monetary remedies in trademark cases: materials

8/8/2019 Monetary Remedies in Trademark Cases: Materials

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Monetary Remedies inTrademark Cases

132nd INTA Annual Meeting

Boston, Massachusetts

May 22-26, 2010

Presented by:

Weston Anson, Chairman

CONSOR Intellectual Asset Management

[email protected]

800.454.9091

www.consor.com

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Monetary Remedies in Trademark Cases

A. VALUATION ISSUES AND DIFFERENCES IN A LITIGATION CONTEXT

We are dealing here with IP and intangible asset valuation in the context of calculationof damages for litigation. There are key differences and issues in this context, sincelitigation issues by necessity must somewhat modify the approach to the value of theassets. Some of these key issues include the following:

What exactly is being valued?

How do we measure that value?

Is it a but-for or a before and after analysis?

Which valuation methodology should we use to measure damages, and isit the same for all of the IP assets being valued?

What lifespan shall we use, and is it the same as a commercial lifespanwould be?

When did the damage occur, and how do we pick a specific date forvaluation?

When overlapping IP assets are involved, how do we allocate valueamongst them?

Is the methodology were using the best for the litigation environment (notnecessarily the best commercial method)?

Can we or should we bundle the assets?

Will royalty rates be important, and how will they be established?

What is the definition of damages: legal, commercial, and statutory?

Remember there are at least 10 types of damage awards that may be available in apiece of litigation, and one must consider the valuation process in the context of whichof those types of damages is being pursued:

1. Reasonable royalties

2. Actual damages

3. Lost profits

4. Economic damages

5. Loss of business value6. Unjust enrichment

7. Corrective advertising

8. Supplemental/Discretionary

9. Punitive/Enhanced

10.Statutory

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The reason why intellectual property and intangible asset valuation in litigation isdifferent is primarily a question of context. But what does this really mean? It meansgreater freedom in calculating the valuation and damages numbers, and the ability to bea bit more speculative and not work with absolute mathematical precision (toparaphrase the court). Often, what works in a litigation context will not work if one were

valuing the same assets for a commercial transaction. Some of the differencesbetween the valuation of IP for commercial reasons versus for litigation can be summedup in the following phrases:

Driven by defendant vs. plaintiff point of view

All or nothing analysis

Single point in time analysis

Enforced transaction environment

Adversarial approach

Extremes rather than mid-points of value

Premium above a marketplace royalty rate (the Panduitkicker)

How do we summarize these differences between the commercial valuation ofintellectual property and the valuation for the purposes of damages in litigation?Perhaps it can best be done by reminding ourselves that the formula in litigation isCause (evaluation) + Valuation = Damages. Commercial valuation tends to seek a truemid-point in value, and both parties from the beginning are seeking agreement on value.Litigation valuation, on the other hand, adopts an advocates position on value, leadingto extreme position. The very nature of litigation alters the perception of value.

Why do we find these perception differences and why do we find such extremes in

opposing valuation presentations during litigation? It is because even the courtsencourage this. As far back as the Georgia-Pacific case where the courts awarded aroyalty, they didnt award a royalty that was reflective of market conditions. Instead, theplaintiffs side asked for 31%, and the defendants side showed that there were actualmarket comparables at 3%. The court awarded an unrealistic and non-market royaltyrate of 20+%. The exhibit below illustrates a real case study, and the differences in thedamages conclusions reached by the experts for the plaintiff and the defendant.

OPPOSING VALUATION CONCLUSIONS

Action: Federal trademark infringement

Cause: Infringing shoe logos and designs

Plaintiff: Large sporting goods company

Defendant: Large shoe retailer

Plaintiff's Expert: $40.0 million

Award: $60.0 million

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B. EVALUATION OF DAMAGES: CAUSATION

The process of valuation analysis in an IP damages case consists of a three-partapproach:

1. Identification of the act or cause of damages;

2. Evidence of the damages that have been caused; and3. Calculation or valuation of the economic loss or amount of damagesincurred.

Causation is always the first step in the process. Key questions must be addressed:How and why did the damages happen? What were the reasons? What is theeconomic theory behind the damages? And, from a business point of view, can a truecause of damages be identified? Evaluation and valuation, therefore, are both equallyimportant in this IP damages process, and can be thought of as follows:

Damages Analysis v. Damages Calculations

a) Damages Analysis = Evaluation/Causationb) Damages Calculations = Valuation/Computation

In trademark cases, causation or the underlying reasons for the damages is still (andperhaps will always be) in a state of change. Various courts focus on different issuesand require somewhat distinctive tests. The standard but-for test or the reasonableforeseeability tests are still acceptable methods of proving causation. However,economic and business principles today are much more important in establishing thecause of damages, and courts seem to be more willing and able to understand basicbusiness and economic arguments. Consistently over the last 100 years, causationremains the root from which the tree of an IP damages case sprouts. In sum, the first

step in an IP damages/valuation case is an evaluation and analysis of the damages.

How does one assess and evaluate whether damages have taken place? There are anumber of different approaches (and phrases) used to describe IP damages. Amongthose phrases are:

Market impact

Economic impact

Future impact

Future market impact

Impact on revenue Impact on profits

Image degradation

Brand value reduction

Customer impact

Retailer or wholesaler impact

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Industry impact

Trade and marketplace impact

Impact on licensees

Impact on contracts and agreements

Impact on the value of associated trade secrets and / orsupporting technical know-how

Decrease in the value of flanker or bundled IP assets (e.g.sub-brands)

Business interruption

Any of the above phrases can be used to describe the immediate cause of damages,and any can be the keystone phrase upon which damages theory and proof is built.

The second part of the evaluation process, prior to any calculation of damages, is ananalysis of what exactly has been damaged -- trademarks only, trademarks and brand

names, logos, copyrights, umbrella brands, etc.

Often in these fast-paced days where intellectual property is the driver of virtually allindustrialized countries, damages cases can involve overlapping assets or overlappingbundles of assets. For example, one could have the following situations:

A core patent that travels with a proprietary trademark or name, as well asspecific technical know-how to implement usage of the patent.

A corporate trademark that is accompanied by two sub-brands, along with acopyrighted character that is also a trademark, as well as a series of copyrightedmaterials and a proprietary corporate color all combined with a corporate brand

name. Operating software can be combined with source code, combined with somepatent protection, combined with copyrighted materials, along with a trademark.

Each of these scenarios is possible (and in fact has been faced in actual cases), and inthe 21st century these types of interlocking and overlapping IP cases will proliferate.Therefore the issue often becomes: What theory or theories of damages does one useto cover all of the IP involved in the litigation? Does one simply take the primary pieceof intellectual property such as the patent and focus on the damages case based onthat single piece of property? Or, does one build multiple damages cases in the samelitigation, covering damages to patents, damages to trademarks, damages to software,

and so forth?

There are no simple answers to these questions. Instead, complex litigation willcontinue to be evaluated and valued for damages on a unique case by case basis more than ever requiring intellectual property experts who are truly experienced in fieldwork with IP, and in hands-on management and creation of intellectual property. As theevaluation and analysis part of the process is completed, the consulting experts, alongwith the attorneys, should identify all possible causes of damages; and evaluate the

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impact of those damaging activities. From there, the experts effort and much of thebalance of the legal prep time moves to the valuation process which is essentially thecalculation of damages.

C. VALUATION OF DAMAGES: CALCULATION

The measurement of damages is the quantification of the injury to the plaintiff, whotypically is the owner of the trademark. In other words, damages is that amount ofmoney that it would take to put the plaintiff or claimant back into the economic position itwould have been in, had there been no infringement and its very important toremember that the amount of money is not necessarily related to the amount of money,income, or rewards that the infringer earned. Thus, the damages to the trademarkowner/plaintiff may be far greater (or sometimes less) than the amount of money or

profit or economic benefit that the infringer received. This is partially so because theplaintiff -- i.e., the damaged party -- may have various damages ranging from reducedsales to reduced profit margins, and from reduced number of customers to reducedmarket share. Therefore it is important when entering into the valuation and calculationphase of a damages case, that the IP expert and the balance of the legal team have anunified theory of damages that accounts for all of the injury, both current and projected,that has been or may be inflicted on the trademark owner.

Three Basic Conceptual Approaches to Damages

While there are many different ways to attack the issue of damages valuation and

quantification, in general three broad approaches are used most often to calculate andquantify economic or business damages:

1. The before and after method. In this approach, one compares the valueof the IP before the damages took place, with the value of the IP after thedamages;

2. The but for method in which an expert will quantify the damages byestablishing what amount of income (sales, profits, etc,) would have been earnedby the trademark owner, but for the damages cause by the infringer. Thismethod typically requires a backward look at economic benefit, as well asforward looking projections for what would have been earned but for theinfringement; and

3. The opportunity cost methodology. In this approach, one can include thevalue or income from the IP that the owner or plaintiff would have earned. This isadded to current or opportunity costs, which essentially is the calculation of valuefor the income or revenue that the plaintiff or IP owner could have earned in thefuture. Taken together, then, these historical and future opportunity costsbecome the basis of the valuation or damages calculations.

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In all three approaches, there are a number of different bases upon which damages canbe quantified, or calculated and valued. Damages can take many forms as notedearlier. And, economic or business damages can be measured in many different ways,depending on the circumstances, industry, and case-specific circumstances, includingthe following:

Increase or decrease in the number of units sold;

Increase in production or management costs;

Decreases in R & D or development costs;

Increases in capital expenditures to run a business;

Increase or decrease in working capital needed;

Increase or decrease in past sales or future sales;

Changes in the price per unit charged;

Changes in market share, both relative market share and absolute;

Reduction in market size; and

The cost of not being the first to market.

All of these can be used as the basis for the valuation and calculation of damages; and,in many cases, multiple approaches will be used in order to capture all of the valueimbedded in the damages case.

Damages valuation in todays world has to be based on creative analyticalmethodology. In the famous Panduit decision, the courts finally adopted a version ofeconomic reality that has been termed the analytical method. The analytical method, inone form or another, needs to be used in all IP damages cases to establish royaltiesand/or to quantify all other damages measurements. It is interesting to note that whilethere are four primary methodologies, there are many proprietary methodologies whichoften are appropriate in specific situations. The four primary valuation techniques areas follows:

1. The market approach;

2. The cost approach;

3. The income approach; and,

4. The relief from royalty approach (a variation of the income approach).

D. TRADITIONAL VALUATION METHODOLOGIES

There is a general agreement on standard methodology in place when it comes tovaluation of intangible assets. And, the traditional valuation methodologies used fortangible assets are, in some form or another, also accepted as traditional approaches tointellectual property valuation in litigation remembering that the tradition of valuingintellectual property has a very short history. Until two decades ago, few people caredabout intellectual property value, and even fewer had the professional credentials toaccurately value intellectual property. In fact, until very recently, (and in some cases

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even today, unfortunately), so-called experts at IP valuation were often nothing morethan CPAs trained to multiply columns of numbers.

In addition to the four primary valuation methodologies mentioned earlier in this chapter,there are also many proprietary, specialized, industry specific, or asset specific

approaches to the valuation of IP and intangible assets. These include proprietarymethods and other theories of value such as the Next Best Cost or the profit splitapproach. A great amount of standardization exists in intellectual property valuationmethodology in the form of the four traditional methodologies. However, there are abroad range of modifications, alterations, and adaptations that can be applied to any ofthese four.

Having discussed the impact of context on the value of intellectual property specifically the litigation context one also must understand some of the other keyvariables. One of the most important factors is time. Typically before one can beginvaluing the assets, or even selecting a methodology with which to value the assets, keyquestions must be asked as to: When are we valuing the assets, at what point in timeand for what period of time? Are the IP or intangible assets under scrutiny being valuedas of today; as of five years ago, when the first hint of damages may have occurred; orwhen litigation commenced; or 10 years in the future when the useful life of the assetwill be up? In many cases, two points in time will be chosen and in all cases, each ofthese time-based scenarios has to be thought through.

We then move from point in time to the period of time. By period of time, we meannothing more than the period over which the damages are being calculated. Is it the lifeof a patent? Or is it the life of a contract or is it some other timeframe? This is aquestion of lifespan. The word lifespan in this context is self-explanatory: it meansnothing more than how long the life of the IP or intangible asset is projected to last.

1. Value Definition and Its Impact on Methodology

As we discussed earlier with IP damages valuation calculations in litigation, there aremany more variables than when dealing with tangible assets. Context, time, and costare all important. There is one other key variable, and that is the definition of value,including:

Fair market value

In-place value

Fair value

Tax value

Liquidation value

Deal value

Licensing value

Transaction value

Securitization value

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Dispersal or disposition value

Replacement value

Reproduction value

But-for value

Before and after valueOpportunity cost value

And so, we see that we come full circle. Starting earlier in this chapter by identifying thefour approaches to value, we find the definition of value can mirror the four coreapproaches or can take other definitions of value.

2. Traditional Intangible Asset Valuation Methodologies

At the beginning of the valuation process to establish damages, it is prudent, in fact

imperative, that the experts consider all the different methodologies available to valuethe particular set of intangible assets. This is particularly so because the informationavailable may not be perfect (and often is not in litigation.) Data gathering may beproblematical at best, and often the data and information available may determine themethodology that is used. The methods used to value intellectual property andintangible assets have many elements in common with the methodologies used to valuetangible assets such as property plant and equipment. However, an importantdifference in most cases, particularly in litigation, is in the availability of the necessarydata, such as finding comparable transactions or relevant royalty rates or other financialinformation. Comparable transactions and benchmark information needed to establisha logical and intellectually sound basis for the valuation of damages may be difficult to

acquire and may take substantial interpretation and interpolation.In the last two decades, the process of valuing IP and the number of people in thepractice area has grown dramatically (unfortunately, the level of sophistication of manypractitioners is not equal to the complexity of the tasks undertaken). Four differentmethodologies have become the most important, whether for litigation purposes or forbusiness and other transactional reasons.

a. The Cost Approach

Whether using historical or future costs, the basic underlying principle for the cost

approach is the principle of substitution. This principle states that the value of anobject or asset or piece of intellectual property is no greater than the cost toobtain that asset elsewhere whether the cost of obtaining the asset is measuredby purchasing it today or replacing it with a substitute asset of equal strength andutility.

Two different general approaches are applied when valuing assets using the costmethod: Either historical cost bases or replacement or reproduction costs bases.Using historical cost, the asset is valued taking into consideration all of the costs

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that have gone into bringing it into its present state, and then calculating thevalue of those costs in todays dollars, remembering that any appropriatedepreciation based on remaining useful life is important. On the other hand, thereplacement or reproduction cost techniques use current prices to calculate thecost of duplicating or replicating or replacing the asset today. The differences

between the historical cost approach and the replacement cost approach includeadjustments reflecting inflation (or in some cases, deflation due to marketefficiencies, competition, or technological improvements).

There are several different variations to the cost approach method and each oneuses a slightly different definition of cost. For example, the difference betweenreproduction cost and replacement cost may seem a question of semantics, butin fact, those two phrases can be very different things. Reproduction costestablishes what it would take to construct an exact replica of the intellectualproperty, while replacement cost establishes what it would take to create orpurchase a piece of IP of equal functionality or utility. Both approaches to thecost methodology, historical and prospective, assess the value of the IP orbundle of assets by measuring the expenditures that would be necessary toreplace the assets being valued. Whether historical or future cost is beingestablished, there are three general areas of cost that must be examined:

Hard costs of replication such as materials, acquisition of assets,etc.;

Soft costs including engineering time, design time, and overhead;and

Market costs including costs of advertising or other costs to build amarket for the IP.

Among the costs to be reviewed include the following, but is not intended as anexhaustive list:

Legal fees

Application/registration and other fees

Development costs

Personnel costs

Advertising costs

Production costs

Engineering costs

However, unless a premium is added to these costs, this method does not givean indication of the economic benefits derived from the development ownershipand utilization of the IP. Instead, it provides a minimum value for the assets.Because the cost approach is based on the economic principle of substitution, itis essentially based on the premise that a damage calculation or valuation shouldbe no greater than the amount which a potential buyer would pay for an asset.

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A brief example of the cost approach to a damages calculation is shown below inthe exhibit below. In this particular case, the client had a group of technologyassets which were rendered obsolete because of infringement. The exhibitbriefly summarizes the cost approach.

COST ANALYSIS

SUMMARY OF HISTORICAL COST

Hard costs of development

Personnel and development costs

Market development costs

Advertising costs

Overhead costs

TOTAL COST

Multiplier for current value

Total value, based on cost, expressed in todaysdollars

$100,000

$25,000

$15,000

$50,000

$50,000

$240,000

160%$384,000

b. The Market Approach

As the name implies, the market approach to the valuation of any asset, tangibleor intangible, is most applicable when a truly active marketplace exists and actualtransactions can found.

The market approach to valuation has traditionally been used with tangibleassets where active markets have existed for decades in areas such as realestate, equipment, and raw materials. However, most intangible assets, at leastuntil recently, have not been bought and sold frequently enough to be able toestablish a value based solely on direct market based comparables; andtherefore, analysis and adjustment are almost invariably necessary. In addition,intangible asset transactions are often cloaked in several layers of confidentiality.

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It is typically difficult to get enough detail on each of the similar or comparabletransactions to be certain that all of the elements of value that make for acomparable to be used in the market approach have been appropriatelyconsidered. On the other hand, because the market approach utilizes actuallytransaction data to the maximum extent possible, and values are derived from

the sale, transfer, license, or other activity of similar assets, it is increasingly thepreferred approach if the necessary data can be found.

The natural strength of the market approach is its connection to actual marketsales, licenses, rents, and deals; and when the data is available the marketapproach is typically practical, logical and applicable to all types of assets not

just intangible assets. Also, along with the income approach and the relief fromroyalty approach, value conclusions under the market approach can be reviewedin the future to see if upward or downward adjustments are necessary based onnew transaction data.

In order to illustrate the market approach, weve constructed the very simpleexhibit below. As the exhibit graphically illustrates, the use of the marketapproach depends on finding one or more comparable transactions, and thenextrapolating those comparable transactions to the value of the IP under review.

MARKET APPROACH METHODOLOGY

Valuation of Database

Comparable Sale #1

Comparable Sale #2

Comparable Sale #3

Average of Comparable Transactions

Adjustment for Asset Size

Market Based Value

$10,000

$20,000

$30,000

$20,000

80%

$16,000

c. The Income Approach

The income approach is one of the most widely IP valuation methodologies.

However, this methodology can be complex and one must decide how tomeasure the income attributable to the asset. Is it measured as sometheoretical rent? Or is it measured as a premium price that a product mayreceive? Or is it measured as a proportion of the operating income earned by aproduct or brand? All of these can be used, but one must be careful in selectingthe most appropriate measure. For that reason, the income approach can bemisleading and overly mechanistic and/or arbitrary.

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A brief example illustrates this: An unsophisticated analyst might see that abranded product is engendering a profit margin of 30% higher than its unbrandedcounterparts; and the expert is tempted to attribute the entire 30% to thetrademark or brand. In fact, only some portion of that 30% can be attributable tothe actual intellectual property, as the balance of the increased profit clearly is

being earned because of the higher volumes, better distribution, and moreefficient manufacturing that the branded product almost certainly has. The threebasic parameters of the income approach are simply as follows:

Future income stream;

Duration of income stream; and

Risk or discount rate associated with the generation of the incomestream.

The subtleties come in identifying the alternative measures of economic incomethat can be used in this sort of analysis. These can include net revenues, gross

income, gross profit, operating income, income before tax, operating cash flow,ebitda, net cash flow, expected incremental income, etc.

The most common error in applying this approach is the experts lack ofdifferentiation between the income generated by the total business enterprise orthe business enterprise value; and the value of the income generated by theintellectual property within that business. In order to use the income approach, itis critical to separate the stream of income that the IP is generating (andtherefore its value), from the value of the business as a whole.

An additional critical element in using the income approach is that the methodrequires that an appropriate capitalization or discount rate be established. One

can take the estimated expected income and apply to it an investment rate ofreturn for an appropriate number of years, in order to capitalize the income. Or inthe alternative, one can apply a present value discount rate to the stream ofincome, which represents the owners minimum cost of obtaining the income.Another caveat in using the income approach is that an appropriate time periodhas to be selected taking us back to the earlier discussion of remaining usefullife.

In summary, when using the income approach the IP or intangible asset valuesrepresent the worth or present value of the future economic benefit/income thatwill (or should have) accrued to its owner. This requires projection of future

income, an estimate of the duration of the income stream and/or useful life, andan estimate of the risk associated with generating the income stream, also knownas the discount rate. An example of the income approach is shown in the exhibitbelow.

INCOME APPROACH TO VALUATION

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Annual Income Generated from IP

Number of years of incomegeneration

Gross value of income streams

Discount rate adjustment

Net value of income streams

$100,000

8

$800,000

15.0%

$450,000

d. The Relief from Royalty Approach

This is a variation of the income approach and a variation that is used quiteoften in litigation. However, it is most peculiar that in some districts and somestate courts, use of the relief from royalty method is not allowed, particularlywith trademarks. This is counter-intuitive and counter to the market realities oftrademarks as to be almost inexplicable to a non-attorney. The relief fromroyalty approach, however, is used so often and is so critically important thatwe provide a brief discussion on the topic of finding and establishing royaltyrates.

Briefly, the relief from royalty method of value for IP is the calculation of thepresent value of a stream of royalties that the IP owner would have received (orthat the infringer has been relieved from paying). Because it is a method that isbased on objective data, it is often used to establish a baseline damagescalculation in litigation. This approach provides a measure of value bydetermining the avoided cost of an infringer not having to pay the appropriateroyalties. It is calculated by assuming that the infringer does not own the

patent, trademark, or copyright and thus has avoided a royalty that he or sheshould be paying for its use. This relief from royalty method uses royalty ratesthat are based on marketplace transactions or interpolations and uses aforecast of revenue for the infringers actual revenue as the income stream towhich the royalties apply.

Thus, this method combines both the income approach and the marketapproach. Value is calculated in the form of an avoided cost or avoided royaltypayment. Specifically when using the relief from royalty approach, the presentvalue of the future or past royalty streams is the measure of damages. Theassumption, of course, is that the assets would have to be licensed in order to

use them. This method determines what the cost would be of that hypotheticallicense, measured by royalty streams. Therefore it incorporates either aprojection of future revenue as in the income approach or past infringerrevenue and relies on comparable royalty rate data.

Usually, data from marketplace comparable license agreements are used asthe source for the royalty rate in the calculation. It must be noted, however,there is no such thing as an exact market comparable royalty rate. Each one is

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different and reflective of the unique IP for which the rate is being charged.However, the inclusion of this market-based information adds credibility to thedamages analysis. With both the income approach and the relief from royaltyapproach, the results can be revisited periodically for updates as needed.

E. ALTERNATIVE VALUATION METHODOLOGIES

Monte Carlo Analysis

Orderly Disposal Value

Premium Pricing Technique

Profit Split Method of Value

Replacement Value

Reproduction Value

Return on Assets Employed Method of Value

Rules of Thumb

Subtraction Value

Technology Factor Technique

The VALCALC Method

VALMATRIX Analysis Technique

F. ESTABLISHING ROYALTY RATES

As noted earlier, the Relief from Royalty valuation methodology is one of the four mostwidely used approaches when valuing intellectual property. It can be applied to virtuallyany type of intellectual property that has been or could be commercialized. While usefuland accepted in most state courts, the application of reasonable royalties to establishtrademark damages is still in question at the federal level. Indeed, case law hasendorsed its use in the second, fifth, seventh, and eleventh circuits; however, others stillremain on the fence. These hesitations are frankly incomprehensible to any businesspractitioner of intellectual property valuation, licensing, or management. Of all types ofintellectual property that we deal with, trademarks are the ones where establishedmarketplace royalty rate comparables are most readily available; and where believable,defensible, and provable industry average royalty rates for different types of trademarksare also available.

That being said, however, caution is needed when using the relief from royalty method.

The methodology is overused by so-called experts and misunderstood by many other ofthose same IP experts testifying in courts today. The relief from royalty method is sobeautifully simple that the temptation for many experts is to fall back on it, having spentconsiderable hours of their clients time and budget seeking out royalty rates, and thenapplying a very simplistic formula as shown in the exhibit below.

RELIEF FROM ROYALTY TRADEMARK VALUATION

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Annual Sales of Brand X Widgets $100,000

Industry Average Royalty Rate for Branded Widgets 15.0%

Estimated Annual Royalty Income $15,000

Extended for 10 years $150,000

Annual Discount Rate 15.0%

Total Value or Damage = $80, 730

There are two kinds of royalties that can be used for establishing a reasonable royalty inlitigation:

1. Royalties that are already established by the parties or closely related parties;and

2. Hypothetically negotiated or hypothetically established royalty.

An established royalty is that which is already in place and where the trademark ownerhas licensed the infringed property to others, and/or where the intellectual propertyowner or the infringer has licensed other similar properties. Other sources ofestablished royalties are industry averages that can be proven, as well as othercomparable transactions. However, caution should be used when looking atcomparable transactions. The second broad type of royalty rates that are useful arethose which would be established in a hypothetical negotiation, based on the knowledgeof the experts involved.

In general, the five approaches to the establishment of royalty rates are:

Rules of Thumb The Analytic Approach

Industry Averages

Comparable Royalty Rates and Transactions

Hypothetical negotiations/market based approach

Within the five general approaches, rules of thumb are the least useful. The analyticapproach is most open to interpretation and manipulation by the so-called expert.Industry averages can be dependable for some types of IP. Comparable transactions,where available, can be an excellent source; and the hypothetical negotiation is useful,

provided that the people calculating the royalty rate in the hypothetical negotiation areactually experienced in the process of licensing.

1. Rules of Thumb

The first rule of thumb is: All rules of thumb are flawed. Rules of thumb shouldbe applied only as a last resort. Nonetheless, a brief discussion of rules of thumbshould include the following:

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The 25% Rule

This rule states that an appropriate royalty rate is established by allocating25% of profit as a royalty. There are variations on this, of course. Someexperts say that 33% of profit should be allocated to the royalty. The

questions this rule raises are obvious and fall into three broad areas: First ofall, where did this rule come from? No one knows and no one can trace itsorigin. Second, what is the definition of profit is it gross profit, operatingprofit, net operating profit, incremental profit, incremental margins,incremental cash flow, EBITDA, or something else? Is it based on profit ofthe entire product line, the entire company, a single product, a singlegeographic use? Is the 25% rule applied to the entire selling price of theproduct that contains a piece of technology or just to a portion of that sellingprice? Obviously, when you are talking about 25% of profit, the licensorwould like to receive 25% of gross profit, while the licensee would be muchmore willing to pay 25% of net after tax profit. Clearly, definitional issues

exist.The third set of observations on the 25% rule revolves around the lack ofanalysis of investment required, or the risk profile of the particular industry.Also, there is a complete lack of analysis as to any other negotiatingconditions or concerns, such as the competitive environment, the market size,market share, etc. In sum, in our opinion, the 25% rule of thumb shouldnever be used.

The 5% of Sales Rule

Again, for unknown but mystical reasons buried in the past, one of the most

popular misconceptions for establishing a suitable royalty rate is that 5% ofgross revenue is an appropriate royalty rate. This very simple and simplisticapproach makes the unjustifiable and frankly foolish assumption that allintellectual property is the same. In other words, this rule assumes that aroyalty of 5% of sales on a breakthrough cancer curing pharmaceutical is justas appropriate as a 5% royalty on a bending tool used in Chinese steel mills,or 5% for the use of the most famous trademarks in the world such as Disneyor NASCAR. This rule of thumb is fundamentally flawed and should never beused albeit on some occasions, after analysis and an examination ofcomparables, a 5 % royalty may in fact prove to be the proper answer.

The Variable Profit Split Rule

The variable profit split approach says that a licensee would be willing to payas much as 100% of their variable profits as a royalty. In this approach, theexpert proposes that a willing licensee, after covering all of their fixed costs ofmanufacturing and marketing, would be willing to pay 100% of their variableprofits or some share of that 100%. This method has been accepted in somecourts. (For example, in a case called Tights, Inc. vs. Kayser-Roth Corp., the

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court established a reasonable royalty of 33% of the infringers cost savingsfrom the patented product design. The court also said that this percentagecould range between 25% and 50% of the variable cost savings.) It should benoted that the variable profit split is no more intellectually rigorous amethodology than the other rules of thumb.

2. The Analytic Approach

This approach is another variation on formulaic methodologies for establishingroyalty rates. The so-called analytic approach varies from expert to expert. Forexample, in his 1993 book on IP infringement damages and the subsequentupdates, Russell Parr states the analytical approach can be summarized in thefollowing equation:

Expected Profit Margin Normal Profit Margin = Royalty Rate

The basis of this analytic approach formula is that the infringer is making unusual

profits on sales that encompass the infringed IP. That being the case, then, thelogic of his approach says that those extra profits above normal industry profitmargins should go to the IP owner as damages. While this is fine in theory, ithas two major flaws. The first is how does one define what normal industry profitmargins are, and how does one collect the data to establish those percentages?The second flaw involves the expected profit margin from the infringing sales.One might be fortunate enough to have access to the infringers internaldocuments, and find a smoking gun statement that they expect to make an extra15% on the new product containing the new technology or trademark, but thechances of that happening are typically slim.

3. Industry Averages

Experts are in debate over the usefulness of industry average royalty rates tobe used to establish royalty rates in hypothetical negotiations. It is our opinionthat this can be a very useful tool, given that enough data exists for the type ofintellectual property. Today there are data available for virtually all types of IPbeing licensed, including:

Patents

Trademarks

Domain Names

Copyrights Characters

Software

Designs

Directories and Databases

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While industry data is available for many pieces of IP such as trademarks andcopyrights, it is not available for all of them. (Additionally, it should be noted thatusing the words industry average is a misnomer in the case of intellectualproperty. The better phrasing would be property averages.) These averageroyalty rates, however, change dramatically for different types of properties. In

fact, some of the key variables on royalty rates and the perspective from whichroyalty rate patterns should be viewed include the following:

Royalty rates vary by type of property

Royalty rates vary by type of product

Royalty rates vary by type of distribution

Royalty rates vary by geography

Royalty rates vary over time

Royalty rates vary when used in different cultures

The two exhibits below are very different. In the first, covering trademark royaltyrate ranges, the average data is based on a survey done annually by EPMCommunications.

RANGE OF ROYALTIES

BY TRADEMARK TYPE - 2008

Property Type

Art

Celebrities/estates

Entertainment/characterFashion

Music

Non-profit

Print publishing

Sports

Trademark/brands

Toys/games

2008

6.2%

10.2%

9.4%8.5%

8.0%

8.3%

8.6%

10.0%

8.0%

8.0%

OVERALL AVERAGE 8.7%Source: The Licensing Letter 2008, EPM Communications

TECHNOLOGY ROYALTY RATE RANGES

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Industry Range

Aerospace 2.0% - 15.0%

Chemical 1.0% - 10.0%

Health Care Equipment 5.0% - 10.0%

Electronics 3.0% - 12.0%

Medical Equipment 3.0% - 5.0%

Software 5.0% - 15.0%

Semiconductors 1.0% - 4.0%

Pharmaceuticals 8.0% - 20.0%

Diagnostics 2.0% - 10.0%

4. Comparable Transactions

Having reviewed industry average royalty rates, we now come to the approachknown as the comparables method or the comparable royalty rate method. Thiscan be a superb way to establish royalty rates, given that sufficient comparabledata with adequate detail is available. In this method, royalties are establishedbased on other royalty rates that have been negotiated in the market. The valueand reliability of this method, of course, depends on the quality of thecomparables as well as on the qualifications and experience of the personanalyzing the comparables.

Even within the same types of IP, variations can be substantial; for example,variations are seen in trademarks for consumer goods, apparel, and sportsapparel. The following exhibit is an example of an actual royalty rate analysis weperformed in connection with an arbitration some years ago over the use of aconsumer goods trademark.

COMPARABLE ROYALTY RATES:

SPORTS APPAREL & TEXTILES

LICENSOR ROYALTY RATE COMMENTS TOTAL

Wimbledon / TM 6.0% 2-4% for advertising 8.0 10.0%

Rawlings 3.5% - 5.0% ------- 3.5% - 5.0%

NFL 8.0% 15.0% 2% for advertising 10.0% - 17.0%

MLBB 6.0% - 12.0% 2% for advertising 8.0% - 14.0%

LA Gear 4.0% - 6.0% 1-3% for advertising 5.0% - 9.0%

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Playboy 6.0% - 10.0% 2% for advertising 8.0% - 12.0%

Bancroft 3.0% - 5.0% Product design fees 3.5% - 5++%

Louisville Slugger 5.0% - 8.0% 2% for advertising 7.0% - 10.0%

RANGE 3.5% - 17.0%

SPREAD 485%

This project focused on the question of what appropriate royalty rate should aninfringer pay for its use of a well-known sports apparel trademark/brand name.Three things jump out from the exhibit: First, while all of the trademarks listed aresimilar, the range of royalty rates varies substantially from one to the other.Second, in addition to the royalty rate, many trademark licenses include fees forother activities like design and advertising. Third, the full range of royalty ratesfrom these eight companies is wide, running from a low of 3.5% in total payments

to a high of 17.0%, charged on net wholesale sales.

Even in this very tightly defined product, the range of royalty rates is very wide.The range of 3.5% to 17.0% translates into a spread of 485% between the highand the low. In other words, the 17% royalty rate is nearly five times as great asthe 3.5% royalty rate.

CRITERIA FOR COMPARABLE TRANSACTIONS

1. The licenses involve commercialization of the IP.

2. The intellectual property comes from the same family, (e.g. patents

or trademarks or copyrights).3. The comparable transactions involve the same geography, be it

U.S. or international.

4. The comparable pieces of IP are equally well-known or equallyvaluable.

5. The licensors be of relatively the same size.

6. The license agreements cover similar products and services.

7. The license agreements have similar lives and renewal terms.

8. The licenses have similar exclusivity or non-exclusivity clauses.

9. The licenses should cover products that are similarly priced andsold through similar channels of distribution.

10. That they not be internal licenses between related entities.

11. The comparable license was negotiated at a relevant date.

12.The comparable transactions have been negotiated between

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willing buyers and willing sellers.

13.The IP covered by the comparable transactions have similarremaining useful lives.

14. The comparable transactions are reviewed for other non-royalty

compensation.15.The agreements do not have what are known as tie-inagreements (arrangements which require the licensee to purchaseproducts or services from the licensor).

5. Hypothetical Negotiations

The hypothetical negotiation methodology is employed in many cases whereroyalties are set in litigation. The hypothetical negotiation environment(sometimes incorrectly referred to as the market based approach,) assumesthat the two parties, IP owner and infringer, would have negotiated an agreementto use the IP at some point in time in the past generally that point in time justbefore the infringing or damaging acts occurred.

This hypothetical negotiation has a key complication and unleashes anunderlying philosophical debate: In an infringement case, should one assumethat at the date of the hypothetical negotiation there was a willing licensor andwilling licensee sitting at the table? Or, more appropriately in most cases, shouldone assume that you have an unwilling licensor/IP owner at the time of thenegotiation? The difference can be substantial. A willing IP owner/licensor willseek to obtain a fair market royalty rate appropriate to the date in question andthe market conditions then existing. An unwilling licensor/IP owner will demand a

royalty rate substantially higher than market because there is a great probabilitythat the owner of the IP did not want to license at that time, and instead wouldhave commercialized the property themselves, or in conjunction with a jointventure partner or possibility another larger, stronger licensee.

This setting of criteria, and analyzing the negotiation in a retrospective manner, isa challenging task for any well-trained IP expert. In using the hypotheticalnegotiating approach to setting royalty rates, it is imperative that an expert befound with true field experience in licensing at the relative point in time. This iswhere an expert can be of maximum utility to the legal team, provided he or shehas been in the business long enough and has been in the type of licensing

business that is relevant.

HYPOTHETICAL NEGOTIATIONS

1. The consideration of the amount of investment that would be required tocommercialize the IP.

2. What investment rate of return would the IP owner have from alternatives?

3. What is the dollar value of the IP that is the subject of this negotiation?

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4. What other assets and activities would be needed to commercialize the IPincluding marketing requirements, manufacturing requirements?

5. What are the other risks in taking the license, including factors such ascompeting technologies, start up issues, governmental regulations, etc.?

6. What is the total market size, and the probability of capturing a given share of

that market?7. What are the competing products or technologies or trademarks against

which the licensee would have to compete?

8. What profit margins would the licensee be likely to earn?

9. What would the licensors alternatives have been?

10.Importantly, what was the relative strength of the two parties at the time of thenegotiation? Was the licensee much larger and more powerful and thereforein a stronger bargaining position, for example?

11.What other compensation might the licensee have been required to provide,either in the form of other monetary compensation for design fees (e.g.) or

non-monetary compensation?12.What technological assistance from the licensor would have been necessary

to ensure the success of the licensee at the time of the negotiation?

All these factors should be considered. While some have a relationship to theGeorgia-Pacific case, these are more current, more realistic, and more businessbased criteria, which is more reflective of a true arms length negotiation. Thehypothetical negotiation of a royalty rate is only one of several methodologiesthat can be used to establish royalty rates.

G. LOST PROFITS IN TRADEMARK INFRINGEMENT

Lost Profits in Trademark Infringement

The obvious issue in the measurement of defendants profits arises because theconcept of profit is not defined in the Lanham Act, nor is it uniquely defined in practicalaccounting practices. Different industries have various customary definitions anddifferent companies have differing needs for management and planning purposes. Inpractice, the level at which profits are defined tends to be operating profits, beforedeductions for interest on debt, income taxes, and any one-time or extraordinary items.

The initial step to defining profits is clearly identifying the infringing sales. This is not

always straight forward, and a non-speculative analysis of the defendants sales mix isnecessary. In many instances, only a portion of defendants sales may be deemedinfringing revenue.

Direct costs such as materials and direct manufacturing labor are clearly deductible, butif not all sales are infringing, indirect costs such as sales commissions based on overallsales, may not be directly traceable to the infringing revenue. Consequently, thedeductibility of what can be loosely considered overhead costs is at the core of theanalysis differences. One approach is not to allow any deductions for overhead,

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particularly when infringing sales are not a majority of the defendants business andthose expenses would have been incurred even if the infringement did not occur. Inother cases, some or all of the overhead costs are deducted from revenue, under thetheory that some of this category of costs was actually incremental with theinfringement. The problem for the damages expert rests on balancing the requirement

to establish a clear nexus between a category of overhead and the sale of an infringingproduct (or service).

Case Study

Typically, the calculation of Lost Profit damages in trademark infringement cases firstfocuses on determining a suitable measure of the amount of profit actually earned onthe Infringing Sales made by the defendant. In a recent case in the high-end appareland accessories industry, the plaintiff argued that the clearly identified infringing saleshad enabled the defendant to obtain substantial profits, as illustrated by the damagesreport we prepared based on the detailed sales information produced in discovery.

The defendant provided information on standard costs, which allowed for the calculationof an estimate of gross profits. Second, utilizing the total expenses itemized in thedefendants financial statements, a proportion of applicable incremental costs werecalculated based on the ratio of the infringing sales to the total sales of the allegedinfringer.

The approach to calculating profits was based on the examination of the reportedexpenses incurred by the defendant in the normal course of business. We determinedthat the following expense categories were justified incremental costs, and thendeducted only those expenses necessary for the manufacturing and distribution of theinfringing sales. These expense categories are:

1. Cost of Goods Sold (Purchases plus net change in inventory)

2. Freight-in (Raw materials)

3. Freight-in (Finished goods)

4. Duty

5. Direct Labor and Payroll Taxes

6. Direct labor Outside

7. Commissions Wholesale

After deducting the appropriate expenses related to the infringing sales, we calculated

the defendants incremental profits specifically attributable to the infringement of thePlaintiffs trademarks for the period up to the end of the infringing period:

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Category(Amounts in Millions

of Dollars)

Incremental ProfitsGrand Total

(as of 10/31/06)

Infringing Sales $ 100.6

Allocated Direct Costs 30.3

Other AllocatedIncremental Costs 25.0

Infringer's Profits $ 45.3

As the table shows, the total amount of incremental infringers profits accrued as of theapplicable period are approximately $45.3 million.

Our calculation of infringers profits does not include profits associated with anyadditional entities related to the defendant, including affiliated manufacturing,distribution, or retail entities, nor does it include a calculation of pre-judgment interest.The final amount of damages could include these additional sources of profits if otherallegations in the case were proved and relevant additional information becameavailable for review.

H. LOSS OF BUSINESS VALUE

In this section we discuss loss of business value as a measure of damages. Loss ofbusiness value is used relatively less often in trademark cases, but is an importantapproach to damages. In this section we believe the easiest way to illustrate loss ofbusiness value is by looking at an actual case. The case was tried in federal court andthe expert report illustrating loss in business value follows below. Naturally, it has beenredacted to ensure confidentiality.

Case Study

Pursuant to your request, we have completed an analysis of the loss of business valueof Co. X, as of December 31, 2004 (the Valuation Date), as a result of alleged actionsof Co. Y. This analysis was prepared for litigation purposes. No other use for ouranalysis is intended or should be inferred.

In conducting our analysis, we reviewed various documents regarding the operationsand financial performance of Co. X, as well as other documents pertinent to the litigation

proceedings. These documents include, but are not limited to the following:1) Financial statements for Co. X for the years ended December 31, 1994through December 31, 2004;

2) An asset depreciation schedule, including asset description, cost andaccumulated depreciation;

3) An accounts receivable aging as of December 31, 2004 and informationrelated to accounts payable as of the same date;

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4) Information related to the primary suppliers of Co. Xs products;

5) Information related to Co. Xs lease agreement;

6) Schedules detailing sales to certain customers for the years endedDecember 31, 1999 through December 31, 2004;

7) Information related to specific products sold by Co. X, including productdescriptions and related product detail; and

8) Discussions with Co. X management concerning historical operatingresults and the prospects for future results.

Loss of Business Value Analysis

Introduction

The definition of economic loss includes damages for the loss of profits or usecaused by an action. In this case, the calculation of economic loss relates to theloss of profits and the loss of business value resulting from the alleged actions of Co.

Y, plus legal and other expenses related to this litigation. This report addresses onlythe loss of business value subsequent to the Valuation Date. Loss of profits prior tothe Valuation Date and legal and other expenses are not included in ourdetermination of economic loss. A brief discussion of valuation theory andmethodology follows.

Although there are numerous techniques for determining business enterprise values,there are only three conceptually different valuation approaches. The threegenerally accepted approaches used in determining the fair market value of abusiness or business interest are the income, market and cost approaches. Thefollowing is a brief discussion of the three general approaches to value.

In conducting our analysis with respect to Co. X, we relied primarily on the incomeapproach and supplemented this approach with a review of market data. Thesource of the market data we reviewed was the Business Valuation Resources database for SIC Codes 3174 and 5013 and NAICS Codes 336399 and 423120 asreported by Pratts Stats, BizComps and Mergerstat/Shannon Pratts ControlPremium Study. Our income approach models are incorporated herein as Exhibit Iand Exhibit II.

We elected to use a discounted cash flow approach application in our incomeapproach methodology. We developed two distinct models. The first model (Exhibit

I) reflects value given the current status of Co. Xs operations, while the secondmodel (Exhibit II) values Co. X including value related to the sales and profits lost asa result of the alleged actions of the defendant.

The discounted cash flow approach is based on the premise that the value of thebusiness enterprise is equal to the present value of the future economic income tobe derived by the owners of the business. The discounted cash flow approachrequires the following analyses: cost of capital analysis, residual value analysis andoperating forecast analysis.

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The cost of capital analysis requires consideration of the following aspects of Co. Xoperations: current capital structure, optimal capital structure, the cost of variouscapital components, the weighted-average cost of capital, systematic andnonsystematic risk factors, and the marginal cost of capital.

The residual value analysis requires the determination of the value of theprospective cash flow generated by the business after the conclusion of a discreteforecast period. This residual value can be determined by various methodsincluding the development of a price to earnings multiple, a price to book valuemultiple or an annuity in perpetuity approach. In our development of a cash flowmodel for Co. X, we elected to use an annuity in perpetuity approach.

The operating forecast analysis includes revenue analysis, expense analysis andconsideration of all other factors affecting the forecast of cash flow, includingworking capital, investment in fixed assets, depreciation and income taxes. Thisanalysis includes consideration of various industry characteristics such as marketdynamics, competitive pressures and regulatory changes among others.

Based on the results of the analyses discussed above, a forecast of net cash flowfrom business operations is made for a reasonable discrete forecast period. In thisinstance, cash flow is equal to net income, plus non-cash charges such asdepreciation and amortization, minus capital expenditures, plus or minus any changein working capital.

The cash flow forecast is discounted at an appropriate discount rate, also referred toas the cost of capital, to determine the present value as of the Valuation Date. Thepresent value of the discrete net cash flow forecast is summed with the presentvalue of the residual value. This summation represents the value of the business

enterprise, per the discounted cash flow approach.

Assumptions

Current Value

For the first year of the forecast (the year ending December 31, 2005) in our currentvalue model, sales increase at the forecasted annual rate of inflation of 1.9% from abase level of $15,866,504, equal to sales for the year ended December 31, 2004, forthe entire forecast period. The cost of goods sold is equal to 57.1% of sales,reflecting an average for the three years ended December 31, 2004, for the entire

forecast period.Operating expenses for year one are forecast from a base expense level of$5,352,145, equal to reported expenses for the year ended December 31, 2004,excluding depreciation and adjusted for expenses related to the subject litigation.Operating expenses increase at the same rate as sales for the entire forecastperiod.

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Working capital assumptions are historical results. As noted in Exhibit I-4, workingcapital as a percent of sales was assumed to equal 47.7% for the entire forecastperiod. Capital expenditures are based on Co. Xs investment in fixed assets as ofthe Valuation Date and are equal to $258,622 in year one of the forecast. Capitalexpenditures increase at a rate equal to the rate of growth in sales.

The cost of capital is based on an application of the capital asset pricing model, oneapplication of a traditional build-up approach. Specifically, the cost of equity wasdetermined for Co. X as follows:

Ke = Rf [Rm - Rf]

Where:

Ke is the cost of equity;

Rf is the risk-free rate of return, estimated as the yield to maturity on 30-yearTreasury securities, or approximately 4.9% as of the Valuation Date;

[Rm - Rf] is the market risk premium, with Rm representing the expected returnon the market portfolio, estimated to equal 7.2% based on historical datapublished by Ibbotson Associates (we augmented this assumption with theaddition of an 8.7% risk premium); and

, or beta, is an estimate of systematic risk, equal to .72 on an unleveredbasis, based on data published by Ibbotson Associates.

Accordingly, the cost of equity was determined to be 18.8% as follows:

4.9% + (.72 * 7.2%) 8.7% = 18.8%

The discrete forecast period in our model extends for 10 years. The residual valueat the end of the 10-year discrete forecast period was calculated using the formulafor a growing, perpetual annuity. The formula is as follows:

St = __Dt___k - g

Where:

St = the present value of all future income streams, as of

the end of year 10;

Dt = the income stream in the first year after the 10-year

discrete forecast period;

k = the cost of capital; and

g = the growth rate of the income stream.

The growth rate in the first year after the 10-year discrete forecast period is equal to1.9%.

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monetary remedies in trademark cases: materials

Documents