An easy-to-understand explanation of a complex subject which is often beyond the scope of most attorneys' expertise. Focuses on quantifying lost profits and reasonable royalties. Cites established methods of calculating damages for patents, trademarks and copyrights. Describes how to use formal damages reports and offers detailed analyses of landmark infringement cases. Includes accessible checklists, sample calculations and practical tips. Supplemented annually.
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The Dominance of Intellectual Property
Intellectual property is the central resource for creating wealth in almost all industries. The foundation of commercial power has shifted from capital resources to intellectual property. In fact, the definition of capital resources is shifting. No longer does the term capital resource bring to mind balance sheets of cash or pictures of sprawling manufacturing plants. The definition of capital includes intellectual property such as technological know-how, patents, trademarks, copyrights, and trade secrets. Corporations once dominated industries by acquiring and managing extensive holdings of natural resources and manufacturing facilities. Barriers to entry were high because enormous amounts of fixed asset investments were required to displace well-entrenched players. Today, companies that once dominated industries are finding themselves fighting for survival. Up-start companies are creating new products and services based, not on extensive natural resource holdings or cash hordes, but on intellectual property resources. Management of these properties will determine the winners from the losers in the decades ahead.
1.1 ECLECTIC SCIENCE
Dr. Leroy Hood was recently featured in a front-page story of The Wall Street Journal. He is in the business of automating the process biotechnology scientists' follow to find the defective genes underlying cancer. The search must be conducted among the 100,000 genes that comprise the human species. Making matters more complicated, the current process is slow and tedious because precisely measured solutions must be manually shuttled among hundreds of test tubes. Dr. Hood is changing the process by combining a broad range of technologies. One of his machines identifies the sequence of the three billion molecules that make up human DNA and does it 60 times faster than manual methods. He has accomplished this by bringing biotechnology together with computer science, mechanical engineering, physics, liquid science, optics, and electronics. Dr. Hood exemplifies the trend that all businesses must now follow if they are to be successful. He marries established ideas and technologies from far flung fields.
In less than ten years corporations have been faced with technological advances including the continued miniaturization of electronics and widespread communications without wires. Surgical equipment manufacturers are facing increased use of noninvasive surgical techniques. Computer makers have seen their mainframe businesses literally reduced to, and replaced by, a tabletop model. CD-ROMs are killing traditional encyclopedia sales. All of these changes are technology based. As a result, all corporations need more technology and it is often the kind they do not possess. The New World order is defined by change. The leaders in this tumultuous environment will be those that embrace change. Change is coming fast and it keeps coming-all driven by technology. Time to gain expertise in all the different technologies required to compete does not exist. There is no room for the old "not-invented-here" mindset. The pace of change does not afford any company the luxury of developing expertise in all the divergent technologies that it needs. It is even doubtful that such a wide ranging goal could be accomplished.
1.2 PARADIGM SHIFT
In the world before the Industrial Revolution, early man moved away from a hunter-gatherer economy to an agriculturally based economy. Our ancestors roamed across large expanses in search of animals to hunt. Self-sufficiency dominated this model. A major shift occurred when early humans decided to stay in one place and grow the materials that they needed for survival. As an enterprise, agriculture employed virtually everyone in the world not living in the cities and used them in a series of repetitive tasks, done sequentially every season; pre-paring the ground, seeding, tending, harvesting. Then the cycle was repeated. In the agricultural paradigm, the amount of sun, rain, and temperature were vital to a successful season. People became accustomed to dealing with cycles measured in terms of days and seasons. Most farms were small and capable of supporting only one family, reinforcing mankind's desire to be self-sufficient. Over time, however, it became clear to some that the agricultural society was constrained by two key elements: labor and land. Farming at a higher level of out-put-above mere subsistence-required more land and more labor. Expansion of the agricultural economy required collective work and abandoning elements of self-sufficiency.
The Industrial Revolution created a new paradigm. Fueled by a world-wide affluence and an expanding population, the industrial revolution was triggered by technology and the realization that some products could be mass-produced and sold much more cheaply than similar hand-crafted products. The new paradigm of economic behavior evolved into one requiring large amounts of capital for the purchase of buildings, machinery, and equipment. Companies were formed to raise the needed capital and individualism initially took another step backwards. The new companies soon learned that the cost of producing their goods meant not only controlling the manufacture of products, but also that vertical integration enhanced cost controls and profits. Soon, large companies were acquiring their suppliers of coal, suppliers of rail transportation, and finally the retailers that sold the manufactured products. The new megacompanies desired to become entirely independent with regard to all of the functions required to obtain raw materials, produce sub-assemblies and component parts, produce finished goods, and retail them to the consumer. Self-sufficiency once again reigned, but this time in the form of a different kind of collective: the megacompany.
The Intellectual Property Age is now upon us and the new paradigm is yet to be fully played out, but clearly the trend again continues away from independence and toward a vital need for the talents of others. Interdependence is at the root of the paradigm shift taking place. Technology management in the future will center on leveraging technology that is owned to gain access to technology that is needed. Sharing technology is a concept many will find difficult to accept but accept it they must. Denis Waitley writes in Empires of the Mind, " The leaders of the present and the future will be champions of cooperation more often than of competition. While the power to maintain access to resources will remain important, 'the survival of the fittest' mentality will give away to survival of the wisest, a philosophy of understanding, cooperation, knowledge, and reason." Access to vital resources has changed because the nature of the most important resources is no longer embodied in fixed material assets. Gaining access to technology means cooperating with other companies, even competitors, in order to gain access to their knowledge-based resources. Independence is being replaced by interdependence. Waitley succinctly explains, "The future leaders will only get what they want by helping others get what they want." This point was previously illustrated by the story about Dr. Leroy Hood who uses technology from far-flung fields to accomplish his goals.
1.3 LOOKING AT INTELLECTUAL PROPERTY VALUE
Intangible assets and intellectual property dominate the value of businesses. Here is a comparison of the market value of selected companies with the accounting value presented on their respective balance sheets. The market value has been determined by combining the total stock value of shareholders' equity and the book value of long-term debt. When this value is compared to the balance sheet for different asset categories a huge gap of value is identified. The gap represents the aggregate value of all intangible assets and intellectual property of a company. A diverse group of companies has been selected for this analysis. They represent a broad cross-section of industries, all of which show a significant gap in accounting for intellectual property and intangible asset values. The following companies have been selected to demonstrate the dominance of intangible assets and intellectual property, not only for specific companies but also for a broad cross section of industries:
(a) H. J. Heinz Company
H. J. Heinz is not a glitzy entertainment company or a high-tech telecommunications company. Heinz is a food company that is the leading producer of ketchup with over 50 percent of the U. S. market.
Trademarks set this company apart from the pack. The Heinz name is placed on sauces, baby food, beans, vinegar, and pickles. A worldwide producer of food products, the company has a stable of well-known trademarks including Ore-Ida, 9-Lives, Chico-San, Orlando, Olivine, Plasion, Sperlari, Gulso, and Weight Watchers. Heinz enjoys the number one brand position in over 50 percent of its products.
Revenues at Heinz have steadily increased from $7 billion in 1994 to $9.3 billion in 1997. Operating profits for 1997 were 8 percent of revenues. As might be expected, Heinz had a significant investment in working capital and fixed assets. Inventories alone accounted for $1.4 billion of the total $8.4 billion in assets. The business enterprise value, on an accounting basis, totaled $5.6 billion.
The value of invested capital for Heinz is calculated below. Equity is valued at the September 15, 1997 stock market price times the number of shares outstanding. The debt component is valued at the book value of long term debt. Together, the equity and debt values indicate that the value of the Heinz enterprise is over $20 billion.
Using the market value of invested capital and the book value of fixed assets, working capital, and other assets, a calculation for the value of intellectual property and intangible assets is represented by a residual. As shown below a more accurate accounting for intangible assets and intellectual property is a value of over $16 billion.
Heinz is a mature company in a stable industry with brand names that have existed for 100 years. Yet, the balance sheet does not adequately reflect the value of assets that are most vital to the Heinz business.
(b) Johnson & Johnson
The same analysis as just performed for Heinz shows that Johnson & Johnson has enormous amounts of intangible assets and intellectual property. In 1886 two brothers developed a dry sterilization process for the production of surgical dressings that were wrapped and sealed in separate packages and ready for immediate use. Innovative process technology and packaging are still the driving force behind J&J which has expanded into one of the broadest product line companies in the health care industry. Also propelling the success of J&J are its well-recognized trademarks. Product categories include consumer goods, ethical drugs, over-the-counter pharmaceutical, medical instrumentals, surgical supplies, and dental products. The company's Jansen Research group is well regarded for efficient commercialization of new discoveries. Jansen commercializes a new product for every 1000 compounds that it synthesizes which is four times the industry rate.
At the end of 1996 revenues exceeded $21.6 billion. Operating profits nearly reached 20 percent of revenues. The business enterprise value, on an accounting basis, totaled $14.5 billion. On a market value basis the value of invested capital was over $80 billion and the intangible assets and intellectual property represented 86 percent of the company value.
(c) Merck & Company
Merck is one of the world's largest ethical drug manufacturers. Products are manufactured for both human and animal use. The emphasis at Merck is on innovative research and patented drugs. Last year the company spent nearly $1.5 billion on R&D, an 18 percent increase over the previous year. From this investment comes patented drugs that command annual sales levels of $500 million and profit margins that can exceed 80 percent.
Strategic alliances provide a special opportunity for enhanced value with Merck. In addition to a joint venture with Johnson & Johnson, Merck has entered into a research and marketing collaboration with Du Pont. The focus is on the discovery of a class of novel therapeutic agents that promise to be the next generation of prescription medicines for treating high blood pressure and heart disease.
Scientific development is the foundation of Merck. Between December 1993 and 1996 revenues at Merck had almost doubled from $10.5 billion to $19.8 billion. Operating profits for 1996 nearly reached an extraordinary 30 percent. The balance sheet showed that the company had $2 billion in cash alone in 1996. Research facilities dominated the balance sheet where total fixed assets were shown to have had a net book value of $5.9 billion. The business enterprise value on an accounting basis was $16.9 billion. On a market value basis, the invested capital of the company is valued at $70 billion with 81.9 per-cent of the value of the enterprise associated with intellectual property and intangible assets.
(d) Microsoft Corporation
Microsoft has developed a broad line of systems software and applications software for microcomputers. The systems software of the company began with the MS-DOS operating system, which was the most widely used system for IBM-compatible computers. From that base the company has expanded its product offerings beyond operating software. Applications software produced by the company include highly acclaimed spreadsheet programs, word processors, file managers, project managers, communications programs, graphic programs, data base management, games, internet browsers, and money management programs. The company also sells a large assortment of books that help customers get the most out of the company's programs. In addition, the company sells CD-ROM products, interface products, and other peripheral hardware. Microsoft has interests in every form of information collection and manipulation service or product that exists-all derived from a $10,000 investment in the basic code for its original disk operating system.
In 1993 revenues for Microsoft exceeded $3.7 billion. By 1996 revenues were $8.7 billion. Operating profits were 35.5 percent for 1996, which is better than the profit level achieved by the world's leading pharmaceutical company. Total assets of the company for the year ending June 1996 were $10 billion. Cash ($6.9 billion) represented almost 70 percent of that amount. Fixed assets totaled $1.3 billion with less than $1 billion shown as investment in other long-term assets. The business enterprise value, on an accounting basis, was $7.6 billion. 7 On a market value basis, the enterprise is valued at $159 billion with an enormous 95.2 percent of the value of the enterprise being intellectual property and intangible assets.
(e) Minnesota Mining & Manufacturing Company (3M)
3M is a highly diversified company centered on innovative research and new product development. The success of this company is driven by a combination of technology, patents, and trademarks. The industrial sector of the company produces pressure sensitive tapes, coated abrasives, cleaning materials, roofing granules, and specialty chemicals. Information and imaging products include computer diskettes, data cartridges, videotape, printing plates, medical diagnostic products, overhead projectors, and transparency films. The life sciences sector of 3M markets medical, surgical, orthopedic, pharmaceutical, and dental products. Consumer products include Scotch tapes, Post-it notes, and other office supplies. 3M is more of an industrial company than any of the other companies already discussed.
Strong revenue growth and high profit margins are characteristics of 3M. Revenues have grown from $11 billion in 1993 to $14.2 billion by 1996. Operating profits for 1996 were 17.3 percent of revenues. Such revenue growth and profit margin levels are not from a commodity business. Significant intellectual property and intangible assets are evident. The business enterprise value, as of the December 31, 1996 financial report, equaled $8.9 billion. 8 On a market value basis, the enterprise is valued at $39 billion with 75.6 percent of the value of the enterprise being intellectual property and intangible assets.
(f ) Philip Morris Company
Philip Morris is one of the world's largest consumer packaged goods companies. Products include cigarettes (Marlboro), beverages (Miller Beer), and the food products of General Foods and Kraft. The intangible assets of the company are represented by one of the greatest trade-mark portfolios in the world. Included are: Marlboro, Benson & Hedges, Merit, Virginia Slims, Maxwell House, Yuban, Sanka, Brim, Post, Jell-O, Log Cabin, Birds Eye, Kool-Aid, Oscar Mayer, Kraft, Velveeta, Miracle Whip, Sealtest, Miller High Life, Miller Lite, and Lowenbrau. In the mature markets of Philip Morris, intangible asset magic is being practiced with the introduction of new products that extend well-known trademarks. Jell-O has introduced ready-to-eat puddings and frozen pudding pops. Kool-Aid is being extended with a line of ready-to-drink single serving products. The company has extraordinary cash flow from cigarette operations and is continually seeking trademarked product acquisitions to expand its line of brands.
Philip Morris shows a balance sheet (December 31, 1996) business enterprise value of $41.8 billion. Intangible assets are shown as $19 billion of this amount. On a market value basis, the enterprise is valued at $125.6 billion with 81.8 percent ($ 103 billion) of the value of the enterprise being the intellectual property and intangible assets that are shown on the books at $19 billion.
(g) Nike, Inc.
Transformation of the lowly sneaker into $9.2 billion of athletic shoe sales is the hallmark of Nike. Almost anywhere in the world the Nike name and swoosh logo can be found on footwear, jogging shorts, tennis clothes, sweatshirts, ski wear, other athletic apparel, and accessory items such as athletic bags. The company has exploited its technologically advanced footwear by expanding the customer awareness that different sports require specifically designed footwear. No longer do weekend sports warriors have one pair of sneakers. Closets are now filled with different shoes for different activities including basketball, running, fit-ness, cross training, racquetball, and most recently, golf. One of the company's most valuable assets is the Nike trademark, which is registered in over 70 countries.
On a market value basis, the Nike enterprise is valued at $16 billion and 81.7 percent of the value is the intellectual property and intangible assets.
(h) Procter & Gamble Company
Procter & Gamble is a leading manufacturer of household and personal care products based upon a combination of innovative product development and the promotion of illustrious trademarks. Some of the trademarks include Tide, Crest, Spic and Span, Citrus Hill, Oil of Olay, Pampers, Luvs, Vicks, and NyQuil.
On a market value basis, the P&G enterprise is valued at $106 billion with 84.2 percent of the value being intellectual property and intangible assets.
All of the companies just discussed have significant intellectual property and intangible assets that drive their success. Regardless of the industry, these assets enormously contribute to revenue growth, profits, and ultimately to the value of the companies. As we have seen from the foregoing analysis, the investments in working capital and fixed assets pale by comparison to the value that the market has placed on the intangibles.
1.4 INVESTMENT PERFORMANCE
The stocks featured in this chapter were first selected as being a small stock portfolio of companies that are primarily founded on intellectual property and intangible assets. They appeared in the 1991 book Investing in Intangible Assets: Finding and Profiting from Hidden Corporate Value, by Russell L. Parr. The stock performance of these intangibles-based companies has been very good. In late 1990, the following stocks were identified as being solid intangible asset-oriented investments. Assuming that an investor had purchased the stocks in late 1990 and held them until the present (September 1997), the over-all investment return would have been 25.2 percent. This return beat the performance of the overall market as demonstrated by looking at the return on the New Standard & Poors 500 Index.
The successful companies that have been discussed have established records, strong market positions, and proven products, all founded on intellectual property and intangible assets. In general, higher amounts of intellectual property and intangible assets provided higher investment returns.
(a) Intellectual Property Infringement Damages
Considering the value and power of intellectual property, it is not surprising that infringement lawsuits are proliferating. Too much is at stake to ignore infringement of such valuable property. Also contributing to the growth in intellectual property infringement cases are:
1. The complexity and variety of technologies used in seemingly simple products.
2. The significant investment in research and development that is lost when imitators enter the market.
3. Huge advertising campaigns that establish and nurture trade-marks which are compromised by imitators.
4. Its potential use as a deterrent to those contemplating entrance into a market.
5. The enormous awards that have resulted for some patentees.
Each type of intellectual property has its own closely aligned definition of damages. Lost profits of the infringed are usually at the top of the list. When lost profits cannot be proven, or aren't considered appropriate, damages are often measured by a reasonable royalty.
(b) Patent Infringement Damages
Title 35 Section 284 of the United States Code (1970) reads:
Upon finding for the claimant the court shall award the claimant damages adequate to compensate for the infringement, but in no event less than a reasonable royalty for the use of the invention by the infringer, together with interest and costs as fixed by the court.
(c) Trademark Infringement Damages
Title 17 of the United States Code Section 1117 reads:
Recovery for violation of rights . . .
(a) When a violation of any right of the registrant of a mark registered in the Patent and Trademark Office shall have been established in any civil action arising under this chapter, the plaintiff shall be entitled . . . to recover (1) defendant's profits, (2) any damages sustained by the plaintiff, and (3) the cost of the action. . . . In assessing profits the plaintiff shall be required to prove defendant's sales only; defendant must prove all elements of cost or deduction claimed.
(d) Copyright Infringement Damages
Title 17 of the United States Code Section 504 reads:
Remedies for infringement: Damages and profits
(a) In General-. . . an infringer of copyright is liable for either-( 1) the copyright owner's actual damages and any additional profits of the infringer, as provided for by subsection (b); or (2) statutory damages, as provided by subsection (c).
(b) Actual Damages and Profits- The copyright owner is entitled to recover the actual damages suffered by him or her as a result of the infringement, and any profits of the infringer that are attributable to the infringement and are not taken into account in computing the actual damages. In establishing the infringer's profits, the copyright owner is required to present proof only of the infringer's gross revenue, and the infringer is required to prove his or her deductible expenses and the elements of profit attributable to factors other than the copyrighted work.
(c) . . . the copyright owner may elect, at any time before final judgment is rendered, to recover, instead of actual damages and profits, an award of statutory damages for all infringement . . . in a sum of not less than $250 or more than $10,000 as the court considers just.
1.5 OVERVIEW OF THIS BOOK
This chapter has provided an illustration of the importance and value of intellectual property. It then provided the basis for damages when intellectual property is infringed. The remainder of this book represents a primer that shows the basics for calculating infringement damages.
In Chapter 2, Business Enterprise Framework, the different types of assets used in a business are described. Intellectual property alone cannot be exploited without using complementary monetary, fixed, and intangible assets and this chapter establishes a framework by which to consider the value of intellectual property.
In Chapter 3, Profit Contribution from Intellectual Property, the means by which intellectual profit contributes to the economic benefits of a corporation are discussed.
In Chapter 4, Lost Profits, Dr. Richard Gering of PriceWaterhouseCoopers, presents a thorough discussion of how to go about calculating lost profits.
In Chapter 5, Royalty Rates and the Georgia-Pacific Factors, the 15 factors outlined in this famous case are listed and discussed as they pertain to deriving a reasonable royalty.
Chapter 6, The Analytical Approach, describes another royalty rate model that was expressed in a court opinion. An example of how it typically is implemented is provided.
In Chapter 7, Investment Returns and Royalty Rates, a method for allocating the total earnings of a company among the assets of the business enterprise shows a unique and comprehensive method for determining royalty rates.
In Chapter 8, Discounted Cash Flow Analysis, another financial-oriented model is presented as a means for determining a royalty rate.
In Chapter 9, Market-Derived Royalty Rates, the use of third-party licenses for determining a royalty rate that can be used in calculating infringement damages is discussed.
In Chapter 10, Royalty Rate Rules of Thumb, general methods that have been historically used to derive royalty rates are presented. Their strengths and weaknesses are discussed.
In Chapter 11, Trademark Infringement, Gordon V. Smith, President of AUS Consultants, brings order and logical discussion to the challenge of calculating trademark infringement damages.
In Chapter 12, Information Checklist, a general list of discovery information is provided along with the reasons that the information is important.
In Chapter 13, Settlement, the expenses of infringement litigation are discussed as going far beyond the costs of hiring lawyers, consultants, and experts.
In Chapter 14, Emerging Trends in Patent Infringement Damages Awards, Julie L. Davis and Kathleen M. Kedrowski, of Arthur Andersen, provide an analysis of 15 years of patent cases' damages awards.
In Appendix A, Theory of Investment Rate of Return, background information about discount rates and the weighted average cost of capital are presented. This information is useful for those that want to better understand the financial models discussed in the main text.
In Appendix B, Company Audit Reports Don't Show Intellectual Property, the inability of audited financial reports to properly show the value of intellectual property is discussed.
Table of Contents
Fundamentals of Infringement Damages.
Profit Contributions of Intellectual Property.
Complementary Business Assets and Intellectual Property.
Investment Returns and Royalty Rates.
Royalty Rates from Discounted Cash Flow Analysis.
The Analytical Approach.
Royalty Rate Rules of Thumb That Do Not Work.
Calculating Prejudgment Interest.
A Formal Damages Report.
Expert Witness (Sage) Cross Examination.
Infringement Damages Information Checklist.