The 25 percent rule is a technique for determining the valuation of intellectual property during patent license agreements or royalty damage calculations. This rule stipulates that the party selling products or services that another owns intellectual rights should pay a 25% royalty on gross profits.
25% Rule Details
The 25% rule is a cautionary guideline for setting public finance debt based on credit ratings and bondholder confidence. It’s also a classic method of calculating intellectual property rates for licensees and patent holders.
Therefore the 25 percent rule is a rule of thumb rather than the optimal threshold or absolute legal requirement. It's customarily applied to trademarks, copyrights, trade secrets, and other intellectual property forms.
In the first instance, the 25% rule is used to make revenue assumptions when local, or state governments are seeking funding for projects. To repay their municipal bond issues, municipalities have to stick to 25% of the proceeds which in turn adds to bond investor confidence.
Violating the 25% rule can cause defaults in repayment obligations and hurt the credit rating of the issuing municipalities. This rule is also applied to private activity bonds that are issued by local governments on behalf of non-profit or private organizations.
Real-World Example of The 25% Rule
In a licensing and litigation for infringement setting, the 25% rule is used by over twenty-five percent of organizations as a negotiation starting point, according to Degnan and Horton, 1997. A profit-sharing analysis, a variant of this rule has also been found to be in use in more than 50% of these enterprises when determining royalties to be paid.
In the early 90s, there was a dramatic uptake of the 25% rule in the negotiations of two petrochemical players referred to as company A and company B. the product in question was a polymer named X, which accrued over $1 billion in annual sales.
The manufacturing process of product X, named P1, required a vital intermediate compound Y that A bought from B in volumes of over $400 million annually.
The patent for the manufacturing process P1 for product X was owned by company A, but it was set to expire in seven years. They, A, developed a new process, P2, essentially switching production as the new process was less costly and could produce a variety of grades for X.
Since P2 didn’t require the secondary product Y from company B, and A offered them the chance to become exclusive international licensees for process P1. A’s evaluation, using the 25% rule argued that since B had been purchasing chemical Y, which A no longer needed, B could manufacture X cost-effectively and be compensated for the loss of selling Y to A.
Significance of The 25% Rule
Used as a starting point in the negotiations on patent royalties, the 25% rule represents a rule of thumb for expected profit percentages paid to license owners. In the last decade, economists have made several attempts to evaluate the empirical legality of using this rule as a parameter for royalty valuation.
One landmark case that cast doubts on using the 25% rule as a launching point in reviewing patent damage in court was the Uniloc USA vs. Microsoft corporation 2011 ruling. Since then, this rule has become inadmissible in court as far as expert engagement in patent licensing issues is concerned.
However, the 25% rule continues to be utilized for arriving at patent royalty proposals. Patent lawsuits like the Uniloc vs. Microsoft need the patent owner to prove infringement damages, which are assessed against the reasonable royalty that would be agreed on in hypothetical negotiations.
Litigants in patent suits face challenges arriving at that reasonable royalty, and courts have provided lists of potential factors to consider.
The jury for the district court awarded Uniloc USA $388 million against Microsoft Corp for damages resulting in patent infringement, but the Federal Circuit Court of Appeals overturned this decision. From there, the 25% rule was determined not admissible and wasn't to be used even as a starting point for assessing evidence of damages.
History of The 25% Rule
In the late 50s, one of the rules authors, Robert Goldscheider performed a series of empirical studies on commercial licenses. One of his clients had eighteen licensees internationally, a Swiss-based subsidiary of an American corporation, each having a three-year term agreement and exclusive territory rights.
There were intellectual property rights involved too, including trademarks by the franchisor, valuable patents, copyrighted product descriptions, and marketing materials. All the licensees faced strong but manageable competition and represented first or second-tier leaders in the sales volumes of their respective marketplaces.
In essence, these licensees generated 20% profits from sales of embodied patented technology products. The franchisees each paid 5% royalties to the Swiss company, which is calculated as 25% of franchisee profits.
By 1971, Goldscheider has published the 25% rule, noting valuation experts were utilizing it in one form or another way before that.
The 25% Rule vs. The 20% Rule
The 25% rule is being used in the negotiations or assessments of patent royalty, or as a guideline for municipal borrowing. But there's also the 20% rule, and the two are often confused. The 20% rule is used by financial providers to stipulate the level of deposits that borrowers must maintain on their outstanding loans.
Though the exact specification varies, the 20% rule depends on interest rates and factors such as a debtor's perceived creditworthiness.
This is an example of banks holding balances to reduce the risk of a loan given, also known as compensating balance. In the past, balances were held strictly at 20%, but in recent years the practice has become led common.
Some banks have scrapped compensating balances altogether in favor of service charges or similar arrangements. Where they exist, they range widely in percentages.
Nowadays, industries use generic data for giving an average royalty rate, although patentees must establish the analytical tool's relevance while laying factual foundations. Patent damage negotiations are more fact-intensive, and any potential litigation calculations may approve or reject the 25% rule as part of a settlement in infringement suits.