September 2003 Philip Green HOFFMAN ALVARY

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1 The 25% Rule of Thumb Analytical Tool or Valuation Folklore? Presentation to Licensing Executives Society Annual Meeting September 2003 Philip Green

2 The Sky Is Falling!! C. Little

3 A starting point for a royalty should equal 25% of the licensee s profits. Robert Goldscheider

4 Mr. Goldscheider and others have written articles purportedly supporting the rule The courts are cited as having affirmed royalties based on the 25% rule In actual practice 25% of licensee profits has become the rate licensors often demand

5 However, the 25% Rule of Thumb: Lacks empirical support Is not consistent t with actual negotiated t rates or industry practices

6 Background of the 25% Rule of Thumb Originated by Mr. Robert Goldscheider As a starting ti point, a royalty should amount to 25% of licensee operating profits Rate adjusted for qualitative factors

7 Background of the 25% Rule of Thumb Based on licensing circumstance in the 1950 s involving: Entire product Multiple patents Copyrighted materials Trademarks Technical assistance Established mature product and track record 25% of = Licensee Profits

8 Background of the 25% Rule of Thumb He does not discuss any other actual licensing transaction that applied the rule

9 Like Mr. Little s Followers, Others Have Provided Rationales to Support the Rule It is the industry norm 75% of the work needed d to make a product is done by the licensee A three times payback ratio is common Technology is the first of four steps

10 Fonar v. GE (1997) Applying the 25% rule of thumb, the plaintiff s expert testified to a royalty of 7.25% of sales or $54 million Coincidentally, the defendant had actually licensed MRI technology for 7% Actual award was $34.1 million, suggesting a lower royalty rate was applied

11 Standard Manufacturing v. US (1999) Mr. Goldscheider proposed royalty rate of 5% based on 20% of licensee profits and Georgia-Pacific analysis Actual royalty award was 16.31%. This rate amounted to approximately 80% of the licensee s operating profits

12 Ajinomoto Co. v. Archer Daniels-Midland Co. (1999) Although the licensing rule of thumb dictates that only one-quarter to one-third of the benefit should go to the owner of the technology. the court concludes that ADM would have been willing to share all of the benefit with Ajinomoto and that Ajinomoto would have settled for nothing less.

13 Relies on Royalty Source data Compares average operating profits with royalty rates

14 Source: Goldscheider et al. Use of the 25% Rule in Valuing IP, Les Nouvelles, December 2002

15 Source: Goldscheider et al. Use of the 25% Rule in Valuing IP, Les Nouvelles, December 2002

16 Source: Goldscheider et al. Use of the 25% Rule in Valuing IP, Les Nouvelles, December 2002

17 Operating Profits and Median Royalty Rates Are Not Correlated 8% ates Royalty Ra Average R 7% 6% 5% 4% 3% 2% 1% 0% y = x R 2 = % 10% 20% 30% 40% Average Operating Profits

18 25% Rule of Thumb Does Not Apply to Most Licensing or Damage Analyses The original licensing circumstance was unique Patents, copyrights, trademarks, processes related to an entire product were obtained by licensees Licensees were not in the U.S. The product licensed was well established The licensor was a large consumer products company No allocation of the 25% paid by licensees was made among the intellectual t l properties licensed

19 There Is Confusion Regarding the Application of the Rule The measure of profits to be used Early articles suggest 25% of gross profits Recent articles use operating profits The royalty base is not defined d

20 The 25% Rule Doesn t Apply to Most Licensing Circumstances The rule is not applicable where the IP at issue is not a significant component of the product No guidelines for adjusting the 25% rule to consider just one type of intellectual property p

21 Industry Practices Don t Support the 25% Rule Stacking in the biotechnology industry Electronics industry 3.5% on DVD players Proposed 5% limit on royalties for G3 enabled wireless telephone equipment IBM s 1% patent t licensing i policy

22 Actual Transactions Don t Support the 25% Rule 60% Licensee s Reported Operating Profits Actual Royalty Rate 50% 40% 30% 20% 10% Coated Stent Epogen Baby Formula WAP Tech. RAID Tech. 0% JNJ - Amgen - Clover - Geoworks - Qlogic - Borg Surmodics Stanford Martek Toshiba Adaptive

23 What to do Without the 25% Rule of Thumb Examine the economic benefits of using a technology Cost savings/expected profits Alternatives Thoroughly research for comparable transactions Measure returns from the use of the intellectual property

24 Conclusion The Sky is Not Falling! The 25% rule is without empirical support and is often misapplied Recent attempts to provide evidence of the rule prove its lack of support Actual negotiated royalty rates rarely amount to 25% of a licensee s operating profits More reasonable financial measures are available

25 The 25% Rule of Thumb Analytical Tool or Valuation Folklore? September 2003 Philip Green

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