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It is reasonably common for one company--especially in the biotechnology industry--to license patent rights in new, promising technology to a second company in exchange for stock. But is this real-world practice relevant when seeking "reasonable royalty" damages for patent infringement?

Consider this hypothetical: Company A is a successful company that quickly went from fledgling start-up in 1999 to established industry leader in 2003. A's stock price has tripled since its initial public offering in 2001. Company B is a new start-up not yet selling its own products, but which has a key patent in A's "space." In 2003, B sues A, seeking damages for A's alleged patent infringement that began in 2001--i.e., near the time of A's IPO. Can B receive an ownership stake in A (or the cash equivalent of this ownership stake) as just compensation for A's alleged infringement? After all, the purpose of patent infringement damages is to fully compensate the patentee, and awarding an "equity stake" might well achieve this. As shown below, however, this "equity stake" theory of reasonable royalty patent infringement damages is unsupported by the governing statute, is riddled with practical problems, and has been squarely rejected by at least two courts. Therefore, patentees must proceed with caution before employing this approach.

In patent cases, damages are governed by 35 U.S.C. § 284, which provides that "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 made of the invention by the infringer . . . ." There are two types of measures for patent infringement damages: lost profits and a reasonable royalty. Rite-Hite Corp. v. Kelley Co., 56 F.3d 1538, 1554 (Fed. Cir. 1995) (en banc). When lost profits are difficult or impossible to prove (e.g., when the patentee has no product that competes with the infringer's product), a reasonable royalty analysis applies. For this analysis, courts weigh various factors in a flexible manner to determine what a willing licensor and willing licensee would have agreed upon as a reasonable royalty if they had negotiated at a time before infringement began. Riles v. Shell Exploration & Prod. Co., 298 F.3d 1302, 1311 (Fed. Cir. 2002); Georgia-Pacific v. U.S. Plywood Corp., 318 F. Supp. 1116, 1120 (S.D.N.Y. 1970) (listing factors). This exercise generally involves determining what portion of the infringer's sales (or cost savings) are subject to a royalty (the "royalty base") and then multiplying those sales by a royalty rate, usually expressed as either a percentage or a per unit royalty. Rite-Hite, 56 F.3d at 1554.

None of the above rules out the possibility that an equity stake in the infringer could constitute a reasonable royalty for the patentee. This equity stake approach typically fails, however, for many reasons:

1. An Equity Stake Is Not a "Royalty" Under Section 284: A "royalty" is defined as "[a] payment made to an author or inventor for each copy of a work or article sold under a copyright or patent." BLACK'S LAW DICTIONARY 1330 (7th ed.); see also WEBSTER'S NINTH NEW COLLEGIATE DICTIONARY 1028 (1987) ("a payment made to . . . to an inventor for each article sold under a patent"). This suggests, therefore, that in the patent context, a royalty is a monetary payment for use of a patented invention--typically on a per use basis, but perhaps also as a lump sum. Basing damages on an equity stake fails to approximate the injury arising from an infringing use, and instead calculates the value of damages based on a stock price tied to the vagaries of the stock market, which is unrelated to the infringement. See Rite-Hite, 56 F.3d at 1546 (loss in value of patentee's stock allegedly due to infringement not compensable because it is not directly related to the infringement).

Moreover, to define a royalty as anything other than a monetary payment would be inconsistent with the Georgia-Pacific factors, which are designed to determine what type of monetary payment terms and schedule would be negotiated. Indeed, Georgia-Pacific itself refers to the necessity to approximate the "amount" negotiated in a hypothetical negotiation, not the amount or its non-cash equivalent. 318 F. Supp. at 1120. And while the Georgia-Pacific methodology is flexible, this flexibility refers to the inclusion of certain events to the hypothetical "willing licenser - willing licensee" negotiation, not unfounded royalty methodologies that are not linked to monetary payments. See Fromson v. Western Litho Plate & Supply Co., 853 F.2d 1568, 1575 (Fed. Cir. 1988).

2. This Remedy Seeks to Go Beyond The Harm Suffered: Damages awards in patent cases are solely intended to provide compensation for infringement, not to serve as a penalty against the infringer, or a windfall to the patentee. Mobil Oil Corp. v. Amoco Chems. Corp., 915 F. Supp. 1333, 1365 (D. Del. 1995). Using an equity stake approach, especially where the alleged infringer's stock has sharply increased since the time of the alleged first infringement, can lead to absurdly large damage numbers that could exceed the alleged infringer's profits or gross sales. This would be quite unusual and likely impermissible. See Hanson v. Alpine Valley Ski Area, Inc., 718 F.2d 1075, 1081 (Fed. Cir. 1983). An equity stake theory fundamentally is a theory of lost opportunity: the opportunity of the patentee to exchange its patent rights for an ownership interest in the alleged infringer. The Federal Circuit, however, has prohibited reasonable royalty calculations that are lost opportunity or lost profit calculations in disguise. Rodime PLC v. Seagate Tech., Inc., 174 F.3d 1294, 1308 (Fed Cir. 1999), (because "consequential business damages" were merely a "species of lost profits," the district court properly excluded evidence of such damages as constituting or supplementing reasonable royalty analysis). And courts have barred the use of reasonable royalties--presumably including such royalties based on an equity stake theory--to recover the portion of the infringer's value attributable to the infringer's unjust enrichment, or to punish the infringer for its behavior. See Aro Mfg. Co. v. Convertible Top Replacement Co., 377 U.S. 476 (1964); Riles, 298 F.3d at 1312.

3. It Would Be Difficult To Quantify The Equity Stake: Adopting an equity stake approach would have many practical problems as well. For instance, attaching any monetary value to the stake would be extremely difficult. For instance, must the trier of fact assume the patentee would have held onto its equity stake from the date of first alleged infringement to the date of the lawsuit? How would the equity stake be valued if the alleged infringer had earlier bought back some of its shares, or had merged with another company? What if the stock price had fluctuated wildly over time? When should the equity stake be valued? To answer these and similar questions would be difficult, expensive, and time-consuming, and would also require unfettered speculation. This weighs strongly against wholesale adoption of the "equity stake" theory.

4. This Theory Has Little Caselaw Support: In our research, we have found no courts that have specifically approved reasonable royalty damages based on an equity stake theory. In fact, two cases squarely reject the equity stake theory. The first is Nilssen v. Motorola, Inc., No. 93 C 6333, 1998 U.S. Dist. LEXIS 12882 (N.D. Ill. August 12, 1998), which involved a reasonable royalty measure of damages under Illinois trade secret law. The district court rejected the equity stake damages theory there because it was too speculative and lacked caselaw support. Id. at *41, 48-49. The second is a June 7, 2001 unpublished opinion by Chief District Judge Marilyn Hall Patel of the Northern District of California in Rockwell Technologies LLC v. SDL, No. C 95-01729 MHP.

In Rockwell, the patentee (Rockwell) was claiming that a reasonable royalty was a 25% equity stake in the alleged infringer (SDL), arguing that SDL could not have thrived without the technology claimed in Rockwell's patent. Rockwell argued that because SDL gave one co-founder an equity stake for intellectual property rights at its formation (when infringement allegedly began), it would have done the same for Rockwell. Rockwell valued this equity stake at $371 million (the value of 25% of SDL's stock when the patent expired and infringement therefore ended), even though it valued a straight running reasonable royalty, based on a 6% royalty rate, at $39 million, about 90% less. (SDL, of course, preferred a much lower number.)

In a summary judgment order, Judge Patel flatly rejected Rockwell's damages theory. She first noted that "[n]o patent infringement case has awarded an equitable stake in a company as opposed to a dollar amount." Order at 6. She also recognized that licenses for equity stakes had never occurred in the semiconductor or optics industries, the relevant industries here. Id. Here, Rockwell had never asked SDL (or any licensee) for any equity stake, let alone a 25% equity stake, while negotiating for a license. Id. Judge Patel distinguished the equity deal with SDL's co-founder as not involving a bare equity-for-IP-rights deal, but rather equity for a number of assets, including some intellectual property rights. She then highlighted many practical complications if she permitted an equity stake to be a "reasonable royalty." Id. at 9. Such complications included whether Rockwell would have agreed to a buyout of its shares when SDL's employees bought the company pursuant to an option plan, whether Rockwell would have even agreed to the option plan, and when Rockwell's stake would have been valued. See id. Judge Patel noted that there were no facts in the record to help a jury decide any of these questions. Id. In the end, Judge Patel found that an equity stake theory "runs afoul of [the] command" that damages should only be the amount that adequately compensates infringement. Id. at 6.

We have found only one case where a court permitted an equity stake approach to go to a jury. See SIBIA Neurosciences, Inc. v. Cadus Pharmaceutical Corp., No. 96-1231 (S.D. Cal. 1999), rev'd on other grounds, 225 F.3d 1349 (Fed. Cir. 2000). In that case, the jury found infringement of a biotechnology patent and awarded $18 million in damages, including a 4% equity stake in the infringer as of the date of first infringement (valued at $1.6 million). Over protest from the alleged infringer, who attacked the patentee's equity stake analysis on the same grounds discussed above, the court allowed the jury to hear evidence about this damage theory. Because the Federal Circuit found on appeal that the asserted patent claims were invalid, it nullified the entire damages award, including damages awarded under an equity stake approach. Thus, no equity stake-based reasonable royalty damages were actually paid.

In conclusion, patentees who employ an equity stake analysis to recover reasonable royalties will usually be disappointed because, in the words of Judge Patel, "an equity stake theory is too far divorced from reality to be a legitimate inquiry under the law." Only patentees in fields such as biotechnology, where equity-for-patent-rights licenses are more common, may succeed with an equity stake approach, and even then, success is not assured.

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Marc J. Pernick is a partner, and Sunil R. Kulkarni is an associate, in MoFo's Palo Alto office. They represented SDL in its lawsuit with Rockwell.