FRAND royalty rates in SEP licensing: comparable licence agreements

Determining FRAND royalty rates in SEP portfolio licensing has become a widely discussed topic in recent years as mobile phone standards have rapidly evolved and an increasing number of handset manufacturers have entered the mobile handset market. This chapter introduces the basic tenets of FRAND licensing and discusses how comparable licence agreements entered into by SEP owners can be analysed and unpacked to determine dollar-per-unit or effective percentage FRAND royalty rates.

ETSI overview

One of the most well-known standards-setting organisations is the European Telecommunications Standards Institute (ETSI), which develops worldwide standards for information and mobile communication technologies. As a general rule, when patented technology is adopted into telecoms standards set by ETSI, the use of the patent (known as the ‘SEP’) becomes essential to implementing the standard. Since manufacturing a product that complies with that standard without practising the patent becomes impossible, ETSI requires that the patent owner agree to license its SEPs on FRAND terms.

Determining FRAND royalty rates

While there are a variety of techniques to determine FRAND royalty rates for SEPs, bilaterally (or arm’s-length) negotiated licence agreements adjusted for comparability are one of the best indications of the true market value of the patented technology. However, ‘adjusted’ is the key term for consideration of comparative pricing or royalty rates. Those adjustments are the most significant elements of ‘unpacking’ comparable agreements and require the most real-world licensing experience.

Comparable licence analysis

Comparable licences are often a direct and important source of real-world information considered by licensees and licensors as a starting point in valuing patents and patent portfolios because comparable licences distil a great deal of exchanged economic information into one package – the price or fully negotiated royalty rate paid for using the patented technology. However, any so-called ‘comparable licences’ must be put into context to be useful in any analysis of FRAND royalty rates.

With respect to valuing SEPs, an analysis of arm’s-length negotiated comparable licence rates, if available, is a useful data point as a measure of (unadjusted) FRAND royalty rates from an economic and licensing perspective for at least two reasons:

• multiple bilateral negotiations, especially between similarly situated parties for comparable patent assets, can provide one of the best sources of information relevant to determining an appropriate range of FRAND royalty rates; and
• comparable licence or market approaches are accepted by economists, licensing and valuation professionals and the courts.

However, extracting implied royalty rates (especially dollar-per-unit rates) from licence agreements is often a difficult task and can require a significant amount of analysis and financial modelling. The structure and terms of a licence can vary significantly. Licences can be based on running royalty payments, lump-sum payments, cross-licence value, non-cash consideration or a combination of one or more of these and potentially other transfers of value (eg, simultaneous joint development or supply agreements, trading patent picks between licensee and licensor and also covenants not to sue or enforce certain non-SEPs). In addition, running royalties can be calculated on a percentage of sales basis, on a dollar-per-unit basis or as a ‘hybrid’ using percentage of sales combined with dollar-per-unit royalty caps and floors.

The most important aspect of a licence agreement for licensing experts when analysing licence agreements is to identify what a licensee really paid for a licence when converted to dollars for comparison. In order to do this, it is often necessary to ‘unpack’ licence agreements to determine the true value and the effective royalty rate that the parties agreed to and had in mind during the licence negotiation. To unpack a licence agreement an analyst must identify and assess all the financial consideration exchanged or promised, various projections of future economic conditions affecting royalties and the structure of future obligations based on uncertainty or payment structure.

The methodology for unpacking a licence depends on the structure of the licence. Most SEP licences are structured based on two different criteria:

• one-way licences versus two-way licences; and
• running-royalty licences versus fixed-payment licences.

One-way licences versus two-way licences

When a licensee does not own a portfolio of patents that confers meaningful grant-back value to a licensor, the licensee typically compensates the licensor for the licence with cash payments only. Such licences are known as ‘one-way licences’.

When a licensee owns an SEP portfolio that has value to the licensor, the licensee typically compensates the licensor with cash payments and with a reciprocal licence to the licensee’s SEP portfolio – often referred to as a ‘balancing payment’. The licence that the licensor receives back from the licensee is called a ‘grant-back licence’ or ‘cross-licence’. These types of licence are known as ‘two-way licences’.

Running-royalty licences versus fixed-payment licences

Licensees make royalty payments in several forms. Some licences are structured where the licensee pays a royalty on each unit sold – known as ‘running-royalty licences’. Other licences are structured where the licensee makes a fixed payment (either all upfront or at the beginning of each year) to cover all sales in a given period – known as ‘fixed-payment licences’ or ‘lump-sum licences’. Sometimes a fixed-payment licence may give the licensee the option of paying a running royalty rate or may require the licensee to make running-royalty payments after its sales exceed a certain threshold that was covered by a fixed payment.

Each type of licence must be unpacked using a different methodology:

• One-way, pure running-royalty rate agreements are the easiest to analyse because there is no need to estimate grant-back value and the contract contains a per-unit royalty term. To calculate dollar-per-unit rates, you need only estimate the average sales price of the units and multiply by the licence terms.
• One-way, fixed payment agreements require more analysis because calculating a per-unit rate requires an estimation of the licensee’s sales volumes over the course of the licence, and an estimation of average wholesale prices over the course of the licence.
• Two-way licences – both running royalty and fixed payment – are the most difficult to unpack because you need to estimate the grant-back value inherent in the cross-licence. This means that you need to value both the licensor’s patent portfolio and the licensee’s patent portfolio to calculate the net amount paid and the true value exchanged. If the two-way licence is a fixed-payment licence, then you need to estimate the grant-back value and calculate an effective per-unit royalty rate by using a forecast of both units and average sales prices.

Methodology to unpack one-way, running-royalty rate licences

An analysis of comparable licences that are one-way, running-royalty rate licences is often straightforward. The running-royalty rate contained in these types of agreement can be multiplied by the estimated wholesale average sales price (ASP) for each technology contained in the licence – such as GSM/GPRS, EDGE, 3G and 4G, to derive implied dollar-per-unit royalty rates. IDC, a global market intelligence firm, is perhaps the only company that reports handset sales prices by technology, for each technology, and for all handset manufacturers. However, IDC reports retail prices, not wholesale prices. Since handset royalties are typically paid on the wholesale price of a handset and margins vary widely between manufacturers, an adjustment is needed to convert retail prices to wholesale prices.

One way to make this adjustment is to compare retail ASP levels to wholesale ASP levels as reported by independent data reporting companies such as IDC and Strategy Analytics. Based on such comparison, it is possible to calculate a multiplier that would convert retail ASPs into wholesale ASPs.

Methodology to unpack two-way licences

Analysing two-way licences is more difficult because it requires simultaneously estimating the value of a licensor’s SEP portfolio to the licensee and the licensee’s SEP portfolio to the licensor over the course of the licence, or at least as of the date that the licence agreement was negotiated. Many two-way licences are cross-licences with a ‘balancing payment’ that is owed to the owner of the most valuable portfolio – all else being equal. The total compensation that the licensor receives from the licensee is typically in the form of:

• a payment made by the licensee to the licensor (including both royalties and other business considerations); and
• the value of the licence to the licensee’s patent portfolio (ie, the grant-back value).

The total consideration flowing to a licensor is in the form of royalties and reciprocal licence value (see Figure 1).

To determine the licensor’s implied one-way royalty rate, the licence must be unpacked to estimate the value of both the licensor’s and the licensee’s patent portfolio.

In general, the royalty component of the licence (or net balancing payment) is equal to the difference between the licensor’s royalty rate multiplied by the licensee’s revenue and the licensee’s royalty rate multiplied by the licensor’s revenue (see Figure 2).

As this equation includes two unknown variables, it cannot be solved without additional information. The equation is often solved by using a ‘portfolio strength’ metric to fix the licensee’s effective rate to the licensor’s effective rate based on the strength of the parties’ respective SEP portfolios. A portfolio strength ration is the licensor’s patent portfolio strength divided by the licensee’s patent portfolio strength (see Figure 3).

There are a number of ways to assess a licensor’s and licensee’s portfolio strength, including an analysis of approved SEP contribution data, as well as an analysis of each parties’ ratio or number of ‘truly essential’ SEPs by qualified independent third parties, or even through a cooperative technical analysis between the parties to the agreement.

With a portfolio strength ratio value, it is possible to calculate a licensor’s implied one-way royalty rate (see Figure 4).

Since two-way-licence analysis typically involves analysing royalty payments due for past sales (during a release period) and future sales, the use of a discount rate is needed to adjust revenue figures and the net balancing payments. A discount rate is used to determine the present value of future cash flows. The discount rate considers not just the time value of money, but also the risk or uncertainty of future cash flows; the greater the uncertainty of future cash flows, the higher the discount rate.

Therefore, calculating the net present value of royalties and revenues requires applying several discount rates. Discount rates are typically applied to:

• past sales;
• future sales;
• future running royalties; and
• future fixed payments.

Past sales

Discount rates for released sales or past sales are often lower because past sales are certain. Therefore, for past sales, all else being equal, a discount rate equal to the Treasury Bill rate may be appropriate.

Future sales

Discount rates for future revenues are generally higher because they involve a large amount of uncertainty. Future sales are dependent on future business success and the mobile phone handset industry is notoriously competitive. As such, the risk of a licensee achieving its projected sales (and, in turn, the risk of a licensor in collecting running royalties on those sales) is commensurate with the usual business risk of the licensee, which is traditionally measured by a company’s cost of equity or weighted average cost of capital, depending on the market conditions faced by that company.

Future running royalties

Like future sales, future royalty payments based on a running-royalty contract involve a large amount of uncertainty. Future running royalties are directly proportional to future sales. Therefore, the same weighted average cost of capital discount rate for future sales should also apply to future royalties.

Future fixed payments

Discount rates for future fixed payments are different from those for future running-royalty rates. A promise to pay a specific amount is not dependent on actual sales. This makes fixed-payment licences much more valuable (excluding collection risk). There is far more certainty with fixed payments and this certainty is valuable. The value of this certainty is reflected in the discount rate. Fixed royalty payments are generally discounted using corporate debt rates because the risk of the amount of payment is less given the fixed, known nature of payments compared to the risk of very uncertain projected revenues or units.

Adjustments for comparability

Once effective royalty rates are determined based on the above, further adjustments must often be made to establish licence agreements as comparable. These adjustments include timing, volume, pricing of each company’s products and the level of utilisation of the technology within the company’s products.

Timing

SEP owners often offer discounted rates to parties that more rapidly reach agreement on a licence or that take a licence early in the lifecycle of an overall licensing programme. Those discounted rates reflect the lower costs that are thereby incurred by the licensor, and the positive signals that are sent to the marketplace of other prospective licensees. SEP owners may grant lower rates to these early adopters. Late adopters (or companies that engage in ‘hold out’) are not entitled to such discretionary discounts.

Volume

SEP owners may offer lower effective royalty rates to licensees that command a large volume of sales; licensors are incentivised to do so for several reasons:

• Gaining a large licensee without the need to initiate and complete litigation will generally send a positive signal to the marketplace of other prospective licensees.
• Conversely, large licensees that hold out, refuse a licence and force litigation will generally send a negative signal to other licensees – particularly to their larger competitors.
• Larger licences, all else being equal, incur lower percentage transaction costs than smaller licences.
• Gaining a large licensee, even at a discounted rate, has a more significant positive impact on the licensor’s finances.

Litigation

When analysing potentially comparable licence agreements, it is important to ascertain whether the agreement being analysed was the result of litigation – which is a common occurrence, as licensing and litigation are often intertwined. A study published by the American Intellectual Property Law Association estimated that the average cost of litigation in a patent infringement action ranged from about $1 million to $6 million, depending on the size of the case. In fact, in a number of FRAND-related cases involving large portfolios of SEPs, the cost of litigation through trial has greatly exceeded the top end of that range. Should litigation be necessary to enforce a patent, as is often the case, a patent owner can also expect a substantial delay between the filing and the resolution of litigation. This delay translates to more costs for the licensor, which the licensor tries to recoup in a subsequent licence agreement. Litigation and settlement costs tend to increase as a case reaches key events (complaint filed, complaint served, answer filed, Rule 26 scheduling conference, claim construction order, summary judgment order and trial). Licences that are entered into as the result of a full litigation through trial are likely to be for a higher amount than the same licence that was entered into soon after a complaint was filed. As such, a careful examination of the litigation history related to potentially comparable licences is extremely important.

Comment

Potentially comparable licence agreements are a useful data point when determining FRAND royalty rates because they distil a great deal of exchanged economic information into one package. However, it is imperative to perform a comprehensive analysis of potentially comparable licence agreements and make relevant adjustments for true comparability. While this chapter covers some of the primary considerations necessary for examination to reach a comparability determination, it is by no means exhaustive.