INTELLECTUAL PROPERTY

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1 INTELLECTUAL PROPERTY VALUATION, EXPLOITATION, AND INFRINGEMENT DAMAGES GORDON V. SMITH RUSSELL L. PARR JOHN WILEY & SONS, INC.

3 INTELLECTUAL PROPERTY

5 INTELLECTUAL PROPERTY VALUATION, EXPLOITATION, AND INFRINGEMENT DAMAGES GORDON V. SMITH RUSSELL L. PARR JOHN WILEY & SONS, INC.

6 This book is printed on acid-free paper. Copyright 2005 by John Wiley & Sons, Inc. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, , fax , or on the web at Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, , fax , and online at Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. For general information on our other products and services, or technical support, please contact our Customer Care Department within the United States at , outside the United States at or fax Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. For more information about Wiley products, visit our web site at Library of Congress Cataloging-in-Publication Data: ISBN X ISBN X Printed in the United States of America

7 Russell Parr would like to thank his mother Dorothy Parr. She gave me the most valuable intangibles in the world, and I have subsequently attained great professional and personal success because of her. Thank you, Mom. For Nancy Bunker Smith, my wife and partner of nearly five decades, and for the wonderful family we enjoy so much, Craig and Susan, Tracy and Lee, Sam, Carlye, Molly, and Jamie.

8 Update Service BECOME A SUBSCRIBER! Did you purchase this product from a bookstore? If you did, it s important for you to become a subscriber. John Wiley & Sons, Inc. may publish, on a periodic basis, supplements and new editions to reflect the latest changes in the subject matter that you need to know in order to stay competitive in this ever-changing industry. By contacting the Wiley office nearest you, you ll receive any current update at no additional charge. In addition, you ll receive future updates and revised or related volumes on a 30-day examination review. If you purchased this product directly from John Wiley & Sons, Inc., we have already recorded your subscription for this update service. To become a subscriber, please call or send your name, company name (if applicable), address, and the title of the product to: mailing address: Supplement Department John Wiley & Sons, Inc. One Wiley Drive Somerset, NJ subscriber@wiley.com fax: online: For customers outside the United States, please contact the Wiley office nearest you: Professional & Reference Division John Wiley & Sons Canada, Ltd. 22 Worcester Road Etobicoke, Ontario M9W 1L1 CANADA Phone: Phone: Fax: canada@wiley.com John Wiley & Sons, Ltd. The Atrium Southern Gate, Chichester West Sussex PO 19 8SQ ENGLAND Phone: Fax: customer@wiley.co.uk John Wiley & Sons Australia, Ltd. 33 Park Road P.O. Box 1226 Milton, Queensland 4064 AUSTRALIA Phone: Fax: brisbane@johnwiley.com.au John Wiley & Sons (Asia) Pte., Ltd. 2 Clementi Loop #02-01 SINGAPORE Phone: Fax: /5/6 Customer Service: enquiry@wiley.com.sg

9 ABOUT THE AUTHORS Gordon V. Smith is chairman of AUS, Inc. and president of AUS Consultants. He has advised clients in valuation matters for over 40 years. His assignments have included appraisals of nearly every type of tangible and intangible property as well as consultations relative to royalty rates, economic life, and litigation damages for intellectual property. Clients have been many of the Fortune 500 and major international law firms, as well as research and educational institutions, regulatory bodies, and the U.S. government. Mr. Smith, a graduate of Harvard University, has lectured on valuation subjects throughout the Americas, in Europe, and extensively in Asia. He has taught university-level courses at Singapore Management University and conducted seminars for the IP Academy (Singapore), the Chinese government, the U.S. Treasury Department, numerous private organizations and corporations, and has lectured in various countries for the World Intellectual Property Organization. He is a member of the Advisory Committee on Intellectual Property and Board of Trustees of Pierce Law, whose intellectual property curriculum is nationally recognized. He is also an adjunct professor there and a regular guest lecturer. An active member of the International Trademark Association, Mr. Smith is also a member of the Licensing Executives Society. His writings include many professional papers and articles that have appeared in publications here and abroad. He has authored four books, published by John Wiley & Sons, Inc., titled: Corporate Valuation: A Business and Professional Guide; Trademark Valuation; Valuation of Intellectual Property and Intangible Assets (coauthor); Intellectual Property: Licensing and Joint Venture Profit Strategies (coauthor), and has contributed to several other Wiley intellectual property and tax reference books. Russell L. Parr, CFA, ASA, is president of IPRA, Inc. Intellectual Property Research Associates ( He is an expert in determining the value of intellectual property. Mr. Parr s books about intellectual property value and management are published in Japanese, Korean, Italian, and English. He is dedicated to the development of comprehensive methods for accurately defining the value of intellectual property. Highlight assignments conducted by Mr. Parr have included the valuation of the Dr. Seuss copyrights and the patent portfolio of AT&T. Mr. Parr also has conducted valuations and royalty rate studies for communications technology, pharmaceuticals, semiconductor process and product technology, automotive battery technology, lasers, agricultural formulations, biotechnology, computer software, drug delivery systems, medical products technology, incinerator feed systems, camera technology, flowers, consumer and corporate trademarks, motivational book copyrights, and cosmetics. His opinions are used to accomplish licensing transactions, acquisitions, transfer pricing, litigation support, collateral-based financing, and joint ventures. Mr. Parr has written 24 articles that have been published in various professional journals. He has spoken at over 30 conferences regarding the value of technology, including those sponsored by the World Intellectual Property Organization in Singapore and Lima, Peru. He also has testified about the value of companies and intellectual property over 40 times at deposition, trial, or for arbitration. Mr. Parr has a master s in business administration from Rutgers University (1981); a bachelor of science in electrical engineering, from Rutgers University (1976); coursework toward Ph.D. in the International Business Management Program at Rutgers University. His professional designations include Chartered Financial Analyst (CFA) from the Association for Investment Management and Research and Accredited Senior Appraiser (ASA) of the American Society of Appraisers. vii

10 viii About the Authors Among Mr. Parr s writings are five books published by John Wiley & Sons and three books published by IPRA, Inc. His Wiley books include: Valuation of Intellectual Property & Intangible Assets, third edition: Intellectual Property: Joint Venture and Profit Strategies, second edition; Intellectual Property Infringement Damages: A Litigation Support Handbook, second edition; Investing in Intangible Assets; and Corporate Strategies for Maximizing Value. His books published by IPRA, Inc. include: Royalty Rates for Pharmaceuticals and Biotechnology, fifth edition; Royalty Rates for Technology, third edition; and Royalty Rates for Trademarks and Copyrights, second edition.

11 ACKNOWLEDGMENTS We continue to learn about the world of intellectual property from our clients, colleagues, and students and wish to recognize those who have come forth to contribute to this book. Anna L. Johns, Esq. is a senior associate with the prestigious law firm of Dewey Ballantine. She is a lawyer and accountant. Her intellect and tenacity reduces mountains of information into clarity. Trade secret damages are complex, and she brings her skills to bear in a chapter at the end of this book that greatly contributes to damages calculations. Robert Goldscheider, John Jaroz, and Carla Mulhern have grappled with the complex controversies of the 25% Rule. Their work on this topic has left the entire licensing industry in a much better position. We are very pleased to include their exhaustive study in this book. Patrick H. Sullivan, Sr. is founder of ICM Group. He is dedicated to the maximum extraction of value from all forms of intellectual property and intangible assets. He is rightly dedicated to bringing these assets to the forefront of executive management mindsets. His abstract thinking can cause headaches but always leaves you better off. Kathleen M. Kerowski of Ernst & Young and Maria S. Lehman of Davis & Hosfield Consulting, LLC, have contributed greatly to the understanding of trademark damages. Charles E. Jerominski of AUS Consultants continues to lend his expertise in the area of statistical lifing techniques. David G. Weiler, managing director of RoyaltySource has provided support in our research, as have Jerome Weinert, Michael Diedrich, and Mary Beth McAndrews of AUS Consultants. Drs. Richard A. Michelfelder and Maureen Morrin are professors at Rutgers University who have greatly assisted us with their research on forecasting models applicable to intellectual property exploitations. Dr. John A. Del Roccili of Econsult Corporation in Philadelphia always brings sharp insight into our discussions, and we appreciate his appendix contribution. ix

13 CONTENTS Preface xxiii PART I VALUATION 1 1 Intellectual Property and Intangible Assets in the World Today Some History Legislation Created Intellectual Property Need for Intellectual Property Valuations Intellectual Property Exploitation Legal Attitudes Enhance Value When Intellectual Properties Collide 11 2 Defining Intangible Assets and Intellectual Property Intangible Assets Intellectual Property 21 3 Defining Intangible Assets and Intellectual Property Trademarks Trademarks Trademark Defined Trademarks The Legal Underpinnings Trademark Creation Naming Rights 61 4 Intangible Assets and the Business Enterprise The Business Enterprise Summary 79 Because of the rapidly changing nature of information in this field, this product may be updated with annual supplements or with future editions. Please call or us at subscriber@wiley.com to receive any current update at no additional charge. We will send on approval any future supplements or new editions when they become available. If you purchased this product directly from John Wiley & Sons, Inc., we have already recorded your subscription for this update service. xi

14 xii Contents 5 Accounting Issues Introduction Accounting Principles Relating to Valuation New Developments in Accounting for Intangible Assets Cost and Value 109 Appendices 5A Intangible Asset List Exposure Draft 112 5B Intangible Asset List Final SFAS No C Relevant Documents in the Development of SFAS No. 141 and SFAS No Tax Issues Tax Considerations Primary Standards Property Definitions Methods for Determining Intangible Asset Transfer Prices Cost-Sharing Arrangements Investment Holding Companies Valuation Principles and Techniques Valuation Principles Valuation Methods Summary Cost Approach General Cost Approach Principles Cautions in Using the Cost Approach for Intellectual Property Using the Cost Approach for Trademarks Using the Cost Approach for Technology Cost Approach Summary Market Approach Market Transactions of Intellectual Property Indicate Value Market Events Can Indicate Value A Lost Patent Indicates Value Analyzing the Business Enterprise to Indicate Value Market Approach Summary Income Approach Quantifying the Economic Benefit Market Value Equals the Present Value of the Future Economic Benefits of Ownership Quantifying the Economic Benefit 185

15 Contents xiii 11 Income Approach Timing and Pattern of Receiving the Economic Benefit Market Value Equals the Present Value of the Future Economic Benefits of Ownership Economic Life Defined Economic Life of Intangible Assets and Intellectual Property Income Approach Evaluating the Risk of Receiving the Economic Benefit and Putting It All Together Market Value Equals the Present Value of the Future Economic Benefits of Ownership Income Approach Putting It All Together When Theory Meets Practice Valuation Challenges Common Valuation Errors Valuation Method Preferences Special Valuation Situations Intangibles in Bankruptcy and as Collateral Ad Valorem Taxes Intangible Assets in Regulated Industries Early-Stage Technology Valuation Early-Stage Technology Cost Approach and Early-Stage Technology Market Approach and Early-Stage Technology Income Approach and Early-Stage Technology Summary International Issues International Valuation Standards Other International Valuation Issues Summary 309 PART II LICENSING Emergence of Intellectual Property Exploitation Strategies Factors Driving Strategic Alliances: Time, Cost, and Risk A Short History of Corporate Strategies Legal Attitudes Enhance Value 320

16 xiv Contents 18 Introduction to Exploitation Strategies Some History Enter Technological Change Business Enterprise Model Economics of Exploitation Development of Intellectual Property Source of Production Factors Internal Strategies The Entrepreneurial Corporation Acquisition External Strategies Ownership Alliances Other Liquidity Concerns Establishing a Cross-ownership Alliance Strategic Alliances Rapid Technological Change Creating Industry Standards Economic Contributions of Intellectual Property Intellectual Property Contributes Powerfully to Earnings Intellectual Property Sustains Superior Earnings Enhanced Profits and Intellectual Property Investment Rate of Return Analysis Discounted Cash Flow Analysis Comparable License Transactions Simplistic Rules of Thumb Global Exploitation Potential Impact of the International Environment Accounting Issues Taxes Transfer Pricing Methods for Determining Intangible Asset Transfer Prices Political Risk New Markets Repatriation Cultural Issues investment Risk Legal Protection Summary Risks of Exploitation Elements of Risk Risk and Royalties 401

17 Contents xv 21.3 Intellectual Property Economic Life Summary Use of the 25% Rule in Valuing Intellectual Property Introduction History of the Rule Explanation of the Rule Illustration of the Rule Application of the Rule Justification for the Rule Criticisms of the Rule Empirical Test of the Rule Conclusions Licensing Economics and Royalty Rates Pricing the Alternatives Licensing Primary Economic Drivers Secondary Economic Drivers Evaluating the Net Present Value Summary Determining a Royalty Rate An Example Description of the Patented DermaPulse Invention Financial Review Intellectual Property Economic Contribution Analysis of Specific Market Transactions Conclusion Dealing with Early-Stage Intellectual Property Early-Stage Technology Development Costs Risk Time The DCF Mechanism Using Discounted Cash Flow (DCF) as a Measuring Tool Trademark Licensing Trademark Royalties Royalty Quantification Licensing Negotiations and Agreements Licensing Negotiations Licensing Agreements 523

18 xvi Contents 27.3 Critical Questions Licensing-In Technology Licensing-Out Technology Conclusion Licensing Internet Assets Internet Background Internet Economics Internet Licensing Another View of Licensing Strategies Defensive Strategies Cost Centers Profit Centers Integrated Management Visionary Intellectual Property Management Making the Big Bucks Intellectual Property Touches all Aspects of Life Intangible Assets at the Center of Deals E-Commerce and Intellectual Property Specific Trends in Intellectual Property Deal Making Trademark Strategies Intangible Riches Joint Venture Ownership Split Expansion at Overboard Industries, Inc Consumer Electronics Access to the Technology Access to the Market Measuring Potential Value from Pin-Point Weighted Average Cost of Capital Internal Technology Development Internal Trademark Development Going it Alone Summary Special Problems with Strategic Alliances University Technology Transfer University Technology Transfer Goals University Offices of Technology Transfer Conflicts of Interest Nonexclusive Licenses Finding Technology 587

19 Contents xvii 31.6 Rewards of Inventorship Harvard University Royalty-Sharing Policy for Intellectual Property Johns Hopkins University Sharing of Revenue from Intellectual Property Dealing with Universities Organizing for the Future Mapping Intellectual Property Identification Assembled Workforce Captive Spare Parts Annuity Computer Software Copyrights Customer Lists Distribution Networks Trademarks Strategic Plan and Gap Analysis Monitoring License Agreements Introduction Overview of Licensing Licensing Business Risks License Management Auditing the Royalty Obligations Common Audit Procedures and Findings Remedies from Breaches of Licensing Contracts Conclusion 614 PART III INFRINGEMENT DAMAGES Lost-Profit Calculations Definition of Lost-Profit Damages Patent Infringement Trademark Infringement Copyright Infringement Lost Profits The Panduit Test for Calculating Lost Profit Calculating Lost Profit After Panduit Incremental Profits Profit and Loss Statements Fixed and Variable Costs An Example of Incremental Profits 640

20 xviii Contents Fixed Costs Aren t Always Fixed Summary Royalty Rates and the Georgia-Pacific Factors Factors for Deriving a Responsible Royalty Summary The Analytical Approach Normal Industry Profits A More Comprehensive Analytical Approach Hypothetical Example Generic Drug Pricing Summary Discounted Cash Flow Analysis PharmaProd Commodity Corp. Value New PharmaProd Corp. Royalty Rate Lost Value Summary Market-Derived Royalty Rates Internal Licenses Are Often Self-Serving Relevant Time Period Financial Condition of Both Licensing Parties Relevant Industry Transactions Governmental Regulations Are the Independent Parties Really Independent? Outcome of an Infringement Lawsuit Summary Trademark Damages Counterfeiting The Law Relating to Monetary Relief Confusion Case Analysis Conclusion Estimating Damages for Infringement of Agricultural Biotechnology-Derived Products Introduction What Is Agricultural Biotechnology? Determining Benefits: The Case of Bt Corn Conventional Methods of ECB Control 701

21 Contents xix 40.5 The Economics of ECB Control Value of Bt A Review of Court-Awarded Royalty Rates in Patent Infringement Cases ( ) Introduction Royalties as a Measure of Damages Royalty Rate Awards Categorized by Industry Basis for Royalty Rates The Hypothetical Negotiation Consideration of the Georgia-Pacific Factors Federal Circuit Decisions on Royalty Awards Other Considerations in the Determination of a Reasonable Royalty Conclusion Trademark Damage Trends in the Federal Circuit ( ) Introduction Overview of Trademarks Injunctive and Monetary Relief Guidance Trends in Trademark Damages Awards Conclusion Recent Decision: Copyright Infringement Damages Can Be Based on Value of Licenses Introduction On Davis v. The Gap, Inc Conclusion Trade Secret Damages Summary of Trade Secret Damages Royalty Method of Calculating Damages for Misappropriation of Trade Secret Plaintiff s Lost Profits Method of Calculating Damages for Misappropriation of Trade Secret Defendant s Profit Method of Calculating Damages for Misappropriation of Trade Secret Other Methods of Calculating Damages for Misappropriation of Trade Secret The Accounting Period for Trade Secret Misappropriation Damages 752

22 xx Contents PART IV APPENDICES 755 A Investment Rate of Return 757 A.1 Investment Rate of Return 757 A.2 Required Rate of Return Components 758 A.3 Rate of Return Models 759 A.4 Weighted Average Cost of Capital 764 A.5 Appropriate Return on Monetary Assets 765 A.6 Appropriate Return on Tangible Assets 765 A.7 Appropriate Return on Intangible Assets and Intellectual Property 766 A.8 Prejudgment Interest Rates 767 A.9 References 768 B C Theoretical Foundations for the Determination of a Fair Rate of Return on Intellectual Property 769 The Use and Abuse of Iowa Curves When Quantifying Appraisal Depreciation 771 C.1 Appraisal Depreciation 771 C.2 Iowa-Type Survivor Curve 772 C.3 Appraisal Depreciation and Iowa Curves 780 C.4 Valuation Theory of Condition Percent 780 C.5 Iowa Curve Misapplication and Underlying Fallacious Assumptions 781 C.6 Effects of Misapplication of Iowa Curves on Appraisal Results 783 D Financial and Business Information Sources 785 D.1 A Starting Point 785 D.2 Financial Data 785 D.3 CD-ROM Databases 788 D.4 Economic Data 789 D.5 International Data 789 D.6 Sources of Sources 789 D.7 Royalty Rate Information 791 D.8 Publications 793 E Sample Royalty Rate Information 797 E.1 Technology Royalty Rates 797 E.2 Trademark Royalty Rates 804 E.3 Pharmaceuticals & Biotechnology Royalty Rates 808

23 Contents xxi F Overview of New Product Diffusion Sales Forecasting Models 817 F.1 Introduction 817 F.2 New Product Sales Forecasting Models: Product Diffusion 817 F.3 Types of Product Diffusion Models 820 F.4 Caveats of the Bass Model 825 F.5 Conclusions 825 F.6 References 826 Index 829

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