Calculating Damages for Lost Profit: Part III
This week we are continuing our semi-monthly blog series with a blog about forensic accounting and calculation of commercial damages. This blog is focused on lost profits and is the third of a three-part series discussing lost profits. The first blog of the series discussed calculating lost profit damages based on product profitability and can be found here. The second blog of the series discusses calculating lost profits based on the diminution in business value and can be found here. This week's article will discuss calculating lost profits based on reasonable royalty.
Lost Profits Calculated Using a Reasonable Royalty Approach
The damages suffered by a plaintiff in a lost profits claim will be the dollar amount, adjusted for the time value of money, required to return the plaintiff to the financial position it would have enjoyed "but for" the alleged bad acts of the defendant.
Proving lost profits in a patent, trade secret, or other intellectual property dispute, generally requires the plaintiff to overcome certain hurdles. In patent cases these hurdles are referred to as the Panduit tests. They 1) prove that there is demand for the patented product, 2) prove the absence of acceptable non-infringing products, 3) prove that the business has the marketing and manufacturing capacity to meet demand, and 4) prove the amount of profit the business would have made but for the defendant's bad acts. Oftentimes a business that has been harmed may not be able to overcome the Panduit tests for a variety of reasons, including:
- The business is a start-up and has little or no manufacturing capacity
- The business is in a market that is different than the market served by the infringer
- The business cannot earn a profit and/or does not have a history of earning a profit
The Reasonable Royalty approach provides a possible solution to quantifying damages in situations such as those described above. Reasonable Royalty approach focuses on what the market would pay for the rights to the technology in dispute.
Reasonable Royalty payments generally follow one, or a combination, of the following three approaches:
- One-time payment
- Percent of the revenue earned by the product under license
- Dollar amount applied to units of the product sold
Since the Reasonable Royalty approach, based on the Georgia Pacific factors, focuses on what the market would pay for the rights to the technology, this approach may not necessarily reflect the impact of market price erosion. This is because the very nature of the hypothetical negotiation assumes that there will be another competitor in the market, the hypothetical buyer. Additionally, the hypothetical negotiation may not be able to reflect the actual profit performance of the plaintiff if the hypothetical buyer has a profit performance history that is significantly below the profitability of the hypothetical seller, since the "hypothetical buyer" will not likely agree to a royalty rate that exceeds its own profit rate. Because of these potential outcomes, the Reasonable Royalty amount has in some cases been adjusted for discretionary adjustments intended to compensate the patent holder for perceived under compensation. It is very difficult to predict if a court will allow the reasonable royalty to be modified to correct for alleged compensation shortcomings, so reliance on this outcome may be risky.
Care should be taken when using a percent royalty approach on bundled products because some methods for determining revenue under GAAP (Generally Accepted Accounting Principles) may not actually measure usage and are therefore problematic if used in a royalty calculation. Depending on the facts of the case and the data available, the results of a Reasonable Royalty calculation may or may not be easily benchmarked.
Some plaintiffs in a patent infringement case may try to invoke a theory often referred to as the entire market value rule ("EMVR"). The EMVR theory asserts that the defendant's damages may be based on the value of an entire product containing several features, if the patented feature in dispute is the basis for customer demand. This theory ignores the contribution of other attributes (e.g., other product features or unique attributes of the defendant's business) that may have also contributed to the product's profit. Consequently, since 2009, there have been a series of court cases that have chipped away at the EMVR. Today the damages expert should determine if the patented feature creates the basis for customer demand or substantially contributes the value of the component parts before asserting the EMVR approach.
Other considerations important to determining Reasonable Royalty are 1) the cost to build around the technology in dispute, and 2) apportionment of the royalty base to the smallest possible saleable unit. The apportionment issue is particularly critical when considering bundled products in which only one of the bundled products contains the intellectual property in dispute.
The preceding discussion has focused on patent infringement disputes. Under certain circumstances, the damages expert can apply the preceding concepts to a lost profit claims for misappropriation of trade secrets and other intellectual property disputes.
The damage expert can use one of several different approaches to determining lost profit damages. In all of these approaches, the damage expert's role is to quantify the lost profits necessary to return to the plaintiff to the position it would have enjoyed but for the defendant's bad acts. One approach to determining lost profits, is to assert a Reasonable Royalty claim. This approach is most often used in patent disputes but elements of this approach have also used in trade secret and other intellectual property disputes. In many situations, the Reasonable Royalty approach is considered the damages "floor" because it may not encompass the impact of market price erosion or a plaintiff's actual profit performance. Courts may allow modification to the Reasonable Royalty amount to compensate the patent holder for perceived under compensation, but the results of reliance on these modifications is hard to predict.
Resolution Experts PC, "ResX, PC", provides independent forensic accounting services for complex litigation and contract compliance and fraud. ResX is based in Michigan and serves clients throughout the United States. For more information and to learn about working with ResX, please visit our website: www.resxpc.com.
The preceding narrative presents concepts that are dependent on facts and circumstances. These concepts can change depending on the specific facts and circumstances of an individual matter.