Determining Reasonable Royalties With Analytical Approach
Article, Law360 – March 2017
Legal / Valuation
In recent years, courts have viewed the determination of patent infringement reasonable royalty damages with increased scrutiny. Mark Pedigo looks at the analytical approach to determining royalty damages in Law360.
As appeared in Law360, March 3, 2017.
By: Mark Pedigo
In recent years, courts have viewed the determination of patent infringement reasonable royalty damages with increased scrutiny. Infringing products are also more complex with multiple features and often only a portion of which are covered by the patent-in-suit. Therefore, it is often necessary to identify new tools to assist in the determination of reasonable royalties or perhaps use an older tool in a new way. The analytical approach, which has been used in one form or another for over 40 years, may be a helpful tool in the complex analysis often required to determine a reasonable royalty.1 This article will first summarize the history of the analytical approach and then discuss its usefulness and limitations.
History of the Analytical Approach
The first known use of the analytical approach, which may be considered in the context of a hypothetical negotiation or independently, was in a Second Circuit case in 1971.2 In this case, the appellate court, based on an assumption that a reasonable royalty should leave the infringer a reasonable profit, calculated the royalty based on Georgia-Pacific’s expected product on the infringing product less its average net profit of 9 percent. The term "analytical approach" was not used by the court, but a common analytical approach formula (expected profit — normal profit) was used by the court.
The hypothetical negotiation approach, also referred to as the willing buyer/willing seller approach, typically considers up to 15 factors, one of which is concerned with the portion of the profit that should be credited to the invention as opposed to non-patented elements and another is concerned with the amount of royalty that an infringer would be willing to pay and yet be able to make a reasonable profit. The Georgia-Pacific appellate court cited the requirement to leave the infringer a reasonable profit in its modification of the district court’s reasonable royalty award.
The analytical approach was used again by Federal Circuit in 1977 as a starting point in the context of a hypothetical negotiation.3 The court used the infringer’s actual profit on the infringing products as a proxy for expected profit since expected profit was not available. The infringer’s historical profit percentage was used as the infringer’s normal profit. The court used the residual profit of 7.65 percent as a starting point and after considering Tektronix’s profitability and risks that were taken by Tektronix and the infringer, adjusted the royalty rate to 10 percent.
The first known use of the term “analytical approach” occurred in a 1985 district court case.4 The court stated that "the analytical approach cited in Georgia-Pacific … and Tektronix … is appropriate to the case at bar." Thus, while the Georgia-Pacific and Tektronix cases did not use the term "analytical approach" the term was used by the TWM court for the methodology used in these two prior cases. In this case, the special master calculated a reasonable royalty as the difference between (1) the infringer’s anticipated net profit from sales of the infringing product, from a pre-infringement profit projection, and (2) the usual or acceptable net profit of the infringer, which was based on average industry profitability.
Since the TWM case, the analytical approach has been used and accepted by the courts on many occasions. In cases where the courts did not allow the analytical approach, the problem was not so much with the approach but with the underlying case facts. Therefore, as one might expect, the analytical approach may not be appropriate for every case. Like any other approach or methodology, its appropriateness and usefulness depends on the specific facts of the case at hand. In the cases where the analytical approach has been used, expected profit was used at times and actual profit was used at times (typically when expected profit or pre-infringement profit was not available). Normal profit has been based on profitability from the infringer’s industry or other products (other nonaccused products or noninfringing alternatives to the infringing product). An infringer’s target (not specific to the infringing product) profit has also been used as a proxy for its normal profit.
Usefulness and Limitations of the Analytical Approach
The analytical approach can be very useful in that it helps isolate the value of the benefit (i.e., profitability) provided by the infringed features by comparing the infringing product profitability to noninfringing alternatives5 (or other measures of normal profit). Isolating this value is important because the focus of a reasonable royalty determination is primarily on the value of the invention in the marketplace and a reasonable royalty is how much should have been paid for additional value.
The analytical approach’s usefulness, depending on the case, can also have limitations. The simplest application of analytical approach may not be sufficient if the accused product has multiple features, some of which are accused and some are not. It may be necessary to further apportion either the royalty base or the royalty rate to account for other features that are not accused of infringement. The analytical approach is a viable model for deriving a royalty rate, but it may need to be used in conjunction with other analyses to isolate the value of the patented feature(s).
A key issue when using the analytical approach is the normal profit that the infringer is allowed to keep. As noted above, it can be based on average industry profits, a company’s target profit, or other non-infringing products. Care needs to be taken when choosing this normal profit.
An additional issue is the use of actual profitability or expected profitability as of the time of the hypothetical negotiation. Actual profitability may be useful but only as an indirect source of evidence if information regarding expected profitability is not known. While there are a number of cases where actual profitability has been used, in most cases it was because no information regarding expected profitability was available. In a hypothetical negotiation, the core economic question is what the infringer would have anticipated the profit-making potential of use of the patented technology to be compared to using non-infringing alternatives.6 Thus, the focus should be on expected profits whenever possible as opposed to actual profits. Actual profits are useful, however, as a proxy when expected profit information is unavailable.
The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.
 Because of the brevity of this article, several statutes and/or cases that provide the legal framework for reasonable royalty damages are omitted. In writing this article it is necessarily assumed that the reader is familiar with the underlying concepts associated with patent infringement reasonable royalty damages. In addition, the analysis of patent infringement damages is complex and this article does not address every factor or consideration that may need to be taken into account when analyzing patent infringement reasonable royalty damages.
 Georgia-Pacific Corp. v. United States Plywood-Champion Papers, Inc., 446 F.2d 295, 299 (2nd Cir. 1971).
 Tektronix, Inc. v. United States, 193 U.S.P.Q. 385, 552 F.2d 343, 349 (Fed. Cir. 1977).
 TWM Manufacturing Co. v. Dura Corp., 231 USPQ 525, 527 (E.D. Mich. 1985). Also see TWM Manufacturing Co. v. Dura Corp., 789 F.2d 895, 899 (Fed. Cir. 1986).
 Apple Inc. v. Motorola, Inc., 757 F.3d 1286, 1315 (Fed. Cir. 2014).
 Aqua Shield v. Inter Pool Cover Team, 774 F.3d 766, 770 (Fed. Cir. 2014).