November 14, 2014

Cellular FRAND royalty levels

What's a fair and reasonable royalty for a cellular Standards Essential Patent (SEP) portfolio license, and how is it determined? This sounds like a simple enough question, but actually it's not. In this post I'll share some of my experiences and thoughts in relation to this much debated subject.

To tackle this subject, I believe one should start by assessing values. Let's first look at the value of the cellular standard to a mobile phone. To say that the cellular standard itself is absolutely crucial for a mobile phone is hardly controversial. In fact, the cellular capability defines the phone as a commercial product: an iPhone wouldn't be an iPhone without cellular capability. Apple is able to sell its iPhone at a price of several hundred US$ more (!) than the price of its iPod, a very similar product but without cellular capability. This price difference demonstrates the tremendous value of adding standardized cellular technology to an otherwise similar device.

So yes, the cellular standard is definitely fundamental to a mobile phone. But what about a cellular SEP portfolio, what's the value of that? Before looking at a given SEP portfolio though, let's start by considering the cumulative. What's the license value of all SEP portfolios taken together. After all, that's the ultimate concern of the Original Equipment Manufacturer (OEM) selling the product. How is this "total mass" of cellular SEP portfolios related to the standard?

To address those questions, let's first assume that we'd like to create a brand new cellular 5G standard as a successor to 4G, but - for whatever reason - we want it to be completely void of SEPs. What could that correspond to in practice? Well, since patents live for up to 20 years, only standardized technical solutions older than 20 years would be completely "safe" to include. So we might actually end up selecting the first (1990) version of GSM (2G) as our 5G standard. This certainly feels like a very bad idea indeed. But why exactly? Because a 2G standard can't possibly fulfil the technical requirements placed on a 5G standard. The example might seem a bit extreme, but I want to illustrate an important point. The value of a standard strongly relates to new pieces of technology added to it. This is because a new cellular standard is subject to more harsh technical requirements - with respect to supported data rates, delay, capacity, flexibility, new services, efficient data compression and so on -  than previous standards. Having own experience from standardization, I know that these new requirements are there to make the new standard as future-proof as possible. While many consumers may accept to change phones quite often, mobile network operators make tremendous investments in infrastructure and will hardly be amused about having to replace it after only a couple of years because it's gone obsolete. In order to fulfil these tougher requirements of a new standard, brand new technological innovations are very often required, and these are also typically patented. So, while all cellular SEP portfolios together may not be strictly equivalent to the standard itself, they represent the value of the standard since they include the technologies that allow the standard to fulfil its specific requirements.

So how about the license value of all cellular SEP portfolios in terms of actual money? And who decides it for that matter? Here I'd first like to point out that the consequences of "wrong" pricing can be tremendous. If too high, then consumer demand will suffer. If too low, then incentives for standards innovation will suffer. But in fact, we can all see mobile device sales and usage expanding strongly and new state-of-the-art standards continuing to be created. So clearly, the market must have somehow managed to settle at a balanced pricing. But at what level? In my experience from working with cellular SEP licensing for quite some time, I can see an established cumulative royalty cost for all cellular standards up to 4G somewhere around 10% of the OEM selling price of a mobile phone. Note that this is not my opinion of what it "should" be. This is the reality that I see.

I'd like to make two important comments in relation to this 10% figure:

1) High-end phones often have
advanced screens, cameras etc. that may be argued to be unrelated to the cellular standard. According to such argument, the percentage-principle leads to an unfairly high royalty for these products. But in reality, those attributes actually increase the usage of the cellular standard. In fact, the 3G and 4G standards were even specifically developed with the performance of such devices in mind. So the value of at least 3G and subsequent standards - and hence of all SEP portfolios relevant to those - is higher for high-end phones. Nevertheless, high-end phones are still often subject to "royalty caps" in order to address the perceived concern. Conversely, at the other end of the spectrum, the percentage-principle may cause very-low-end phones to devalue SEP portfolios. In such cases "royalty floors" may be used as well.

2) Most major SEP-holders are practicing entities, i.e. they sell standards-compliant products themselves. When such an SEP-holder offers a license to its SEP portfolio to an OEM, it typically also needs a license to the OEM's SEP portfolio. This is known as a "grant-back" license. In these cases, there will be a "royalty-netting" effect. One party pays a net royalty to the other based on their respective SEP portfolio strengths and net product sales. Therefore, SEP-holding OEMs ultimately pay a lower net cumulative royalty rate than non-SEP-holding OEMs. Importantly, this is not a violation of the Non-Discriminatory ("ND") part of FRAND since the value of a license is transferred back in place of some royalties. An OEM either makes large investments in basic R&D - resulting in innovations and patents - or pays full license fees. After all, there are no free lunches. 

Some OEMs new to the market have recently started to argue that the cumulative royalty should instead be no more than a fraction of the cost of a "baseband chip". This is a component inside the mobile phone that includes cellular connectivity functions. Such a change would actually make the cumulative royalty about an order of magnitude lower than what it is today. This argument doesn't make sense to me because it doesn't go to the value of using the cellular connectivity, but rather to the cost of a component necessary for that connectivity. Patent damages, i.e. the royalties determined by a court, are based on the value for the use made of the invention (e.g. in the US according to 35 USC 284).

As a parallel, one could look at a movie DVD. The entire component and manufacturing cost is probably no more than US$0.50. Yet nobody would seriously argue that the IPR value for the product as a whole, including the movie script, production, direction, screenplay, music, acting and so on, should be a fraction of that amount. It's the value of the IPR to the end product that's important. Arguing for a 90% de-valuation of cellular SEPs when there's been an established and well-working SEP valuation regime in place for decades seems irrational to me and would certainly disrupt the market balance, and for sure not in favour of innovation.

Having discussed the cumulative royalty at some length, I can now return to the original question:
What's a fair and reasonable royalty for a given cellular SEP portfolio license, and how is it determined? Or in other words, how much should a given SEP-holder obtain within the cumulative budget and how is that fraction actually decided?

Most market participants agree that there has to be some form of proportionality at play here, in keeping with general principles of fairness and reasonableness. SEP-holders with "stronger" portfolios are entitled to larger royalty fractions. But using what metric? Counting SEPs? Valuing the SEP portfolios in terms of "innovation value"? This is not an easy question. Still, the actors in the market - the SEP-holders and established OEMs - over time "get to know" the overall value of each other's portfolios. They do this through license negotiations as well as by gaining knowledge of each others' R&D, standardization activities and patenting quality. The main challenge arises for someone who's inexperienced with this market.

Take as an example a willing licensee OEM new to the market and without standardization involvement or SEPs. It needs to allocate around 10% of its product price to cellular SEP license royalties, but how does it determine the fractions? Are there ways to find at least estimates of the distribution of those 10%? Well there are indeed some commonly discussed methods, which I'll briefly explain here:

1) ETSI IPR database declarations

Due to its apparent simplicity, it's very tempting to look at various patent holders' SEP declarations on ETSI's IPR database and to estimate royalty fractions based on them. However, such results are actually totally unreliable, since neither the declarer nor ETSI has any obligation to verify essentiality. The original purpose of the database was to ensure that there would be no hidden surprises in terms of unknown patents turning up at a later stage as SEPs. For this reason, patents "believed" to be essential could be declared, even though they might turn out not to be. As a result, significant over-declaration regularly takes place. This leads to gross over-estimates of the total SEP holdings and distorts the distribution of SEPs. So at best, this kind of study may be used to get a picture of potential SEP-holders rather than estimates of actual SEP holders' relative fractions.

2) Third party evaluations

Some instead turn to SEP evaluations performed by third parties. Unfortunately many such evaluations tend to be based on "keyword searches" in patent databases, which make them about as useful as horoscopes. More serious evaluation attempts actually try to look at the patent claims in some detail and compare them to the standard. Although those evaluations could in principle give indications of actual SEP-holder fractions, they also tend to suffer from reliability restrictions. Besides the obvious concern of bias, their accuracy is also limited due to time and cost constraints in combination with the large mass of potential SEPs to go through.

3) Accepted standards contributions
A newer method, originally explored by Ericsson, is
not to look at patents at all (!), but instead at "accepted standards contributions" to the 3GPP standardization process. That essentially refers to technical solution proposals accepted into the standard. It's assumed that this metric has a strong correlation with SEP-ownership over time and that significant standards contributors all have similar "patenting rates" and "patenting quality". Since these assumptions are actually quite reasonable and the contribution data is all publicly available, this method is potentially accurate. Interestingly, it also aligns itself with incentivizing technical contributions to the standard. However, with this method becoming more widely used, its accuracy may suffer in the longer term since some standards-participants can be tempted to make numerous proposals on relatively trivial technical solutions solely to increase their "accepted contribution rate".

In practice though, these kinds of estimations are mainly used only as tools to roughly gauge the SEP portfolio landscape. Our new OEM will obtain the most accurate information about the SEP-holders' portfolios and FRAND royalty requests simply by conducting licensing negotiations with different SEP-holders in parallel. In this way the OEM can scrutinize the different SEP portfolios down to whatever detail it sees fit. This may be done through examining and discussing so-called claim-charts detailing the patents' relation to the standard in question. If needed, OEMs sometimes even employ external experts for such evaluations. Over time, these negotiations typically do result in a fair and reasonable royalty partitioning.

In this context I'd also like to point out that OEMs don't always fully appreciate the restrictions that the non-discriminatory ("ND") part of FRAND places on the SEP-holder. Many SEP holders have a multitude of already signed SEP portfolio license agreements in place and simply can't discriminate against existing licensees in favour of a new OEM. It's also inappropriate for a new OEM to compare itself with unwilling licensees - i.e. those essentially not wanting to pay anything - in terms of how much royalty it should pay. Doing so further exacerbates the "patent hold-out" problem discussed in my previous post.

In this post I've tried to describe the realities surrounding cellular SEP royalty levels for mobile phones, based on my own SEP licensing experience. Under the FRAND regime, I believe that the market has managed to strike a balance between innovation value and consumer value and established a cumulative royalty rate at around 10% of the mobile phone OEM selling price for all cellular standards up to 4G. I'm aware that some still believe that cumulative royalty rates are too high, that there's too much litigation going on and that radical changes to the system are urgently needed. I'll end this post by addressing these issues one by one.

Are cumulative royalty rates "too high"? I can't really tell for sure, but at least I don't see any obvious support for that notion. As I mentioned in an earlier post, consumer choice and new future-proof cellular standards hardly seem to be lacking. Also, among the top-10 global mobile phone OEMs of today, virtually none of them had sold a single mobile phone only a decade ago, and some of them didn't even exist a that time. So at least entry barriers are low. Margins may be getting lower for some OEMs, but that can be an effect of fierce global competition thanks to those low entry barriers (!) and perhaps partly even the result of patent hold-outs, i.e.some other OEMs paying  - ironically - too low (i.e. zero) cumulative royalties.

Is there "too much litigation"? Well, with some high-profile litigation cases going on in recent times, one might think that most cellular SEP portfolio license negotiations end up in court. But actually, this is a classic example of an availability error - "if you see it, it must be common". The truth is that most such negotiations are successfully concluded in good faith, far from the limelight, and only a small fraction end up in court. Actually, the most visible litigation case, Apple-Samsung, is fundamentally not about SEPs at all but rather about Apple's attempts to protect its proprietary smartphone user interface functions.

Are changes to "the system" needed? Well no system is perfect, so improvements are always needed. For example, new ideas for improving the transparency of the various fractional ownerships of the total SEPs could be welcomed, especially by new OEMs.  But I can't see an obvious need for any radical changes, since the FRAND technology sharing regime largely works the way it's supposed to work. Policies should continue to encourage successful cellular SEP portfolio licensing through good faith FRAND negotiations, which is still the norm today as it has been for decades. It's important that the cumulative rate and SEP portfolio proportionality principles are respected by all market participants. Any policy adjustments should work within the current framework and in a balanced way continue to make sure that it's difficult for individual SEP-holders to seek too much royalty as well as for OEMs to hold out for too little royalty.