The classic 25% Rule is one of several methods of intellectual property valuation for the purpose of calculating a royalty in a patent licensing agreement. The classic 25% Rule is comprised of 4 different components that are calibrated upwards or downwards to ensure an equal division amongst the parties.
Basic Approaches to Technology Valuation
According to A New Method to Value Intellectual Property by Ted Hagelin, there are several approaches to the valuation of royalties in technology licensing agreements, specifically, 1) the cost approach, 2) the market approach, and 3) the income approach.
The cost approach measures the value of the intellectual property asset by examining the cost to replace the asset with an identical or equivalent asset. The market approach, on the other hand, values the asset based upon comparable transactions between unrelated parties. The income approach values assets based upon the present value of the net economic benefit expected to be to be received over the life of the asset. The 25% Rule is an income-based approach widely discussed and used for the purpose of apportioning a technology’s value between the licensor and licensee to achieve a fair royalty rate as between the parties.
The Classic 25% Rule
The classic 25% Rule is based on 4 individual components: 1) the 25% Rule of Thumb, 2) the Georgia-Pacific Factor 13, 3) the next best alternative axiom, and 4) Fromson’s Book of Wisdom.”
The 25% Rule of Thumb
The 25% Rule of Thumb is an empirically suggested baseline that allocates a 25:75 ratio between the licensor and licensee, respectively in accordance with the allocation of risk.
The parties estimate the licensee’s expected profits for the intellectual property asset at issue for a given period of time. Then, the profits are divided by the expected net sales over the same period of time to achieve a profit rate. Then, the profit rate is multiplied by 25% to arrive at a running royalty rate. The Licensor’s royalty payment is calculated by apply the running royalty rate to the net sales.
Georgia Pacific Factor 13
The 25% Rule focuses on the language of Georgia-Pacific Factor 13, which instructs the trial court to consider “The portion of the realizable profit that should be credited to the invention as distinguished from non-patented elements, the manufacturing process, business risks, or significant features or improvements added by the infringer” to calibrate the baseline 25% Rule of Thumb.
Consequently, if a licensor possesses strong intellectual property assets, the licensor may be entitled to the 25% or more of the profit share. Correspondingly, a weaker set of assets would support a lower percentage of the profit share to dovetail the weaker strength of the bargaining party.
The Next Best Alternative Axiom
Thirdly, the 25% Rule examines the next available alternative to provide the licensee with a “good indication of the strength and practical value of the intellectual property to be licensed.”
These alternatives are, specifically, 1) use of the technology at the risk of a lawsuit; 2) independent development of the same or similar technology; 3) design of the licensee’s operation around licensor’s property rights; 4) licensing of comparable property rights from another source; or 5) avoidance of any use of technology within the purview of the licensor’s property rights.
Accordingly, if a licensee finds several viable alternatives at a relatively low cost, the value of the asset is consequently diminished, and the licensee may consider offering a lower royalty. On the other hand, if there are little to no viable alternatives, the licensee should be willing to pay a higher royalty to correspond to the relative strength of the asset in a given field.
Book of Wisdom
Finally, the 25% Rule is re-calibrated under the scrutiny of Judge Howard’s “Book of Wisdom.” The Book of Wisdom consists of a set of practical and logical questions that focus on the consequences of infringement in determining the valuation of the royalty rate between a licensor and licensee by evaluating the following:
- Is the quality of the invention, as patented, such that it is technically very difficult or economically very expensive for a third party to design around, or otherwise avoid?
- Are purchasers of the product or users of the process of which the patented invention forms a part, aware of the presence of the impact of the invention, and is this awareness crucial to the decision to purchase or use?
- Is the impact of the invention such that it influences the sale of other components, assembled products and subassemblies, directly related to the invention, as well as other products such as the concepts of ‘the entire market value rule’ or ‘collateral’ or ‘convoyed sale’ should be taken into account?
The Book of Wisdom relays the importance of foresight that evaluates the cost of potential litigation as a determinant in risk allocation between the parties. The Book of Wisdom ultimately considers any potential real events of serious consideration that may unfold at the time of infringement. As seen above, the 25% rule would be re-calibrated to account for these risks.
Proponents of the 25% Rule suggest:
- It is an industry norm
- 75% of the work needed to develop and commercialize a product must be done by the licensee
- The licensee, who markets the product, makes the rules
- A 3:1 ratio is a common payback ratio
- Technology is only the first of four required steps of commercializing a product
- The ratio of research and development to profits is often within the range of 25-33%.
Detractors of the 25% Rule of Thumb suggests the 25% rule:
- Fails to account for the unique relationship between the patent and the accused product
- Fails to account for the unique relationship between the parties
- The rule is essentially arbitrary and does not fit within the model of the hypothetical negotiation with which it is based.
The classic 25% Rule provides a historic template for licensing valuation of intellectual property assets. Its strength lies in its ability to produce business-like results, its flexibility, and its place as an industry standard. On the other hand, according to the Federal Circuit, the use of the 25%
Rule of Thumb, alone, is fatally flawed and barred from use in court as a method of calculating a reasonable royalty.
Though the 25% Rule is not the only method of asset valuation, the 25% Rule provides an industry-backed method of valuation when used as an initial method in the valuation of a particular intellectual property asset.