Calculating the Patent Royalties

Patent contract theory argues that, in essence, a patent is a contract entered into between an inventor and the public whereby the disclosure by the inventor of his technology is the consideration for the government, as representative of the public, to grant him the exclusive right to use his technology. The PRC Patent Law permits a patent holder to license use of his patent to a third party without transfer of the ownership. Such a license is an exemption corresponding to the exclusivity. After receiving monetary compensation, the patent holder will no longer pursue the third party’s liability for infringement of the patented technology. It is in essence a transaction of civil rights. As the value of the exemption is mainly dependent on the regulations for damage for infringement in the laws of a country, when calculating the amount of patent royalties, the concerned party will generally consult the rate for calculating the damages for patent infringement specified in the law.

However, whether it is the rate for damages in a developed country or in China, it is a method of calculating damages based on the validity of the patent and the establishment of infringement, without consideration of the effect on the patent royalties of the validity of the patent or the finding of infringement. Given this shortcoming, the famous US patent lawyer David E. Wang derived a new formula (the David formula) based on the US practice of “rule of thumb” and the “5% royalty method”, innovatively introducing the patent infringement and patent invalidity risk factors into the formula.

The David formula is represented symbolically as follows: R = S × X% × I × V × Y (where R = royalty; S = sales revenue; X% = a reasonable sales royalty percentage; I = infringement, i.e. infringement risk; V = validity, i.e. the validity or stability of the patent; and Y = year(s), i.e. the number of years for which the patent is licensed).

When applying Article 65 of the PRC Patent Law to calculate the measure of damages, the principle of “actual loss” is applied on a priority basis, followed by the principle of “profit derived from the infringement”, followed further by the principle of multiples of the reasonable royalties and the principle of statutory damages and compensation for the losses incurred in the safeguarding of rights. Of those, compensation of actual losses and compensation for profits derived from the infringement can be combined with the David formula to carry out localized transformation and produce a new formula: R1 = S × X1% × I × V × Y and R2 = S × X2% × I × V × Y (where X1% is the patent holder’s actual loss rate per unit of product and X2% is the infringer’s or licensee’s profit rate per unit of product. The meanings of the other symbols remain identical to those for the David formula).

However, there is one flaw in the David formula: the formula applies only in the case where the entire product is covered by the patent claims, and is not applicable where only a certain component of a finished product is covered by the patent claims. The author would solve it as below by combining it with Chinese laws and judicial practice:

Article 16 of the Interpretations of the Supreme People’s Court of Several Issues Concerning the Application of the Law in the Trial of Patent Infringement Dispute Cases specifies that, “if a product that infringes upon an invention or utility model patent is a part or component of another product, the People’s Court shall reasonably determine the measure of damages based on such factors as the intrinsic value of the part or component and its role in realizing the profits derived from the finished product.” This suggests how to determine the measures of damages for the infringement of a component. When such a component is a part of a new product that is not yet on the market, determination of its value is difficult, so the most conservative calculation method is using its actual manufacturing cost as a substitute for the “value of the component itself”.  Reasonably determining the degree to which the component contributes to the profit from the finished product requires taking into consideration the facts of the case, accordingly, the reasonable percentage cannot be determined in advance.

Accordingly, under non-exclusive license theory, the formula for calculating the patent royalties solely for the purposes of infringement of a part or component can be expressed as follows: R = (I × V × Y × X%) × (cost of the component ÷ cost of the entire item) × the degree to which the component contributes to the profit (where X%, depending on the specific case, can be the rights holder’s loss per unit of product or, alternatively, the sales profit rate or operating profit rate).

Furthermore, in a patent license contract entered into by a patent holder and licensee, the patent holder will often insert terms that limit the licensee’s rights, for example, requiring the licensee to license any new technology developed using the patented technology to the patent holder free of charge or at a low price, setting a limit on the price or bundled sales for the product incorporating the patent sold by the licensee, etc.  Under such a circumstance, the licensee may request that a “royalty reduction/exemption factor C arising from the contract limitations on the rights” be added to the formula for calculating the patent royalties.  Such factor is to be smaller than or equal to 1, with the value of such C factor decreasing as the restrictions on the licensee increase and their effect on the profit increases.

In summary, when calculating the patent royalties in a patent licensing transaction, reference may be made to the principles for damages in the event of patent infringement as specified in laws, but the risk of a charge of infringement being rejected or the patent being invalid need to be considered. Where the patent holder can substantiate the actual losses he has incurred, the formula for calculating the patent royalties should reflect a factor for “actual losses”. Where the patent holder cannot substantiate such losses, the formula should reflect a factor for the “profit derived from the infringement”. Where the infringing product is only a component of the finished product, a corresponding factor should also be added to the formula.  Where the licensee’s rights are restricted by the contract terms, the formula should also correspondingly add a “patent royalty reduction/exemption factor C”.

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Degang Ma, Partner

(86 10) 5809 1011

[e-mail]

Mr. Degang (Robert) Ma is a partner of Jingtian & Gongcheng.

He specializes in PRC Intellectual property law and international IP.

Mr. Ma has been in the legal practice for more than 15 years.

Mr. Ma practice focus on IP protection, IP transaction and IP litigation. Mr. Ma handled many cases that appealed to the Supreme Court and many provincial level High courts. Mr. Ma is a patent specialist that passed China Bar, New York Bar and China Patent Bar. He is an experience IP lawyer that ever handled almost every kinds of China IP case including Patent Infringement, Copyright Infringement, Trademark Infringement, Trade Secrete Infringement, Patent Invalidation, Trademark Oppositions, Administrative Litigation for Trademark Review, FTO, Internet Domain Name dispute, Software Protection and Commercial IP cases.

Per international IP experience, Mr. Ma represents two Chinese respondent s in an Section 337 Investigation cases before USITC and are working as legal counsel for another Chinese respondent in a different Section 337 Investigation case.

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