Converting Royalty Payment Structures for Patent Licenses

The parties to a patent-licensing agreement may choose from a variety of royalty structures to determine the royalty payment that the licensee owes the patent holder for using its patents. Three common structures of a royalty payment are (1) an ad valorem royalty rate, (2) a per-unit royalty, and (3) a lump-sum royalty. A royalty payment for a license might use a single royalty structure or a combination of these three structures.

Converting a royalty payment with one structure into an equivalent payment with another structure enables one to compare royalty payments across different licensing agreements. For example, in patent-infringement litigation, an economic expert can estimate damages for the patent in suit by examining royalties of comparable licenses—that is, licenses that cover a similar technology and are executed under circumstances that are sufficiently comparable to those of the hypothetical license in question. However, licenses for a single patented technology might specify the royalty payment using different structures. One license might specify a per-unit royalty, a second might specify a lump-sum royalty, and a third might combine a lump-sum payment with a royalty rate. To analyze and compare the different royalty payments of those licenses, an economic expert or court must convert the royalties to a common structure. For example, a question related to the conversion of the royalty structure arose in August 2016 in Trustees of Boston University v. Everlight Electronics Co., where, in granting an interlocutory appeal, the court asked “whether a district court can correct a damages figure on a motion for remittitur by extrapolating a royalty rate and base from the jury’s lump-sum award without express expert testimony explaining how to do so.”

Some courts have been skeptical that one can convert royalties across different structures. For example, also in August 2016 in Baltimore Aircoil Co. v. SPX Cooling Technologies Inc., Judge Catherine Blake of the U.S. District Court for the District of Maryland excluded, in an order ruling on the patent holder’s Daubert motion, the opinion of the alleged infringer’s economic expert, Kimberly Schenk of Charles River Associates, for using “lump sum agreements in calculating running royalty rates.” Judge Blake faulted Ms. Schenk for providing no justification for using the alleged infringer’s sales projections in converting between the two royalty structures and concluded that her opinion “offer[ed] mere speculation masquerading as quantitative analysis.”

In this article, I explain how economic methodologies can enable an expert or a court to convert royalty payments reliably across different royalty structures. I show that such conversion of royalty payments requires not an accounting framework, but rather an economic framework. Projecting future sales, product prices, and market conditions are vital not only to producing accurate estimates of expected royalty payments, but also to converting those royalty payments across licenses that might specify different royalty payment schedules. Although those projection methods require additional judgment beyond a simple and straightforward calculation, converting royalty payments across different structures is a standard exercise that involves processes similar to those used to value patents outside adversarial proceedings. The conversion of royalty payments across different structures need not be unreliable or inherently speculative.

In Part I, I describe three common structures of royalty payments for patents and analyze their main differences. In Part II, I explain how one can deconstruct a royalty payment into an equivalent payment with a different royalty structure in both simple and complex one-way licenses. In Part III, I show how to extend this framework to include the value of a cross license flowing back to the net licensor. I show that such methods enable courts to convert and reliably compare the royalty payments of different structures.

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