Technology companies are a prime target of nonpracticing entities (NPEs), also known as patent trolls. Because NPEs have no products or services in the marketplace, they do not qualify for lost profits under the patent statute and often cannot obtain injunctions against infringement. The statute does provide NPEs with one remedy—the “reasonable royalty.” 

The “reasonable royalty” acts as a floor for damages. Typically, based on expert testimony from both sides, the jury determines a royalty and then applies this rate to the royalty base (i.e., the number of infringing units). Many tech companies have been hit hard by jury awards in the past decade and have called into question the “reasonableness” of experts’ damages theories, permitted by the courts and awarded by juries.

Some of the problem arises out of the analysis established by the now venerable Georgia-Pacific Corp. v. United States Plywood Corp. decision. Georgia-Pacific sets forth a 15-factor balancing test for determining the royalty that would result from the “hypothetical negotiation.” The hypothetical negotiation is a legal construct where a willing licensor and a willing licensee arrive at licensing terms prior to the commencement of infringement.

Some of the problems arise from the calculation of the royalty base. Although you might think that calculating the base should be simple, in many cases, it is not clear. For example, what is the proper royalty base for a patent that covers the graphics chip in a laptop? Is it the laptop itself, the graphics card, the chip or something else? 

Necessarily, damages are hypothetical in this regard, but they are not permitted to be speculative. Slowly but surely, over the past four years, the Federal Circuit has been tightening up on reasonable royalty-based damages. 

First, the Federal Circuit clamped down on the kind of data points that experts could use in the reasonable royalty calculation in Lucent Technologies Inc. v. Gateway Inc.and Inc. v. Lansa Inc. The first three factors of Georgia-Pacific are sometimes referred to as the “comparable licenses” factors: the royalties received for licensing the patent or tending to prove an established royalty; the rates paid by the licensee for use of other similar patents; and the nature and scope of the license, such as whether it is exclusive or nonexclusive, restricted or nonrestricted in terms of territory or customers.

Where a patent has a long history of being licensed and many licenses in the market, these factors are easily analyzed. Where a patent has few (or sometimes no) licenses, the analysis becomes more difficult. Lucent and address how divergent data points can be from the “hypothetical negotiation” before the expert crosses the line into speculation. 

Often when data points are sparse, the expert relies on so-called “rules of thumb.” The Federal Circuit has also curtailed this practice. In Uniloc USA Inc. v. Microsoft Corp., the Federal Circuit has declared the previously popular 25 percent rule, where an expert would posit that the licensor would share in about 25 percent of the profits of a licensed product, as per se unreliable.    

Most recently, in the Laser Dynamics decision, the Federal Circuit has curtailed the ability of experts to inflate the royalty base. Often, experts relied upon something called the “entire market value” exception to inflate the royalty base. Returning to our chip/graphics card/laptop hypothetical, experts would commonly argue that the royalty base of the patent should be the entire market value – in this instance the laptop itself. According to this argument, the chip is essentially useless unless operating inside the laptop. 

The Federal Circuit in LaserDynamics Inc. v. Quanta Computer Inc. essentially ruled that using the “entire market value” exception in this way allows the exception to swallow the rule. In the court’s view, absent compelling evidence to the contrary, the proper royalty base should be the “smallest salable unit” that practices the invention. Depending on the evidence, that could be the graphics card or the chip that controls the graphics card, but would not be the laptop itself.

The bottom line is that the Federal Circuit has started and continues to demand a new level of rigorous analysis from damages experts in patent cases. Tech companies that are frequent lawsuit targets should take note and prepare their motions to exclude evidence.