An Innovator’s Guide to Standard Essential Patents – Part III: How to value standard-essential patents
This article is the third of a three-part series titled “An Innovator’s Guide to Standard Essential Patents” in which I elaborate on how Standard Essential Patents are created. In the first part of this series, I described a standard-essential patent (SEP) as a patent that claims an invention that must be used to comply with a technical standard, for example the 5G standard. In the second part, I explained that innovative companies join standard-setting organizations (SSOs) to influence development of a standard and to streamline their SEP declarations. In this third part, I discuss techniques for valuating SEPs and how these techniques have been used to determine the value of SEP portfolios.
- An Innovator’s Guide to Standard Essential Patents – Part I: What is a standard-essential patent?
- An Innovator’s Guide to Standard Essential Patents – Part II: How are standard-essential patents created?
- An Innovator’s Guide to Standard Essential Patents – Part III: How to value standard-essential patents (This article)
An Innovator’s Guide to Standard Essential Patents – Part III: How to value standard-essential patents
The vast majority of SEPs are created by companies that are members of an SSO. Member companies are obligated to offer fair, reasonable, and nondiscriminatory licenses (FRAND licenses) for SEPs they hold to anyone wanting to implement the relevant standard (i.e., “implementors”). Thus, to determine what a portfolio of SEPs might be worth, we must first understand what really constitutes a FRAND license, and more specifically, what constitutes FRAND terms and conditions. “Fair” refers to terms that are not anti-competitive. In other words, terms that would not be considered unlawful if imposed by a dominant market player. “Reasonable” means that the total royalty stack, paid by an implementor to implement a product or service that embodies the standard, must not be burdensome. For example, a total royalty stack that exceeds 20% may be considered burdensome in many industries. Finally, “nondiscriminatory” indicates that the SEP holder need not offer the same royalty rate to all potential licensees. However, different rates should be justified, and differences in sales volumes alone cannot justify discriminating against smaller licensees.
Almost all FRAND licenses grant an implementor the right to use a SEP portfolio in exchange for payment of a royalty (as opposed to payment of a lump-sum fee). While practically every FRAND license is unique, there are norms and best practices that have developed over time. And while there is no such thing as a FRAND royalty rate, the royalty stipulated by a FRAND license is almost always based upon the same factors, including the specific portfolio, the parties involved, expected or historical sales volume of the implementor, cross-licensing opportunities between the SEP holder and the implementor, and so on.
A fair royalty rate can be determined using a top-down method or a bottom-up method (also known as a “comparable licenses” method). Courts of law often choose one of those methods as a primary method and the other as a secondary check.
There are two main steps in the top-down method for determining a fair royalty rate.
- Step 1: Determine a total aggregate royalty for the relevant standard that a licensee would reasonably expect to pay to implement the standard.
- It is acceptable to use the SEP holder’s own public statements for guidance, for example, if the SEP holder published marketing or informational materials that indicated a total royalty stack.
- The total aggregate royalty should be apportioned by the value attributable to the implemented standard. For example, the royalty stack for a 5G cellular connection in a vehicle may be 8%, but that does not mean that the aggregate royalty should be 8% of the entire wholesale price of the vehicle.
- Step 2: Calculate the share of value attributable to the SEP holder’s portfolio.
- Several factors are usually considered, including the number of SEPs in the portfolio, the age of the SEPs, the number of forward citations per SEP, and the geographical reach of each SEP.
- A simple numerical ratio is often used to determine the SEP holder’s share:
𝑵𝒖𝒎𝒃𝒆𝒓 𝒐𝒇 𝑺𝑬𝑷 𝒉𝒐𝒍𝒅𝒆𝒓′𝒔 𝑺𝑬𝑷𝒔 𝑐𝑜𝑣𝑒𝑟𝑖𝑛𝑔 𝑡ℎ𝑒 𝑠𝑡𝑎𝑛𝑑𝑎𝑟𝑑
𝑻𝒐𝒕𝒂𝒍 𝒏𝒖𝒎𝒃𝒆𝒓 𝑺𝑬𝑷𝒔 𝑐𝑜𝑣𝑒𝑟𝑖𝑛𝑔 𝑡ℎ𝑒 𝑠𝑡𝑎𝑛𝑑𝑎𝑟𝑑.
An example of the top-down method using the simple numerical average can be seen in the TCL v. Ericsson case that involved the 4G standard (TCL Comm’n v. Ericsson, C.A. No. 14-CV-341 (C.D. Cal. December 21, 2017)). In the first step, the court used Ericsson’s prior public statements, that a “6-10% aggregate royalty rate for 4G is appropriate,” to determine a total aggregate royalty (varied by geographic region). In the second step, Ericsson, the SEP holder, argued there were 1,796 SEPs covering the standard and that it held 112 of them. Thus, Ericsson claimed its share should be 112/1,796 = 7.5% multiplied by an appropriate aggregate royalty rate of 6-10%. In contrast, TCL, the implementor, argued that there were 1,673 SEPs covering the standard and that Ericsson held only 70 of them. Thus, TCL claimed Ericsson’s share should be 70/1,673 = 4.7% multiplied by an appropriate aggregate royalty rate of 6-10%. After weighing several additional factors, the court found that Ericsson’s share was 5%, and therefore computed the royalty rate as 5% multiplied by the appropriate aggregate royalty rate of 6-10% for a given geographic region.
One benefit of the top-down method is that it avoids the royalty stacking problem because the total aggregate royalty is explicitly determined. However, that aggregate royalty is just an educated guess. One drawback of the top-down method is that the parties often disagree on which SEPs are truly essential. Moreover, determining essentiality of all SEPs involved can be costly, on the order of $10,000 per SEP. As a reference, during litigation concerning the MPEG standard it was found that determining essentiality for 700 SEPs cost $5.25 million.
Bottom-up (comparable licenses):
The bottom-up method is applicable when there is at least one other license that can be used as a comparison, or reference. A fair royalty rate for an unlicensed implementor should resemble the royalty rate for the licensed implementor named as a party to the comparable license. For this method to be valid, the compared licenses should be technologically and economically comparable. Technologically comparable means that both licenses concern the same or a similar technology—which can usually be demonstrated easily for SEPS concerning a standard. Economically comparable requires an accounting of certain factors, including:
- Do the current parties have similar bargaining powers as the parties to the comparable license?
- Was the comparable license the result of an arm’s length negotiation or by litigation or settlement?
- What were the terms and conditions of the comparable license?
An example of the bottom-up method can be seen in the Unwired Planet v. Huawei case that involved SEPs of the 2G, 3G, and 4G standards (Unwired Planet v Huawei and Conversant v Huawei and ZTE,  UKSC 37). Unwired Planet sued Huawei and Conversant for infringing some of its SEPs that were granted in the United Kingdom. While Conversant agreed to take a worldwide license to Unwired Planet’s SEPs, Huawei wanted to take a UK-only license. The court held that that a FRAND license between large multinational companies should be global, and therefore, Huawei must take a global license from Unwired Planet comparable to the license that Conversant agreed to take from Unwired Planet.
One benefit of the bottom-up method is that existing licenses are the best evidence of market value of a SEP portfolio. Another benefit is that the bottom-up method is typically much less expensive than the top-down method. However, there are several drawbacks to the bottom-up method. First, the current parties must be situated similarly as the parties to the comparable license, for example in terms of relative market size, bargaining power, and scale/scope of operations. Further, the terms and conditions of the comparable license must be similar to those desired by the current parties, including any fixed-fee arrangements, lump-sum payments, payments in kind, non-monetary synergies, cross-licensing reductions, and so on.
The table below shows actual valuations for SEPs and SEP portfolios determined by the top-down and bottom-up methods described above. In both cases, the fair royalty rates (fourth column) were determined to be between approximately 0.02-0.5% of the average selling price (ASP) of the mobile handset device, which is significantly less than what the SEP holders advertised as their fair royalty rates. It is interesting to note that the average royalty (last column) is only between approximately 0.9-8.1¢ per SEP (depending on ASP). While several cents may seem like a tiny royalty per SEP, those pennies add up to multiple millions of dollars when all products that implement the standard are considered.
In summary, valuating standard-essential patents is a difficult problem that might be solved in several ways. The top-down method attempts to determine a total aggregate royalty for a given product that embodies a standard and then to determine a SEP holder’s share of that aggregate royalty. While this may appeal to the analytically-minded, the method is fraught with hidden complexity and expenses. On the other hand, the bottom-up method attempts to identify an existing license between parties that are similarly situated as the current parties and whose licensed technology is similar to the current technology, and then to use the terms and conditions of the existing license as a reference. While this may appeal to the business-minded, the method rarely works for advanced technologies that lack anything to compare against. The best approach to determine the value of a SEP portfolio has been to use both the top-down and bottom-up methods—focusing on the strengths of one to overcome the weaknesses of the other.
This article is for informational purposes, is not intended to constitute legal advice, and may be considered advertising under applicable state laws. The opinions expressed in this article are those of the author only and are not necessarily shared by Dilworth IP, its other attorneys, agents, or staff, or its clients.