The licensee has tobe patient and should keep remind-ing the potential consumers aboutthe new product with the position-ing messages till it takes off.

Whether it is a bird, a dom-bird, aswoop eagle or a circling eagle, avery interesting aspect of this con-viction stage is that consumers arevery likely to be different from oneanother in their need, willingnessand ability to get convinced. Thereis an inherent heterogeneity in themarket with respect to this stage.There will be some who will get con-vinced immediately, some a littlelater, some a long time after andsome probably never.46 In otherwords, there will be segments in thepotential consumer pool, rangingfrom the gullible to the skeptical,with respect to how tough it is toconvince them on the usefulness ofthe new product. A major market-ing challenge is to identify thosedifferent segments, understandthe requirements of each segmentclearly (i.e., with respect to whatwould convince them), and finallycome up with some novel tech-niques to design and deploy strate-gies appropriate for each segment.Marketing research techniques suchas factor analysis, discriminantanalysis, multidimensional scaling,etc. can be used for identifying thesegments. It is not unusual to findthat the segments will be so differ-ent from one another that the com-pany cannot afford to go after all thesegments because the amount oftime, money and effort needed totarget all the segments would beoverwhelming. Sometimes, it willbe logical to go after certain seg-ments initially and the other seg-ments later. Tools such as SWOT47

analysis will be very helpful at thisjuncture. While the primary re-

sponsibility of picking and target-ing the right segments is that of thelicensee, the role of licensor will bevery useful at this stage since heknows more about the product, itsfunctionalities, limitations and fu-ture developments in its design.Moreover, both the licensor andthe licensee should be aware thatthis segmentation-based approachneeds a systematic monitoring anda periodic updating.Stage 4. Uncertainty Reduction

Even after getting convincedabout a new product’s utility andbenefits, the consumers may still notadopt the product. This is becauseof the uncertainty (both real andperceived) surrounding the newproduct per se. This is especiallytrue with eagles.

A major but natural uncertaintythat consumers have regarding aswoop eagle or a circling eagle and,to some extent, a dom-bird is withrespect to its performance (or non-performance and unknown side ef-fects) such as whether it wouldwork, what will happen if it doesn’twork, what to do if it fails suddenly,whether the price charged is right,etc.48 Further, barring a few, consum-ers may not have any immediate ur-gency to adopt the new product.They can afford to wait till it isproven in the market. This uncer-tainty makes the potential consum-ers more risk averse, especially ifthey don’t have any urgent need forthe product. Or, as mentioned else-where, consumers may simply failto see the overall increase in utilitythe product promises to his life-style. Then, the consumers will sim-ply postpone adopting the productuntil after receiving a good word ofmouth feedback from those whohad already adopted it or from re-ports such as consumer reports andarticles in trade journals. These bitsof information basically go to reduce

44. It is widely believed that consumersthought of the refrigerator as just a big ice-box. To cite another example, consider FedEx.Except those who were desperately lookingfor an over-night service, many would havefound it to be a high-end luxury product, onlyto be appreciated but never to be used.45. For example, in the FedEx case discussedin the previous footnote, consumers wouldhave gradually found that what FedExprovides is not just over-night delivery butfreedom from planning 3 days-ahead forsome mailing and an additional 3 days forthe activity concerned! This “convenience”makes consumers allocate their time to thevarious activities much more effectively andefficiently.46. Note that this heterogeneity exists in thefirst two stages also, but their impact on theprocess is minimal.

47. SWOT stands for Strength and Weakness(of the company with respect to what it cando in a given segment), and Opportunity andThreat (of the dynamics of the segment underfocus with respect to the attractiveness of thesegment now and in the near future).

48. This does not mean that the consumersdo not have problems with any of theirexisting products. However, with existingproducts, the problems are rather wellknown and the consumers know how tohandle them.


the uncertainty associated with thenew product’s performance or bringout the overall increase in the util-ity one can potentially realize withthe product or both. Since a consid-erable part of such uncertainty canbe attributed to the inherent natureof a consumer, the decision ofwhether and when to adopt can beexpected to vary across consumerswidely, just like the conviction fac-tor we discussed in the previousstage. In the case of a circling eagle,this uncertainty may exist in manyconsumers and for a long time withthe result that the sales in the initialyears will be close to zero.

Between birds and dom-birds,there is divergence in the adoptionpattern between durable and non-durable goods. If the bird is in a con-sumer non-durable category, theadoption dynamics will basicallyfollow “let’s try it” behavior of theconsumer because the trial proce-dure is almost with zero risk, anduncertainty is unlikely to be a ma-jor factor. However, with some non-durable consumer goods, such asOTC drugs, detergents and babyitems where the potential side ef-fects can be disastrous even with a

single consumption process, theadoption pattern may sometimesfollow that of an eagle. The slowgrowth of generic drugs in place ofpatented drugs after the patent ex-pired is a clear example.49 In general,word of mouth is least likely to playany major role (except when theproduct turns out to be “bad”) sinceconsumers can afford to make deci-sion on their own.

Let us consider a bird in a con-sumer durable such as a car (ex:Lexus) or TV or an industrial du-rable such as a forklift truck or a newcopier machine meant for smallbusiness units. There will be someuncertainty with respect to its per-formance, but in general the adop-tion decision will be affected moreby price-performance criterion50

and need for replacement of theexisting product. In the case of in-dustrial non-durable goods (calledconsumables), this uncertainty mayplay a more important role becauseit may have a serious impact on thefinal product.51

The licensee can try to evaluatethe extent of uncertainty in theconsumer’s mind and address itthrough various marketing effortslike clear positioning (preferablytuned to different segments),money-back guarantees schemes(this will reduce the perceived riskof product failure), product demon-strations in various places, guaran-teeing service delivery within acertain time, endorsement from es-tablished spokespersons/leaders inthe market, establishing chat pagesand group discussions to facilitateword of mouth generation andspread52, etc. However, whateveryou do, some degree of uncertaintywill subsist in the minds of the po-tential consumers that only passageof time will cure.53 All these efforts

have only a limited effect, and thisis a function of the product charac-teristics and the target market’s eco-nomic and social characteristics.Stage 5. Adoption

The preceding four stages help usunderstand the process a consumeris likely to go through and is likelyto be led by a smart marketer, be-fore making a decision to adopt anew product. The first two stages(Awareness, General Knowledge)take him near the product while thelast two stages (Conviction and Un-certainty reduction) make it worth-while for him to adopt it. We saw,however, that the consumers arevery heterogeneous with respect totheir readiness, ability and need toget convinced and with respect touncertainty and how it is reduced.This implies that whatever the lic-ensee does in terms of marketingefforts, there will always exist a siz-able fraction of the market who willstill be meandering along in the 3rdand 4th stages. As more and moreconsumers adopt the product, theconviction and uncertainty reduc-tion will happen gradually and au-tomatically and more and moreconsumers will move on to theadoption stage. In other words,there is a natural time bound “de-lay” in the adoption process in agiven market, some adopting imme-diately (i.e., early adopters) andsome postponing the adoption (i.e.,late adopters). Usually, the transi-tion from early adopters’ actualadoption decision timing to that oflate adopters is smooth. This dy-namic process is very true withswoop eagles, circling eagles and, toa lesser extent, birds and dom-birds.Note that, as explained elsewhere,in case of circling eagles, the transi-tion from early adopters to lateadopters will not be smooth, espe-cially if the characteristics of thesetwo are vastly different, and thismay result in a sharp time gap be-tween the early adopters and thelater adopters. This gap, also calledchasm, can be mistaken for failureof the new product. 3.2 Market Level Sales GrowthPattern

So far we have been discussing the

49. Note that slow growth need not beattributed to slow adoption alone. A poordistribution (by design or ignorance) wouldalso result in a slow growth. An example of apotential risk associated with a new consumernon-durable good is the recent debacle ofUnilever’s new detergent in Europe, wherecertain ingredients in the product damagedthe fabric instead of attacking the dirt.50. Consider for example the micro-processorcategory. When a new chip comes into themarket, the consumers (both OEM and theend-consumers) would do a mental cal-culation on how the new enhanced chipperforms with respect to the current chip andat what cost. For this comparison purposes,consumers tend to pick a dominant attribute(processing speed in this case) for per-formance evaluation, although the product(i.e., the chip) has to be, strictly speaking,judged on more than one attribute. Onceestablished in the consumer’s mind and inthe market, it is very difficult to replace thatdominant attribute. The recent attempt byAMD, the second leading chip manufacturer,is a case in point.51. The recent tire controversy in FordExplorer shows that a poorly designed ormanufactured tire may eventually lead to amajor product failure.

52. It is believed that the movie Titanic’sspectacular growth was mainly fuelled by theword of mouth spread among the teen-agedgirls (the principal target market) through thechat pages maintained by the movie studio.53. However, understanding this time-boundprocess is critical. This is explained in Stage 5next and in Section 3.2 further.


adoption of a new product at indi-vidual consumer level. Although itis very important to understand thetypes of marketing efforts needed tobe expended at every stage of theadoption process for different prod-ucts, both the licensee and the licen-sor will be equally, if not more,interested in understanding how thesales grow at the market level. Thisis because the market level salesgrowth is what will bring them theanticipated revenue and profits, anda licensee would like to eventuallyinfluence this through his under-standing of the adoption processand the impact that marketing in-struments have on it. The mainquestion now is how to use theAKCUD process and explain whatis happening at the market level.This is the focus of this section.

The various individual level fac-tors underlying the AKCUD frame-work can be summarized in threemarket-level sets of variables:

1. Social and economic variablesof the target market as applicable tothe focal product: These include fac-tors such as whether the market isrisk averse, how many need thisproduct desperately, whether thedecision making is purely rationalor affected by emotional factors,how strong the word of mouth ef-fect is, etc.

2. Product related variables: Theseinclude factors such as type of nov-elty, potential risk of side effects,whether the functionalities claimedare easily verifiable or not,54 extentof estimated overall utility with re-spect to immediate utility, etc.

3. Marketing efforts expended bythe licensee: These include advertis-ing, positioning, pricing, promo-tions, sponsoring internet chatpages to facilitate word of mouthspread, financing, warranty provi-sions, distribution reach, retail sup-port, sales force efforts, etc.

Several points are worth notinghere. First, while the third set (i.e.,the marketing efforts) is under the

control of the licensee and the sec-ond set (i.e., the product related is-sues) owes its presence to the licensor,the first set is not under the controlof either. Second, how the licenseecrafts the marketing efforts, whichare necessarily a function of the firsttwo sets of variables, decides the fi-nal outcome, i.e., the market levelsales growth. Third, the eagles arelikely to be dominated by the firstset of variables while the birds arelikely to be dominated by the sec-ond set of variables. Hence, eaglesand birds will have different pat-terns of market level sales growth.

3.2.1 Eagles: Although the com-plex interactions among the threesets of variables make one wonderabout the resulting sales growth ofthe product, it is interesting to notethat the sales growth always exhib-its an inverted-U shape (see Figure3) for an eagle. This is called a dif-fusion curve, the exact shape ofwhich differs from one product toanother. The differences can occurin the starting sales (impact frompredominantly the first two stagesof AKCUD), rate of growth (impactfrom predominantly the last twostages of AKCUD), peak sales (im-pact from predominantly the thirdstage of AKCUD) and peak salestiming (impact from all stages ofAKCUD). Although differencesmay exist, it is really interesting tonote that the sales growth will al-

ways have an approximate in-verted-U shape pattern. This par-tially implies that the first two setsof variables (also called exogenousvariables) have a profound impacton the adoption process. Thus themain role of marketing efforts is tokick start this diffusion process andcontrol it in such a way that certainobjective, which is jointly set by thelicensee and the licensor, is achieved.This objective could be maximizationof profits from the sales over, say thefirst five years or maximizing mar-ket penetration in, say two years, orsome combination thereof, etc.

In order to effectively utilize mar-keting variables to control the dif-fusion, one needs to know first howthese variables affect the diffusionprocess and then derive the optimalway of utilizing it. Regarding thehow step, although one can conjec-ture that the impact of an individualmarketing effort will have a typicalS shape pattern (i.e., the impact ris-ing slowly initially, rapidly later andplateaus out in the end – see Figure4), its impact on the diffusion pat-tern will not be that easy to decipherbecause the diffusion takes placeover time and there are powerfulexogenous forces at play. What this

54. The tougher it is to verify easily, the morethe dependence on the word of mouth.

Figure 3.

55. Bass, Frank M., Trichy V. Krishnan andDipak C. Jain (1994), “Why the Bass ModelFits without Decision Variables,” MarketingScience, 1994, Vol. 13, Number 3.

PeakSales

InitialSales

A Typical Diffusion Eagle

SwoopEagles Circling

Eagles

TimePeak Sales

Time

SlopeSales(Adoptions


means is that the impact of mar-keting efforts and the exogenousforces are so intertwined at everypoint of time that it needs specialefforts to understand how market-ing efforts affect the diffusion pat-tern. Although it is a big challengeto factor all the individual ele-ments in the three sets of variablesand finally come up with a mar-ket level sales growth process,marketing researchers have beensuccessful in carving out modelsby focussing on the key elements.For example, Bass, Krishnan andJain55 have developed a diffusionmodel that captures the impact ofprice and advertising (the key ele-ments of the third set of variables)and the key elements of the first setof variables on the sales growth of anew product. The interesting prop-erty of this model is its flexibility toinclude other marketing variablesalso. Now, consider the second stepof optimization. Having under-stood how the marketing variablesimpact the diffusion process, onecan use mathematical techniquesto find out the optimal marketingefforts. In this line, a recent articleby Krishnan, Bass and Jain (1999)56

establishes the optimal pricingpolicy to be adopted for a new prod-uct introduction.

3.2.2 Birds: The market-level salesgrowth of a bird, on the other hand,does not in general exhibit any par-ticular pattern. Given the nature ofbirds and dom-birds, it will be pru-dent to focus more on the marketshare growth of the bird in the cat-egory it is a part of. To relate themarket share growth to the market-ing strategies one can use well de-veloped marketing models such astrial-repeat purchase models, con-joint analysis and choice models incombination with the diffusionmodels discussed earlier.

In this section, we provided aframework that describes how theadoption of a new product by a con-

sumer takes place, what factors areinvolved therein, and how the indi-vidual level process translates to amarket level sales growth and howa licensee can use marketing vari-ables such as price and advertisingto control that sales growth to hisadvantage. Next, we will see howthis framework can be used to fa-cilitate the royalty determination ina licensing context.4.0 Diffusion Process (LegalConsiderations in RoyaltyDetermination andArrangments)

As we saw at the beginning of thisarticle, there are two possible situa-tions where royalty may have to bedetermined. The first is where licen-sors and licensees voluntarily cometogether to decide on the royalty forthe use of the IPR. We can call it the“Negotiated Royalty Situation.” Thesecond is where no license is in-volved but there has been an in-fringement57 of the IPR and theowner has taken recourse to legalaction for redress. Here, the courtsdetermine the damages to be paidby the infringer to the owner and we

will call this the“Reasonable RoyaltySituation.”

The licensor and licensee mayeach hold IPR that is valuable toother and may settle for mere crosslicenses without any money ex-changing hands. Such a situation,though not impossible, is uncom-mon. Even in cross licensing situa-tions, if the parties can determinethe monetary value of the licensesgranted to the other, it can be veryuseful in determining the additionalor incremental value that one re-ceived over and above what theother received. Once the monetaryvalue of the licensed-out rights andthe licensed-in rights are calculatedand the parties are satisfied that theyare equivalent, it may help the de-cision makers to justify their actionsto the general body of shareholders,in case it is necessary to do so.

In Section 4.1, we focus on a fewNegotiated Royalty cases and inSection 4.2 we focus on a few Rea-sonable Royalty cases.4.1 Negotiated Royalty

There are basically two variablesthat play a vital role in a royaltyagreement: dollar payment and termof payment. The dollar payment canbe either a lump sum royalty or arunning royalty or a combination ofboth. The running part can be eitheran ascending type (for products thatinvolve high fixed costs to help re-

56. Krishnan, Trichy V., Frank M. Bass andDipak C. Jain (1999), “Optimal Pricing Policyfor New Products,” Management Science, Vol.45, 12.

57. The term “infringement” is used forinfraction of patent, copyright and trademarkrights, whereas the term “misappropriation”is commonly used in the case of trade secrets.In this paper, we use the term infringementto refer to infraction of rights of the owner.

Figure 4.

SaturationPoint

Base-Sales

Impact of Marketing Effort on Sales

Marketing Effort

Sales ina Given

Period


duce burden on licensee) or a de-scending type (fixing royalty ratesinversely proportional to sales vol-ume as incentive to licensees to tryand whip up sales). Whether it islump sum royalty or running roy-alty, the term over which such pay-ments are to be made is the secondimportant criterion. Although thistwo-variable royalty structure hasbeen in use for a long time, it israther unfortunate that the royaltydetermination process is far frombeing satisfactory. Even today, it iswrought with lot of problems, bothlegal and commercial. We will ana-lyze a few of those problems in de-tail and show how our proposedframework can be used to addressthose issues.4.1.1 Issue 1 (Most FavoredLicensee)

It is common for licensees to in-sist on grant of Most Favored Lic-ensee status by including a clauseto that effect in the License Agree-ment.58 The grant of such a status toa licensee puts the licensor at a defi-nite disadvantage since he mayhave to disclose details of otherdeals to this licensee, which the li-

censor may otherwise not wish todo. What is the royalty payable as aMost Favored Licensee has come upbefore the courts for determinationin the past. In Hazeltine Corp. v. Ze-nith Radio Corp.,59 Zenith had a li-cense to pay either a specificpercentage of the computed sell-ing price of the apparatus or a lumpsum payment in lieu of the percent-age royalties, to be elected in ad-vance and paid quarterly in advanceunder specified conditions. Zenithwent to court, contending that a lic-ensee who opted to pay the lumpsum royalty provision may obtain,because of the volume of its sales, alower rate of royalty.60 The court re-jected this argument and held that“a rate of royalty which is a fixedamount per period of time, is not insubstance the same as a rate of per-cent of selling price royalty.”61

Problems associated with licens-ing to different licensees in differ-ent areas can be handled moreamicably and systematically if thelicensor can break down the effortsneeded to be put in by the licenseesin their respective areas, and thendecide on the royalty terms basedon those efforts. The proposedframework can help in such break-ing down of the whole licensingtransaction into quantifiable compo-nents so that the licensor will be ableto categorize licensees in terms of

the components that they contrib-ute. The licensor will also be able todetermine more accurately the termsof license to various licensees since itis highly unlikely for two licensees tomake identical contribution to theventure. Thus, the proposed frame-work will protect the licensor to alarge extent in such cases, even if hewere to grant the Most Favored Lic-ensee status. 4.1.2 Issue 2 (Patent Abuse)

Another commonly occurring is-sue in negotiated royalty involves alicensor being charged for Misuse62

and Antitrust63 violation. Misusecan be termed a lesser form of anti-trust violation. In a 1950 decision,the United States Supreme Courtheld that “payment of royalties ac-cording to an agreed percentage ofthe licensee's sales is unreasonable.Sound business judgment could in-dicate that such payment representsthe most convenient method of fix-ing the business value of the privi-leges granted by the licensingagreement.”64 In a later decision, theSupreme Court decided “that con-ditioning the grant of a patent li-cense upon payment of royalties onproducts which do not use theteaching of the patent does amountto patent misuse.”65 The Court hav-ing said that, went on to provide anescape route for total-sales royalty

58. The most favored licensee clause willaddress the following: (a) how and when thetransferor will notify the licensee of the detailsof the other licence; (b) a territory or field ofuse in which the favorable terms apply; (c)the duration of the most favorable terms; (d)the method of valuing non-cash consideration(for examples, cross-licences or equity); (e)whether the adjustment will be retroactive;(f) how to deal with prior licences; and (g)how the licensee will elect to accept the mostfavored licensee clause, if the adjustment isnot made automatically. John T. Ramsay,Technology Transfers and Licensing, 129-130(1996).59. 100 F. 2d 10 (7th Cir. 1938)60. The rationale of the argument is this: Onelicensee having agreed to pay the lump sumroyalty produces and sells x quantity ofapparatus using licensed patents. Anotherlicensee also agrees to pay the lump sumroyalty but produces (x+y) quantity ofapparatus using the licensed patents. Whenthe lump sum royalty is converted in to apercentage of the computed selling price ofthe apparatus, the latter licensee pays lessthan the former. Zenith claimed that the lumpsum into actual rate conversion has to be doneand it has to be provided the lowest of suchconverted rate.61. Hazeltine, 100 F. 2d at 11

62. The concept of Misuse was first recognizedin Morton Salt Co. v. G.S. Suppiger Co., 314 U.S.488, 62 S. Ct. 402, 86 L. Ed. 363 (1942). It washeld that ‘[a] patent operates to create andgrant to the patentee an exclusive right tomake, use and vend the particular devicedescribed and claimed in the patent. But apatent affords no immunity for a monopolynot within the grant and the use of it tosuppress competition in the sale of anunpatented article may deprive the patenteeof the aid of a court of equity to restrain analleged infringement by one who is a com-petitor.’ (citation omitted)63. The antitrust laws promote innovationand consumer welfare by prohibiting certainactions that may harm competition withrespect to either existing or new ways ofserving consumers. Antitrust Guidelines forthe Licensing of Intellectual Property issuedby the U.S. Department of Justice and theFederal Trade Commission, 1995.64. Automatic Radio Mfg. Co. v. HazeltineResearch, Inc., 339 U.S. 827, 835 (1950)

65. Zenith Radio Corp. v. Hazeltine Research, Inc.,395 U.S. 100, 89 S. Ct. 1562, L. Ed. 2d. 129(1969).66. Id., at 139.67. See Kearney & Trecker v. Giddings & Lewis,Inc., 7 U.S.P.Q. 650 (7th Cir. 1971), cert. denied,405 U.S. 1066 (1972)68. See Mobil Oil Corp. v. W.R. Grace & Co.,180 U.S.P.Q. 418 (D. Conn. 1973) The courtdetailed over three years of negotiation andconcluded that there was no coercion.69. Brulotte v. Thys Co., 379 U.S. 29, 13 L. Ed.2d 99, 85 S. Ct. 176 (1964).70. Laitram Corp. v. King Crab, Inc., 244 F. Supp.9, modified 245 F. Supp. 1019 (D. Alaska 1965)The case turned not on the evils of pricediscrimination but the effect of the pricediscrimination on the competition in theshrimp peeling industry. The court concludedthat the price discrimination affected theability of Pacific Northwest industry tocompete with the Gulf Coast industry.71. Bela Seating Co. v. Poloron Prods. Inc., 438 F.2d 733, 738 (7th Cir. 1971)


provision when it said that “if con-venience of the parties rather thanpatent power dictates total-salesroyalty provision, there are no mis-use of the patents and no forbiddenconditions attached to the license.”66

In licensing situations where the to-tal-sales royalty provision is beingused, the licensor has to ensure thatit is “convenience of the parties” thatmade them to choose this option.67

The licensor should also develop thenecessary paper trail that would dis-prove any charges of coercion.68 Thelicensor is also forbidden from re-quiring the licensee to pay royaltiesfor patented products beyond theexpiration of the patent.69 Antitrustviolation was found where the pat-entee of a process for machine peel-ing of shrimps leased the machinesat twice the price to Pacific North-west shrimp processors as to GulfCoast processors.70 Licensors cantake heart from the decision of theSeventh Circuit when it said “thereis no antitrust prohibition against a

patent owner’s using price discrimi-nation to maximize his income fromthe patent.”71 In non-exclusive li-censing arrangements,72 the licensormay be tempted to fix the price ofthe licensed product to ensure thatthe price charged by a licensee iscomparable to the price charged byhimself or other licensees. The licen-sor may also be interested in doingso to ensure that one segment of themarket is not affected because of thepricing policy of the licensee. Itshould be remembered that pricemaintenance rings alarm bells loudand clear since it spells antitrust vio-lation to the U.S. Department of Jus-tice.73

Clearly, pricing is a key issue inthese antitrust and patent misuseallegations cases. Interestingly, pric-ing is very important from a mar-keting point of view as well becauseit affects not just the profit marginfor the licensee but also the salesgrowth of the new product and theeventual market penetration. Theproposed framework can, as ex-

plained in detail in Section 3.2, beused to address many aspects of thisissue.4.1.3 Issue 3 (Abuse of RoyaltyTerm)

We have seen that the period overwhich royalty is payable is also avariable that needs to be determinedin transactions involving runningroyalty. A patentee’s use of a royaltyagreement that projects beyond theexpiration date of the patent is un-lawful per se.74 This preclusion ap-plies even if the license is grantedprior to application or issuance ofanticipated but subsequently issuedpatents.75 But, in the case of prod-ucts incorporating more than onepatent, the life of the agreement andconsequently royalty payment canbe extended until the last patent ex-pires.76 Therefore, licensors shouldbe aware of the duration of the grantof each right and should ensure thatthe royalty payment is not projectedbeyond the expiry of such grant.Trade secrets can remain secret for-ever and so there is no time limit forwhich trade secrets can be licensed.The only limitation is that at the timeof license, it has to be unknown tothe licensee. Even if the secret en-ters public domain immediately af-ter it is licensed, the licensee cannotescape his liability to pay royalty forthe duration of the license.77

From a commercial point, a mainreason why the life of a licensingcontract can really be a thorny issuein royalty negotiation is the unevendistribution of sales happening be-fore and after the expiry of the con-tract-term. Further, this distribution

72. Exclusive license precludes the licensorand his successors from the rights to thelicensed rights. If the licensor reserves theright to the patent for its own use the licenseis a “sole license.” A non-exclusive license isone where the licensor may practice thepatented invention and license others. It isnothing more than a waiver of the licensor’sright to sue for infringement.73. In United States v. General Electric Companyet al., 272 U.S. 476, 47 S. Ct. 192, 71 L. Ed. 362(1926) it was held that where the patenteelicenses the selling of a product, he may limitthe method of sale and the price, providedthe conditions of sale are normally andreasonably adapted to secure pecuniaryreward for the patentee’s monopoly. InLucasarts Entertainment Co. v. HumongousEntertainment Co., 870 F. Supp. 285 (N.D. Cal.1993) the license stated that Humongous maynot sell its games which utilize the SCUMMprogram to any third party distributor otherthan LucasArts for less than a certain priceand that Humongous must verify its com-pliance with the licensing agreement atLucasArts’ request. The court upheld theclause. Although the two decisions men-tioned above may seem to indicate that thelicensor may consider price maintenanceclause, it will be highly imprudent. Thefarthest the licensor can go is suggest a retailprice as long as there is no coercion. Thissuggestion of retail prices by licensor has beenupheld in American Indus. Fasteners Corp. v.Flushing Ent. Inc., 179 U.S.P.Q. 722 (N.D. Ohio1973).

74. Brulotte v. Thys, 379 U.S. 29, 85 S. Ct. 176,13 L. Ed. 2d 99, (1964)75. Robert Boggild & anr. v. Kenner Prods., 776F. 2d 1315, 228 U.S.P.Q. 130 (6th Cir. 1985). Inthis case the license was granted in 1963stipulating payment of royalty for a minimumof twenty-five years, whether or not theanticipated patents were issued. Subsequentlyapplications were filed and patents weregranted. The design patent had an 1979 expirydate and the mechanical patent had a 1983expiry date.76. Lula Belle Hull v. Brunswick Corp., 704 F. 2d1195, 218 U.S.P.Q. 24 (10th Cir. 1983).77. Warner-Lambert Pharmaceutical Co. v. JohnJ. Reynolds, Inc., 178 F. Supp. 655 (S.D.N.Y.1959) aff’d 280 F.2d 197 (2nd Cir. 1960). In thiscase, usually referred to as Listerine case, J.W.Lambert agreed to pay Dr. J. J. Lawrence a sumof $20 per gross of Listerine manufactured andsold by him. For about 75 years paymentswere made but in 1956, Warner-Lambert suedto terminate royalty payments since theformula was made public by publication inthe Journal of the American Medical As-sociation as early as 1931. The court ruledagainst Warner-Lambert holding the formulanot being a trade secret was not a bar forpaying license fees. One who acquires a secretformula or a trade secret through a valid andbinding contract cannot escape from anobligation he bound himself to simplybecause the secret is discovered by a thirdparty or by the general public.

78. In the United States, federal law governsPatents, Copyright and Trademark. Underthe Constitution, Congress has been grantedthe powers to regulate grant and governanceof patents and hence state law is wholly pre-empted. The federal Copyright Act is trace-able to the power granted to Congress underArticle I, Section 8 of the Constitution. In viewof the express pre-emption contained in 17U.S.C. § 301, it can be said that the state lawis almost pre-empted. The federal lawrelating to Trademarks can be found in theLanham Act, enacted under the CommerceClause. State statutory law and common lawalso govern Trademarks, subject to theprinciple of federal pre-emption.


can be influenced by the market-ing variables, which are under thecontrol of the licensee and not thelicensor. This implies, for example,the licensee can price and adver-tise in such a way that a major partof the sales happen after the expiryof the contract. Our proposedframework is clearly very helpfulin this scenario.

So far we have been discussingsome of the issues surrounding thenegotiated royalty determinationcase and how these can be ad-dressed using our proposed frame-work. Next, we will see how it canbe used in patent infringement casesas well.4.2 Royalty and Infringement

We have already seen that the IPRinvolved in a product can be pat-ents, copyright, trademark or tradesecrets. These rights are collectivelycalled Intellectual Property Rightsand although all these rights aresimilar in the sense that they tendto “exclude” persons other than theowners from practicing them, thereach of such exclusionary rightsvaries greatly. In the United States,patents, copyright and trademarksare statutory rights.78 Trade secretslaw is partly statutory and partlycommon law.79 The statute govern-ing each right also stipulates themanner in which the damages forviolation of each right are to be de-termined. A consideration of the lawrelating to damages in respect ofeach of these rights is necessary toappreciate how necessary it is tounderstand the method of calculat-ing reasonable royalty.4.2.1 Patent Infringement

In patent infringement actions,the courts are required by law toaward the claimant damages ad-equate to compensate for the in-fringement, but in no event lessthan a reasonable royalty for theuse made of the inventions by theinfringer, together with interestand costs as fixed by the court.When the damages are not foundby a jury, the court shall assessthem. In either event the courtmay increase the damages up tothree times the amount found orassessed. The court may receiveexpert testimony as an aid to thedetermination of damages or ofwhat royalty would be reasonableunder the circumstances.80 Thestatute merely stipulates the floorbeneath which the damages shallnot fall. The statute contemplatesthat when a patentee is unable toprove entitlement to lost profits oran established royalty rate, it is en-titled to “reasonable royalty” dam-ages based upon a hypotheticalnegotiation between the patenteeand the infringer when the in-fringement began.81 The patentowner bears the burden of proofon damages.

In cases where the owner is ableto establish the lost profits, he canvery well get damages that wouldcompensate his loss. To obtain asdamages the profits on sales hewould have made absent the in-fringement, i.e., the sales made bythe infringer, a patent owner mustprove: (1) demand for the patentedproduct, (2) absence of acceptablenoninfringing substitutes, (3) hismanufacturing and marketing ca-pability to exploit the demand,

and (4) the amount of net profit hewould have made.82 The FederalCircuit has also laid down how theowner’s burden of proof of lost prof-its is discharged and shifted to theinfringer.83 Where the owner is un-able to prove lost profits or actualdamages, the onerous task of ascer-taining “reasonable royalty” is leftto the courts. The courts are autho-rized to seek expert testimony, ifneeded. Historically, the methodol-ogy has been problematic as amechanism for doing justice to in-dividual, non-manufacturing paten-tees.84 In Fromson, while remandingthe case to the trial court for recal-culation of a reasonable royalty, theFederal Circuit held that royaltymay be measured as a percentage ofgross or net profit dollars, or as a setamount per infringing article sold,or as a percentage of the gross or netprice received for each infringing ar-ticle. One court85 has proposed alaundry list of factors that courtsshould consider in figuring out rea-sonable royalty. They are:

The royalties received by the pat-entee for the licensing of the patentin suit, proving or tending to provean established royalty;

The rates paid by the licensee forthe use of other patents comparableto the patent in suit;

The nature and scope of the li-cense, as exclusive or non-exclusive;or as restricted or non-restricted interms of territory or with respect towhom the manufactured productmay be sold;

The licensor’s established policyand marketing program to maintainhis patent monopoly by not licens-ing others to use the invention or bygranting licenses under special con-ditions designed to preserve thatmonopoly;

The commercial relationship be-tween the licensor and the licensee,such as, whether they are competi-tors in the same territory in the sameline of business; or whether they areinventor and promoter;

The effect of selling the patentedspecialty in promoting sales of otherproducts of the licensee; the exist-ing value of the invention to the li-

79. With the passing of Economic EspionageAct of 1996, federal trade secrets rights havebeen created. It provides for criminal pen-alties but no private cause of action. Apartfrom the Economic Espionage Act, the tradesecrets law is otherwise controlled by statelaw.80. 35 U.S.C. § 284.81. Hanson v. Alpine Valley Ski Area Inc., 718 F.2d 1075, 1078, 219 U.S.P.Q 679, 682 (Fed. Cir.1983). See also, Unisplay, S.A. v. AmericanElectronic Sign Co. Inc., 69 F. 3d 512, 36U.S.P.Q.2d 1540 (Fed. Cir. 1995).

82. Panduit Corp. v. Stahlin Bros. Fibre Works,Inc., 575 F2d 1152, 197 USPQ 726 (6th Cir.1978)83. Rite-Hite Corp. v. Kelley Co., Inc., 56 F.3d1538, 1577-78, 35 USPQ2d 1065, 1069 (Fed. Cir.1995) (in banc), cert. denied, 516 U.S. 867(1995)84. Fromson v. Western Litho Plate & Supply Co.,853 F.2d 1568; 7 U.S.P.Q.2d 1606 (1988)85. Georgia-Pacific Corp. v. United StatesPlywood Corp., 318 F. Supp. 1116, 1120(S.D.N.Y. 1970)


censor as a generator of sales of hisnon-patented items; and the extent ofsuch derivative or convoyed sales;

The duration of the patent and theterm of the license;

The established profitability ofthe product made under the patent;its commercial success; and its cur-rent popularity;

The utility and advantages of thepatent property over the old modesor devices, if any, that had been usedfor working out similar results;

The nature of the patented in-vention; the character of the com-mercial embodiment of it as ownedand produced by the licensor; andthe benefits to those who haveused the invention;

The extent to which the infringerhas made use of the invention; andany evidence probative of the valueof that use;

The portion of the profit or of theselling price that may be custom-ary in the particular business or incomparable businesses to allow forthe use of the invention or analo-gous inventions;

The portion of the realizable profitthat should be credited to the inven-tion as distinguished from non-pat-ented elements, the manufacturingprocess, business risks, or signifi-cant features or improvementsadded by the infringer;

The opinion testimony of quali-fied experts;

The amount that a licensor (suchas the patentee) and a licensee (suchas the infringer) would have agreedupon (at the time the infringementbegan) if both had been reasonablyand voluntarily trying to reach anagreement; that is, the amountwhich a prudent licensee - who de-sired, as a business proposition, toobtain a license to manufacture andsell a particular article embodyingthe patented invention would havebeen willing to pay as a royalty andyet be able to make a reasonableprofit and which amount wouldhave been acceptable by a prudentpatentee who was willing to granta license.

Most of the factors cannot be as-

certained, especially in a new prod-uct scenario. Moreover, close paral-lels or yardsticks may not be availablethat can be used to rationally assessthe probable performance of the newproduct. Evaluating the damages toa patent holder in a patent infringe-ment is a very challenging case. Thisis because the profits accruing to theinfringer from the product is a re-sult of both the product and theinfringer ’s marketing efforts.From this view point, our pro-posed framework can be used toascertain this. Another interestingcase of infringement involves twocompeting brands, both of whichare more or less similar versions ofthe same new product idea, but oneof which holds a proper license andthe other is an infringer. The chal-lenge here is to use the actual salesgrowth of the two brands happen-ing in parallel and evaluate the salesgrowth that would have happenedfor the proper licensee in the ab-sence of the infringer. For this, theproposed framework can be used inconjunction with the diffusion mod-els such as Krishnan, Bass andKumar (2000).86

4.2.2 Copyright LawIn copyright law, an infringer of a

copyright is liable for either thecopyright owner’s actual damagesand any additional profits of the in-fringer or statutory damages.87 Thesection describes in detail how “ad-ditional profits of the infringer” areto be ascertained and also the man-ner in which the copyright ownercan discharge his burden of proof.The section also provides for in-creased statutory damages for willfulinfringement and the circumstances

under which statutory damagesmay be remitted.88 The CopyrightAct also contains provisions forstatutory licenses of sound record-ings,89 compulsory licensing ofnondramatic musical works,90 andnegotiated licenses for public per-formances by means of coin-oper-ated phonorecord players.91 The Actalso provides a limited exception toantitrust laws in respect of noncom-mercial broadcasting of certainworks92 and facilitates collective ne-gotiation by copyright owners. TheLibrarian of Congress is also autho-rized to appoint and convene arbi-tration royalty panels to makedeterminations concerning the ad-justment of reasonable copyrightroyalty rates and guidelines havebeen provided to such a panel.93 Inestablishing a Panel, the Act seeksto achieve the following objectives:

•afford the copyright owner a fairreturn for his creative work and thecopyright user a fair income underexisting economic conditions; and

•reflect the relative roles of thecopyright owner and the copyrightuser in the product made availableto the public with respect to relativecreative contribution, technologicalcontribution, capital investment,cost, risk, and contribution to theopening of new markets for creativeexpression and media for their com-munication.94

The model that we suggest here,with necessary modifications, canbe utilized to arrive at a royalty thatachieves the objectives listed in theCopyright Act.4.2.3 Trademark Law

The Lanham Act provides that forviolation of any right of registrant ofa mark, he can recover the infringer’sprofits or any damages sustained bythe registrant. The registrant needprove only the sales of the infringerafter which, the burden shifts to the

86. Krishnan, Trichy V., F.M. Bass and V.Kumar (2000), “Impact of a Late Entrant onthe Diffusion of a New Product / Service,”Journal of Marketing Research, Vol. 52.87. 17 U.S.C. § 50488. 17 U.S.C. § 504(c)(2)89. 17 U.S.C. § 11490. 17 U.S.C. § 11591. 17 U.S.C. § 11692. 17 U.S.C. § 11893. 17 U.S.C. § 801

94. 17 U.S.C. § 801(b)95. 15 U.S.C.A. § 111796. The six states are New Jersey, New York,Pennsylvania, Tennessee, Texas and Wyoming.97. Section 3 of Uniform Trade Secrets Act


infringer to prove all elements ofcost or deduction claimed.95

4.2.4. Trade Secret Law It is mostly state law that governs

trade secrets. Forty-one states haveenacted laws based on the UniformTrade Secrets Act (UTSA), modellegislation drafted by the NationalConference of Commissioners onUniform State Laws. Alabama andMassachusetts have laws not mod-eled after UTSA. Six states protecttrade secret rights under commonlaw.96 Under the UTSA damages caninclude both the actual loss causedby misappropriation and the un-just enrichment caused by misap-propriation that is not taken intoaccount in computing actual loss.In lieu of damages measured byany other methods, the damagescaused by misappropriation may bemeasured by imposition of liabilityfor a reasonable royalty for a mis-appropriator's unauthorized disclo-sure or use of a trade secret. In theirComment, the Commissioners ob-serve that “as an alternative to allother methods of measuring damagescaused by a misappropriator's pastconduct, a complainant can requestthat damages be based upon a de-monstrably reasonable royalty for amisappropriator's unauthorized dis-closure or use of a trade secret.97 Inorder to justify this alternative mea-sure of damages, there must be com-petent evidence of the amount of areasonable royalty.”98

4.2.5. Reasonable RoyaltyDetermination

We find that determination of rea-sonable royalty is required in patentinfringement cases, trade secret mis-appropriation cases and compul-sory licenses under Copyright Act.The laudable objective is to compen-sate the owner for the loss occa-sioned by the improper use by theinfringer. Expert evidence is permit-ted to help the court determine rea-sonable royalty. It is natural forcompeting sides to adduce experttestimony that would bolster its side

leaving to courts the unenviabletask to electing to accept the testi-mony of one set of experts over theother or collating pieces of testi-mony from the gamut of experts tosupport the court’s decision. Ourframework, on the other hand,breaks down the entire process intoverifiable and quantifiable elementsmaking it easy for the courts tomerely identify the contribution ofcontending parties and apportion-ing the profits proportionately.

5.0 Conclusions and Direc-tions for Future Research

Introducing new products is themajor effort many companies un-dertake in order to win new custom-ers and establish new markets andthereby improve shareholders’wealth. However, ideas for newproducts and the new productsthemselves are mostly licensed fromoutside parties such as individualinventors and other companies.Thus licensing of new products hascome to occupy an important placein the current commercial world.While licensing laws in general haveevolved over years to address manyissues a licensor and a licensee mayface in the post licensing stage, theprospective licensors and licenseeshave very few precedents to turn to.

In this paper, we first describedwhy licensing of new products canbecome a thorny issue in discus-sions. We basically argued that thesuccess of any new product is a re-sult of the product’s intrinsic valueto the target customer and how thelicensee effectively makes the cus-tomer get to know, understand andappreciate that value. Thus, weshowed that, it is the combinationof the product’s utility and the mar-keting efforts that should determinethe outcome, and hence the royaltydetermination should be based onthese two. Next, we proposed amodeling framework where weclassify the new products into fourfundamental types and use thatclassification to describe the differ-ent types of marketing efforts thatare needed for the different stagesof the consumer adoption process.This framework enables us to break

down the marketing efforts into dif-ferent elements, explain the role oflicensor and licensee for each ofthose elements and bring out theoverall importance of each elementin the final outcome. We further ex-tended this framework to show howone could derive the impact of mar-keting efforts on the market levelsales growth of the new product.This breaking-down of the requiredmarketing efforts is the key to solvemany of the problems arising in roy-alty negotiation. To stress thisunique contribution of the frame-work, we next described in detail afew licensing issues typically en-countered in royalty determinationdiscussions and patent infringe-ment cases, and showed how ourproposed framework can be used toaddress those issues.

We strongly believe that the frame-work proposed in the paper will goa long way in addressing many ofthe issues companies typically facein royalty negotiation. This frame-work can also be used as a benchmarkby the licensor and the licensee tostructure the marketing aspects ofthe licensing contract and to deter-mine the royalty. The frameworkcan also be utilized by courts of lawwhile determining ‘reasonable roy-alty’ in infringement actions. Sincethe framework is based on the nec-essary ingredients required tomaximize commercialization of aproduct, its use to craft royalty willenable licensors and licensees toavoid many of the pitfalls that usu-ally result in wasteful litigation. Weshould however caution against ablind application of the frameworkwithout fine tuning the various ele-ments described at various places inthe paper.

It should be noted that our pro-posed framework does not makeany distinction between the varioustypes of IPR involved, namely, copy-rights, trade secret, trademarks andpatents. One suggested direction forfuture research is to focus on eachof these IPR types and develop amodified version of the frameworkfor each. A second direction for fu-ture research will be to identify theconditions that are unique to vari-

98. Comment to Section 3 of Uniform TradeSecrets Act.


ous industries, namely, chemical,electronics, automobiles, etc. andmodify the proposed framework ac-cordingly for each field. Licensingis a discipline that requires collabo-ration among professionals fromvarious fields like engineering,medicine, finance, accounting, mar-keting, and law, depending on thesubject matter of licensing. Inputsfrom professionals on their respec-tive fields are essential to achieve anoptimum final outcome. Our frame-work focussed on the inputs to a li-censing situation from a marketingand legal viewpoint. A possiblethird direction could be for researchpapers advocating frameworks thataccommodate viewpoints of profes-sionals from other fields.

© Trichy V. Krishnan and MuraliSanthanam 2001.


Introduction

F or companies involved inthe business of providingsatellite, broadcasting or tele-

communications services in Asia,the effective negotiation of technol-ogy acquisition contracts is a criti-cal activity. Technology acquisitionis a capital-intensive activity, and inmany instances the selection of a par-ticular technology and/or technologyvendor results in the purchaser being‘locked–in’ to a technology and/orvendor for system expansion, main-tenance and support for years tocome. Examples of critical technol-ogy acquisitions in the mobiletelecom area include the purchaseof radio base stations, switches andsupporting software; in the satellitebusiness the selection and purchaseof a satellite and contracting with alaunch service provider; for digitalpay television broadcasters, the se-lection of a conditional access sys-tem and set-top box manufacturer;and for an electronic assemblymanufacturer, the purchase of auto-mated manufacturing equipment.General Rule

Over the years, and in each re-spective industry, various practiceshave developed for the negotiationand closing of key technology pur-chase contracts. As each company hasits own history, corporate personalityand manner of doing business, theprocess for making technology acqui-sition decisions differs. In general,a company seeking to acquire tech-nology will first have its in-houseteam identify potential vendors thatmay provide the required systems,and then prepare a ‘Request ForProposal’ (RFP). The RFP typicallyincludes a general description of thepurpose of the request, a scope ofwork (SOW), technical specifica-

Negotiation Strategies ForTechnology Acquisition Contracts

BY JEFFREY J. BLATT*

*Jeffrey J. Blatt is CEO, X-Ventures Co.Ltd. Bangkok, Thailand.

tions and draft terms and conditionsfor the technology acquisition con-tract. On receipt of the RFP, inter-ested vendors prepare a responsethat should include a detailed com-pliance matrix identifying whichpoints in the RFP the vendor’s pro-posal is, or is not, in compliancewith (e.g. compliance with thesystem’s technical requirements, thevendor’s willingness to ‘comply’with the purchaser’s requirementfor certain legal and commercialterms in the contract, etc.). The pur-chaser then reviews the potentialvendors’ responses and short liststhose vendors coming closest tomeeting its overall requirements asset forth in the RFP. After the shortlist is agreed internally, in major ac-quisitions it is common for the pur-chaser to enter into negotiationswith the top two or three potentialvendors to narrow the issues andattempt to obtain the best deal pos-sible. Ultimately, the purchaser se-lects one of the candidate vendorsto proceed to final contract negotia-tions and closing.The Asian Situation

While the process outlined aboveis common to most major technol-ogy acquisition exercises around theworld, there are a number of issuesthat companies in Asia frequentlyencounter but do not always nego-tiate as rigorously as they should toprotect their rights and ensuingcapital investment. In many in-stances where technology is soughtfor deployment, the vendor or itssub-contractors must develop newsoftware and/or hardware for thepurchaser’s system. These new fea-tures, functions or systems mayhave application to other future cus-tomers of the vendor and may laterbe included in the vendor’s overall

product line. An example of this inthe telecom area is where a vendoris required to develop enhancedfunctionality for a mobile switch ora new customer care graphic userinterface. In the pay television busi-ness a vendor of a traffic and con-trol system for channel schedulingand play out may be required to de-velop a more advanced air-timesales module or interface function-ality to a subscriber managementsystem with which it has never be-fore interfaced. Even in the satellitebusiness, an operator may requestthat certain technology be adaptedand integrated into a satellite designrequiring new development. Thecommon point in all of these ex-amples is that the purchaser is re-quiring the vendor to do somethingthat the vendor has not previouslydone, thereby requiring develop-ment of new software, technologyand/or interfaces (collectively describedin this article as ‘new functionality’) forthe purchaser’s particular project.Ownership of Rights toNew Functionality

A key issue that is frequentlyoverlooked in negotiations by thepurchaser is how much of the de-velopment cost for the new func-tionality the purchaser should payfor if the new function has utilityand may be offered by the vendorto its current or future customers.Vendors never raise this issue in ne-gotiations because it is in their in-terest to have the first customerrequesting the development to payfor the costs, and then for them tohave the ability to offer it to othercustomers in the future. It is up to


the purchaser to identify and toraise the issue and to use it as lever-age in the negotiations. In essence,the point that the purchaser mustmake is that it will not agree to payfor either all, or even a majority, ofthe development cost for the newfunctionality unless the purchaserowns the intellectual propertyrights to such new functionality. Toput it succinctly, if the purchaser isgong to be required to pay for thebulk of the development of a newfunctionality then it should beowned by the purchaser. Accord-ingly, the argument goes, the intel-lectual property rights for the newfunctionality should be transferredto the purchaser on acceptance. Thepurchaser may, as part of its strat-egy in the negotiations, offer to li-cense the vendor the right to includethe new functionality into its prod-uct line for a royalty, but refuse topay for what should be carried onthe vendor’s books as a non-recur-ring investment in technology toenhance the vendor’s product line.

Vendors in many major technol-ogy acquisitions in Asia will not an-ticipate a purchaser raising thispoint in the negotiations because thepurchaser is a buyer and user oftechnology, and not in the businessof owning and licensing features ofthe vendor’s technology. The busi-ness concerns of the purchaser areto acquire the technology and de-ploy it as quickly as possible to al-low the purchaser to get on with itsbusiness (for example as a mobileoperator, television broadcaster orsatellite service provider), not ownand exploit intellectual property toa system that may have limited ap-plication to a single vendor. The lev-erage, of course, is that for the ven-dor the ownership of the newfunctionalities to its base product isvery important.

By raising the issue in the nego-tiations the purchaser may then tryto compel the potential vendor ei-ther to disclose the details of the de-velopment and its costs, whatshould be considered pre-existingtechnology owned by the vendorversus new development, and dis-cuss the logistics of a grant back li-

cense from the purchaser to the ven-dor – or to cut the purchaser a bet-ter deal. If a new functionality haspotential value in the product lineof the vendor, most vendors willprefer to negotiate a lower price forthe development work to ensurethat it maintains all ownershiprights to intellectual property for thenew function. As a rough generalrule, the purchaser should not payfor more than 20–30% of the totaldevelopment costs for new func-tionality that the vendor can incor-porate into its product offering.

The potential leverage a pur-chaser has in raising the issue oftechnology development and intel-lectual property ownership is high-est where the purchaser still has theability to go to another vendor. If thepurchaser is already locked into thevendor’s technology, the vendormay insist on its price and to main-tain ownership of the intellectualproperty, thereby forcing the pur-chaser to capitulate; forgo the newfunctionality; or proceed throughwhat may be an expensive processof replacing the vendor’s productsin the purchaser’s system to escapetechnology lock-in.Source Code Control aKey Issue

In addition to the issue of owner-ship of technology specifically de-veloped for the purchaser under atechnology acquisition contract, arelated issue is the requirement bythe purchaser that the vendor placeall critical software in a source codeescrow.1 A source code escrow is anaccepted structure whereby a ven-dor places its source code into an‘escrow’ with an established sourcecode escrow agent under pre-de-fined and agreed release conditions.In the event that any one of the re-lease events occurs, the source code

is released to the purchaser for usein maintaining and supporting thepurchaser’s system. Most releaseconditions relate to the situationwhere the vendor either goes out ofbusiness, or is unable or refuses tosupport its service and maintenanceobligations under the contract withthe purchaser. Source code escrowsare common practice in the UnitedStates and Europe and there are es-tablished source code escrow com-panies that provide professionaland reliable service to licensees andvendors of software. However, inSouth East Asia source code escrowsare not yet that common and manyAsian technology purchasers do notinclude source code escrows as acontract requirement in negotia-tions. While the negotiation issuesand strategy for putting a sourcecode escrow in place are beyond thescope of this article, it is useful tonote that the concept of a sourcecode escrow can be used in conjunc-tion with negotiations for the devel-opment of new functionalities in atechnology acquisition contract.Conclusion

Purchasers negotiating with po-tential vendors should consider (i)what new functionality must be de-veloped by the vendor for the con-tract being negotiated, and (ii) whatsoftware owned by the vendor willbe critical to keep the system up andrunning if the vendor defaults on itsobligations to support the softwareor goes out of business. Followingthe discussion above with regard tonegotiation of new functionalities,the purchaser should insist that solong as it is the owner of the newfunctionalities all source code com-prising the new functionalitiesshould be delivered to it on accep-tance of the system (even if the ven-dor as part of its maintenancecontract agrees to maintain and sup-port the new functionalities). Withregard to other software that thevendor will provide but is criticalto the continued operation of thesystem in the event that the vendorgoes out of business or in breach ofits contractual obligations to sup-port and maintain, the source codeof such software should be depos-

1. Computer programs are written by pro-grammers in what is called ‘source code’ butlicensed to customers in machine executablecode referred to as ‘object code’. The sourcecode is kept confidential by the vendor andnot released to customers or otherwise madepublic. However, to maintain, support andenhance the program access to the sourcecode is usually required.


ited with a reputable source code es-crow agent. Vendors will predictablyresist transferring ownership of newfunctionalities to the purchaser andwill attempt to limit the scope of thecode required to be deposited in asource code escrow. Knowing this,purchasers may use this to theirown advantage in negotiating alower price and better terms in theacquisition contract, but must becareful that they remain protectedand have adequate recourse in theevent that the vendor breaches itssupport or maintenance obligations.


COPYRIGHT ACT DOES NOT PRE-EMPT ACLAIM FOR BREACH OF A CONTRACT PRO-HIBITING REVERSE ENGINEERING

In Bowers v. Baystate Technologies, Inc., No. 01-1108, -1109, (Fed. Cir. August 20, 2002), the Federal Circuit heldthat the Copyright Act did not preempt a claim forbreach of a contract prohibiting reverse engineeringbecause that claim is not coextensive with a claim ofcopyright infringement. The court affirmed a judgmentof breach of contract and reversed a judgment ofpatent infringement.

Harold Bowers sold a Designer’s Toolkit, whichincluded a patented template to improve computeraided design (CAD) software and a copyrightedimprovement add-on program that operated with CAD.Mr. Bowers sold the Toolkit with a shrink-wrap licensethat prohibited any reverse engineering. After obtainingcopies of that product, Baystate Technologies, Inc.introduced a product with substantially the samefeatures, and filed an action seeking a declaratoryjudgment that its products do not infringe the Bowerpatent and that the Bower patent is unenforceable. Mr.Bower’s counterclaimed for copyright infringement,patent infringement, and breach of contract. Followingtrial, a jury found for Mr. Bowers on all claims andawarded him monetary damages for each claim. Thedistrict judge set aside the copyright damages asduplicative of the damages awarded for breach ofcontract. The Federal Circuit affirmed as to the breachof contract, reversed as to patent infringement, and didnot reach the issue of copyright infringement.

In affirming the breach of contract verdict, the FederalCircuit held that the Copyright Act does not pre-empt aclaim for breach of a license prohibiting reverseengineering. Applying First Circuit law, the court notedthat the First Circuit has held Copyright Act does notpre-empt a cause of action under state law as long asthe state cause of action requires an extra element,beyond mere copying, preparation of derivative works,performance, distribution or display. Although the FirstCircuit had not specifically addressed the issue ofwhether the Copyright Act preempts a state law contractclaim that restrains copying, the Federal Circuitconcluded that the First Circuit would hold that the

Copyright Act does not pre-empt the state contract actionin this case. The Federal Circuit reasoned that the mutualassent and consideration required by a contract claimrenders that claim qualitatively different from copyrightinfringement. Further, the court explained that acopyright is a right against the world, while a contractaffects only the parties to the contract and does not createan exclusive right. The Federal Circuit concluded thatthe district court erred in holding that Bowers’ breachof contract claim was limited by the Copyright Act,but that this error was harmless because the evidenceof copyright infringement supported the breach ofcontract claim.

The court noted that the shrink-wrap license un-ambiguously prohibited reverse engineering which,according to the court, involves studying a device inorder to learn details of design to produce a copy orimproved version. The court further noted that therecord indicated that Baystate analyzed Bowers’template to duplicate its functionality, that Baystate’sproduct and Bowers’ template contained curioussimilarities including many idiosyncratic design choicesand inadvertent design flaws, and that the operation ofthe two software programs was similar, all of whichsupported the jury verdict for breach of contract. Finally,the Federal Circuit affirmed the award of damages,agreeing with the district court that separate monetaryawards for breach of contract and copyright infringementwould be duplicative because both claims rest onBaystate’s copying of Mr. Bowers’ software and includethe same claim for lost sales.

Finally, the Federal Circuit reversed the district court’sholding of patent non-infringement, disagreeing withthe claim construction and concluding that a reasonablejury could find that Baystate’s software product infringesunder the correct claim construction.LICENSE NEGOTIATIONS IN U.S. ARE SUFFI-CIENT TO CONFER PERSONAL JURISDICTIONIN U.S. COURT OVER CANADIAN DEFENDANTDESPITE FOREIGN ARBITRATION ANDCHOICE OF LAW PROVISIONS. HOWEVER, IN-TERNATIONAL COMITY REQUIRES STAY OFU.S. COURT ACTION PENDING OUTCOME OFCANADIAN ARBITRATION

A recurring featureby Brian Brunsvold and John Paul

Recent Decisions InThe United States

John PaulBrian Brunsvold


Open Book

T his is an excellent practical book, a timelyaddition to our literature on intellectual assetmanagement. For me it filled a void with in-

depth, well reasoned and useful resources. It is one ofthe best collections of articles I have read and I appreciatethe artistry of its organization. I tend to underline inyellow what I like – don’t do that unless you like readingyellow pages. Thanks, Bruce Berman, for the two yearsyou spent encouraging these experts to write, and thenorganizing the material in such a thoughtful manner.

The second part of the title describes this book best –information to assist the executive to invest inintellectual property in his business, or the investor todetermine if that investment was well made and thusshould attract her funds. Reading this collection of 25articles is a good investment of your time if you are abusiness executive or investor; if you are an IP specialist,you will read it to learn how investors look at the tacticsyou are using to protect, manage and exploit intellectualproperty. You will enjoy this book more if you have readat least a good primer on knowledge management, suchas Thomas Stewart’s Intellectual Property The New Wealthof Nations. If you liked Rembrandt’s In the Attic orUnlocking the Hidden Value of Patents, which is writtenfor the more casual reader, you will like this text evenmore for its depth.

We have had a number of books that tease our interest,such as Sullivan’s Value-Driven Intellectual Capital, butthey tend to leave us asking: “You raised the questions,now where are the answers?” Berman’s collectionprovides some of these answers.

This is a collection of 25 chapters by different authorswith an IP glossary, databank, further reading list, andannotated links to websites. The authors are leadingpractitioners and have not been afraid to share some oftheir knowledge.

The main part of this book (558 pages) is divided intofour parts: Part One – Identifying and UnderstandingIntellectual Property, Part Two – Exploiting IntellectualProperty, Part Three – Measuring Intellectual PropertyPerformance, and Part Four – Intellectual PropertyTransactions and Finance. Berman suggests that youmay read the chapters sequentially or pick which onesyou want to read separately. I recommend that you firstread it sequentially unless you are familiar with thetopics and are only looking for refinement of yourexisting knowledge.

One of the concerns about a collection like this is thatthe articles do not build on each other, but that eachneeds to develop the requisite background to make theauthor’s point even though this background may be in aprevious article. Also, collections of this type are often notwell coordinated, the topics do not flow one to another.This book handles the latter concern well. For the mostpart, the articles are well organized in a logical sequence.

Since Berman proposed that these articles can be readindividually rather than sequentially, there is morerepetition than I would have preferred. I read it firstsequentially and then chapter by chapter, picking outtopics I wished to pursue further. For example, once Igot to Chapter 5 (“Managing IP Financial Assets”) atpage 111 (Alex Arrow’s contribution), I found I wasgetting what I had been told earlier and wasted valuablepages before I got to his material on call option values.Similarly I felt that Malackowski et al. had more to tellme than Chapter 7 gave me, but they repeated groundcovered earlier. Than I got to Parr’s article, in Chapter13 at page 271, who I really do like as an author, andfound once again material covered earlier. At this pointin the book, reading Parr’s article, I did not need thefirst half of the twenty page article to build a case thathad already been done, particularly when the last tenpages were so good. How much more I would havelearned if he had assumed we understood thebusiness case.

Having said all of this, I might sound greedy. This is agood book that I would recommend and share with mycolleagues and clients. I just feel there is so much moreI need to learn from these experts and any page wastedis a page too much.

Part One sets up the background for the other three

From Ideas To AssetsInvesting Wisely In Intellectual Property

Bruce Berman, Editor

Publisher: ©2002 John Wiley & Sons, Inc., New York


A recurring featureby John T. Ramsay, Q.C.

A review of current publications relating to the field ofIntellectual Property licensing, transfer and tools therein.

parts. Jackson Knight starts off with an excellent IP primer.It is one of the best primers for the business executivethat I have read. He develops what a patent is and verysuccinctly tells us that the exclusivity provided by apatent is impacted in part by the scope of the grantedclaims. This leads us to Hanchuk’s Chapter 2, “How toRead a Patent,” which walks us through the constructionof a patent. Knight reads very clearly, for example:

“The claims in a patent can be broad or narrow, and thusthe exclusivity can be broad or narrow. For example, thepatent could claim a method for making snowmen,which would be very specific. The claim might insteadclaim a method for making ice crystals, which wouldhave a much broader scope. Both claims would beexclusive; the degree of exclusivity would be different.”

Knight briefly develops, at page 11, the difficulty inchoosing when to apply for a patent, whether it be earlyin the innovative stage, or later in the commercial stage.This is a topic picked up again, without much repetition,by Brandt in Chapter 3, “Capturing Innovation,” at page78-9 where he writes:

“Examining the relationship between the businessdevelopment process and the related patent process, onecan begin to see the value of timely action to protectentrepreneurial innovation. If an early business conceptis filed prematurely it may be incomplete or even so faroff track as to significantly reduce the value of an issuedpatent to the actual business. If an early business conceptis filed too late in the business development process, itis of less value at the launch of the business.”

Fox et al. in Chapter 9, “Making Innovation Pay,” picksup this theme again at page 195:

“Many innovative businesses find that much of theirrevenue is due to products or services that have beenintroduced into the market within the last two years.This means that much of their revenue two years fromnow will come from products that have not yet beenput on sale. Innovative businesses competing with otherinnovative businesses may find that waiting until aninvention has been fully developed into a commercialproduct does not provide an adequate patent portfolio.Indeed, there is no legal reason to wait so long to seekpatent protection. Historically, there may have beenfinancial reasons, which are no longer valid for aninnovative business. In the past, companies wanted tosave money and only file patent applications on theinventions determined to be in the final product.

We now know that simply because an invention doesnot make it into the final product does not mean that ithas no value. In fact, in many cases, it means that theinvention is merely ahead of its time. The inventionwill likely be in a future product. Waiting for such aninvention to be developed into a future product mayresult in the invention losing its novelty. By the timethe invention is disclosed and evaluated, othercompanies may have come up with similar if notidentical inventions in the meantime. Waiting to protect

the invention until it has been implemented in aparticular form may result in narrower protectionbecause the general broader idea has already been eitherpublicly disclosed or patented by someone else.”

Each of these discussions of somewhat the same themeare proper in the context of the individual author’smaterial and serve to reinforce the merit of the argument.

Chapter 2’s primer on reading a patent is reminiscentof an IAM session that I attended at the 2001 LES AnnualMeeting; well done and needed by those who approachpatents from the business side rather than the traditionallegal and science side. The section on how to evaluatestrengths and weaknesses of patents is also very useful.

Chapter 4, “Clarifying Intellectual Property Rights forthe New Economy,” draws on the findings of a task forcemission by the Brooking Institute: “despite a rapidlyincreasing relevance on intangible assets, United Statescompanies have a decidedly poor handle on what theyare and how to deploy them.” I might have preferredmore in-depth discussion of the Brookings findings. Therest of the book had built the basis for me. However Irecognize the context of the authors – the task force hadfound a surprising lack of knowledge on the part ofbusiness executives.

Chapter 4 in Part One and Chapter 5 in Part Two coverin part much the same territory and both could havebeen improved by talking up to the audience. Chapter5 covers the Black-Scholes call option theory as youwould expect from a representative of PLEX, and couldbe better placed after Chapter 24 (“Patents on WallStreet”). The case was built in Chapter 24 for thisdiscussion, but without a cross-reference, the reader isleft on his own to find the correlation. This is not a bookon valuation, but the development of the call optiontheory is appropriate if moved into this context. In itspresent place, we are left with a detailed developmentof only one valuation method and this gives unfairemphasis to the call option theory.

In Chapter 6, Jorasch develops the market for abusiness or market driven patent process and sets thestage for Malackowski et al. in Chapter 7, and Fox et al.in Chapter 9.

One of the best chapters for my money was Fox’sChapter 9, “Making Innovation Pay.” The first part ofthis chapter picks up the theme about business drivenpatent process, then gets into the discussion of anInnovation Workshop and the InventShop – structuredpatent disclosure and evaluation processes.

Chapter 10, “Patent Brands,” was the chapter thatinitially drew my attention to this book. Berman et al.show that old economy companies known for the trade-mark brands may be missing an opportunity to impresstheir stakeholders with their patent strengths, andshould develop patent brands – i.e., “conveying theresults of IP management to key audiences in ameaningful way.” (page 213) They write at page 221:

“Firms whose patent assets, performance, and strategy


are not clearly articulated to investors and other keyaudiences may be inaccurately valued because investorsmust wait until the products that result from R&D cometo market and prove profitable before including theirvalue into firm value. Similarly, attributes of a firm’sproduct may be effectively protected by a well-stakedpatent or series of patents. However, if these protectionsare not understood by market participants, then theobserved valuation may never fully reflect the value ofthe product line because the observed value will includea discount for the possibility of competitors entering themarket. In the best case, failure to communicate IPstrengths and strategies results in an unnecessary delaybetween value generation and stock price appreciation.In the worst case, failure results in permanent stockmarket undervaluation.”

In Chapter 11, “New Economy Innovations from anOld Economy Giant,” Weedman shows how Procter &Gamble have applied the concepts developed moreacademically by others in this book. Experience lendscredibility. I like his “Redefining competitive advantageat Procter & Gamble” at page 204:Redefining Competitive Advantage atProcter & Gamble

Old Economy Definition:• I’ve got it. . . you don’t.New Economy Definitions:• I’ve got it . . .you’ve got it . . . I’ve got it cheaper.• I’ve got it . . .you’ve got it . . . I’ve got it with no

(or less) capital.• I’ve got it . . .you’ve got it . . . I’ve got it with

18 months’ lead time.• I’ve got it . . .you’ve got it . . . now you follow

my technology.• I’ve got it . . .you’ve got it . . . and I got to

market two years faster than I could have alone.• I’ve got it . . .you’ve got it . . . I make money

when I sell it, and I make money when you sell it.Chapter 12 (“Measuring Intellectual Property Portfolio

Performance”), the first chapter of Part Three, developsIP strategies further and gets in the newer territory ofpatent landscape analysis, patent citation, etc. Goodmaterial! More focus on these topics rather thanrepeating other material earlier developed would havebeen welcome. Likewise, I like Parr’s Chapter 13 butmuch of the material was covered elsewhere. Thismaterial would have been better placed in Part One withIP Strategies or have been narrowed to a more in-depthdiscussion on securitization and then integrated morewith the other chapters on securitization.

Narin et al. in Chapter 14, “Using Patent Indicators toPredict Stock Portfolio Performance,” do give us morein-depth indications of patent value. Like Chapter 5(Arrow), this chapter develops tools used by theauthor’s company, but neither Narin nor Arrowsuccumb to the temptation to make their article aninfomercial; there are nuggets of knowledge to be gained

whether or not you retain their services. Supportingempirical material to patent indicators of value is given inChapter 15 (“Patenting Activity as an Indicator of RevenueGrowth”).

Chapter 16 (“The Economics of Patent Litigation”)gives an interesting cost/benefit analysis of the cost ofobtaining patents. The costs are modest in relation tothe cost of the R&D they protect. The bulk of the benefitsmay not be from licensing (woe the licensing executive!)but rather “from the market advantage they secure. Thereal value lies in all of the things your competitors couldnot do; they could not move into market X, they couldnot offer feature Y” (page 332). But then the best partcomes - the analysis of patent litigation costs. First theauthor, Samson Vermont, points out that patent litigationis expensive due to the inherent complexity of the law,the stakes are so high that the large legal fees are smallin relation to the risk or reward, and the patent litigationprocess often gets divorced from the client’s businessgoals. He then develops a useful decision tree or decisionanalysis primer. This is recommended reading for anybusiness executive embarking on patent litigation. Onecould complain that it is overly cited with its 209footnotes, but I disagree – it is an illustration of thedepth the author has tried to take us. It is always adifficult balance between being too academic (this isan academic work) and still practical (and this is apractical work).

Chapter 17 (“Avoiding Transaction Peril”) gives goodhints as to why and how to do IP due diligence, withcharts and checklists. Chapter 18 finishes out Part Threewith its review of branding, essentially that given bytrademarks, perhaps a useful reminder that IP is not justpatents.

Part Four is dedicated to securitization. For some, thepreceding portions of this book will merely be a properlead up to this excellent conclusion. Some of us LESmembers may be aware of some securitization projectssuch as the Bowie Bond that had a high profile at theLES Kananaskis 2001 Summer Meeting. But we mayhave thought the securitization was restricted toentertainment and particularly music. This Part takesus a step further.

In Chapter 19 (“The Basics of Financing IntellectualProperty Royalties”), Agiato gets right down to businessand tells us what is IP royalty financing:

“IP royalty financing is nonrecourse debt financing.A licensor of IP can take the future cash flow expectedfrom a license agreement and receive a cash paymentup front, representing the present value of the futurecash flows. This allows the owner of the IP to leveragetoday what they expect to get in the future, and thus,add another tool for IP exploitation. Often faced withlimited options and funds, financing a royalty streamcan provide much-needed capital to research institutions,small and mid-cap companies, and individual inventors.

This type of financing is not particular to any specific


type of IP. It includes patents, copyrights, trademarks,and trade secrets. Unlike other types of financing, IProyalty financing allows the owner of the IP to retain allof the upside in asset value. IP royalty financing is aunique source of capital collateralized by IP royaltystreams and a need for capital. Given the manyadvantages this type of debt financing offers, asdiscussed below, companies have a strong incentive tochoose IP royalty financing over traditional financingmeans. Further, every responsible IP manager needs toinvestigate IP royalty financing as a way of lowering aportfolio’s risk and leveraging the IP’s return.”

Agiato points out that a “major obstacle stunting thegrowth of IP financing is the lack of understanding byIP managers. Most IP managers do not understand thefinancial instruments enough to know that they canactually increase shareholder value by leveraging theirroyalty stream” (page 428). Hopefully, Part Four willraise this awareness and understanding. Then, Agiatodevelops a model transaction. Canadian licensors(where in Canada there is not a clear rule as to whetherlicenses will survive bankruptcy, as the Americans dowith their post-Lubrizol remedial legislation) will findinteresting the discussion of the Special PurposeVehicle (an IP holding company) which is used in theroyalty trust to avoid the effects of bankruptcy of thelicensor/patentee.

One of the many topics in Chapter 20 (“Credit Analysisof Intellectual Property Securitization”) is the royaltytrust (what was used for the Bowie Bond). This topic isfurther developed in Chapter 21 (“Asset-Backed IPFinancing”) and its discussion of the first pharmaceuticalroyalty securitization rated by Standard & Poor’s.Royalty trusts are familiar to those of us who practicein Alberta where they have been used in the oil and gassector for some time. However, their use for IP isrelatively new. This chapter is a must read for all IPmanagers – but only after they read Agiato’s “Basics ofFinancing Intellectual Property Royalties.” Part Four issuperb the way it builds on the earlier chapters for awell crafted development of the topic.

Then we get the IP Glossary – 16 pages of usefuldefinitions. This is an excellent resource for anyonedrafting a technology transfer agreement, but may beeven more valuable to anyone drafting a prospectus orsecuritization agreement.

The databank that follows will be a good resource forany technology transfer officer.

From Ideas to Assets sets a benchmark of quality forother intellectual asset management books, both forits solid content and for its organization. If Bermanhad dropped the idea of making each chapter a standalone chapter, the book would have raised thebenchmark even that much higher.


NE

W P

UB

LIC

AT

IO

N

THE HAGUE - LONDON - NEW YORK

Despite the harmonizing effect of TRIPS and intellectual property law in general, technology transferremains firmly rooted in domestic contract law and public policy. However, similarities in legal cultureacross many national borders keep this problem to a minimum - until we approach the technologicallyadvanced countries of East Asia. For practitioners worldwide working with technology transfer in thisculturally heterogeneous part of the world, Legal Rules of Technology Transfer in Asia is a godsend.

For each of nine significant technology market jurisdictions - the PRC, Taiwan, Japan, Korea, Vietnam,Thailand, Malaysia, Singapore and Indonesia - this nuts-and-bolts approach to the applicable nationalrules provides all necessary legal information and guidance. Country chapters by local authorities arestructured to cover the following essential factors:

• government policy on technological research and transfer;

• intellectual property system;

• licensing agreements;

• registration and notification;

• dispute resolution;

...and many other invaluable details to help lawyers and business persons avoid pitfalls and makethe most of the technology transfer opportunities available in these countries. Two introductorychapters provide a much-needed perspective on technology transfer in the context of the world traderegime as it especially affects East Asia, with an emphasis on the trend to clarify and strengthen anti-trust rules. A concluding chapter surveys the market anthropology of the region and offers anexpert assessment of the probable future development of technology transfer trade in the region. Withits first-hand, in-depth, country-by-country analysis, and its firm grasp on a diversity of relevant legaland cultural issues, Legal Rules of Technology Transfer in Asia is unexcelled for desktop use in officeshandling East Asian trade in technology products.

Contents:Acknowledgement. About the Authors and Editors. Introductory Overview. Part 1: International andComparative Aspects. 1. Rules of Technology Transfer and Anti-trust in Current InternationalAgreements and the Proposed International Anti-trust Code; W. Fikentscher. 2. Technology Transfer inContext: Competition Policy Issues of Access to New Technologies; H. Ullrich. Part 2: The “Mandarin”Jurisdictions. 3. Technology Transfer in the PRC - An Academic’s Perspective; Zhi Wei. 4. TechnologyTransfer in the PRC - A Foreign Investor’s Perspective; S. Tetz. 5. Technology Transfer in Taiwan;Kung-Chung Liu. 6. Technology Transfer in Japan; C. Heath. 7. Technology Transfer in Korea; Byung-ilKim. Part 3: The ASEAN Countries. 8. Technology Transfer in Vietnam; Pham Duy Nhgia. 9. Technology Transfer in Thailand; J. Kuanpoth. 10. Technology Transfer in Malaysia; J. Chong.11. Technology Transfer in Singapore; Ng-Loy Wee Loon. 12. Technology Transfer in Indonesia; C. Antons. Part 4: Outlook. 13. Market Anthropology and Global Trade; W. Fikentscher. Index.

September 2002, 304 pp., hardboundISBN 90-411-9883-0

By special arrangement with Kluwer Law International, members of LES will receive a 10% discountand Kluwer will make a contribution to LESI for each copy of the book purchased by an LES member.The price to LES members is EUR 135.00 / US$ 129.00 / GBP 86.00. If you desire to order, pleasesend your name, address and credit card information to Renate Siebrasse, MEDTAP International, Inc.,20 Bloomsbury Square, London WC1A2NS United Kingdom, facsimile +44 20 7299 4555

Legal Rules of Technology Transfer in Asia

edited by Christopher Heath & Kung-Chung Liu

• tax considerations; • transfer of patents; • choice of law questions; • franchising; • publicity and merchandising; • anti-trust rules.

es nouvelleslesnouvelles.lesi.org/lesnouvelles2002/lesnouvelle... · tionship between real-world...

Documents