(Second Edition)

Kenneth L. Port,  Jay Dratler, Jr.,  Faye M. Hammersley, Esq.,  Terence P. McElwee,
Charles R. McManis, and Barbara A. Wrigley

On-Line Problem Supplement
Copyright © 2005   Carolina Academic Press.   For permission, see CMI.

Chapter 5

Problem 5:  IP Valuation, Risk and the Negotiation Process

1.  Contair is considering competing offers for its VRS voice recognition software from two companies—GNN, Inc., the world's largest automobile manufacturer, and Assist, Inc., a start-up company created to exploit new technologies that can help disabled persons to drive.  GNN, which demands an exclusive, worldwide license, has offered a running royalty of 5% on net sales of the VRS option on each vehicle so equipped.  Assist also prefers an exclusive license and has offered a 25% interest in Assist as a lump sum, up front royalty, which you have rejected.  In the alternative, Assist has proposed that Contair and Assist form a joint venture, each contributing its intellectual property to the venture and sharing any profits equally.  The table below illustrates a hypothetical comparative analysis of the GNN and Assist offers based upon the following strategic information you were able to obtain for the negotiation:
    The U.S. auto market is about 15 million new vehicles per year; the foreign (non-U.S.) market is another 20 million. GNN's market share in the U.S. is 33%; in the foreign market it is 40%.
    GNN estimates the initial cost of designing and manufacturing the VRS option package at approximately $3,500 per car, and the initial retail price as $5,000.  Thus, 5% royalties proposed by GNN would net Contair $250 for every car sold with VRS installed.
    The Assist proposals present special problems.  Although its IPO was a great success and it has considerable capital, Assist is not an automobile manufacturer, so the Contair/Assist joint venture would need to sell VRS to the major automobile manufacturers, each of whom would rather develop its own competing product.

Table of Projected Income, Expenses, and Profit

Assist Joint Venture
GNN Exclusive License
Proposed compensation 50% equity, no established market value 5% on net sales of VRS
Profit on worldwide sales Using GNN's sales figures and assuming 1% market penetration, $195 million in gross profit (assuming same gross margin as GNN's) $32.5 million in royalties

Short-term costs to Joint Venture of R&D, product development, marketing, regulatory approval, and capital equipment:

$55 million per year

$1 million per year
Initial annual profit $70 million (50% of JV) $31.5 million

To better assess each offer, you commissioned the following risk analysis from an outside consultant:

Table of Risk Factors and Adjustments

Assist Joint Venture
GNN Exclusive License
Total estimated profits, next 10 years $7 billion $1 billion
U.S. patent issues 85% 85%
Risk-adjusted value $5.95 billion $850 million
Technology is commercialized at affordable retail cost 60% 85%
Risk-adjusted value $3.57 billion $722 million
U.S. Dept. of Transportation regulatory approval 50% 50%
Risk-adjusted value $1.78 billion $361 million
Public acceptance 50% 65%
Risk-adjusted value $890 million $235 million
Public preference 65% 85%
Risk-adjusted value $578 million $199 million

In addition to the above risk factors, how might the following developments affect royalty projections?
    *  Any deal will require a significant contribution of time and effort from Kuruma, the inventor.
    *  The joint venture will require financial, managerial, and marketing support from Contair estimated at $50 million per year, in addition to the $55 million of expenses estimated above.  Furthermore, Contair would have to contribute one of its best high-level executives to become the joint venture's CEO.
    *  You have heard a rumor that the U.S. Defense Department would like VRS for military use and is considering a compulsory license of VRS to one or more major defense contractors, one of whom is GNN.
    *  Contair's CEO wants GNN to pay an additional royalty on the increase in GNN's overall market share attributable to VRS.  Could such a royalty be fairly determined?

2.  If the Defense Department were to take VRS via eminent domain (See Hughes v. United States), which of the offers, if any, would constitute the best evidence in court of a "reasonable royalty"?

3.  GNN has tendered the following royalty language in its proposed exclusive license:
    Net Sales as used herein means GNN's billings for products produced less the sum of credits on return goods, sales, use and excise taxes, outbound transportation prepaid or allowed, and packing charges included in the amounts received.  Products shall be considered "sold" when billed out or invoiced.
* * *
    Royalties shall be payable to Contair for every VRS product sold by GNN as follows:

      (a)  5% of the net sales of each unit;

      (b) One-fourth of the royalty received by GNN for every sub-license to other manufacturers;

      (c)  For derivative works of VRS prepared by GNN on new VRS-related products, the parties shall negotiate in good faith a royalty amount that fairly compensates Contair for its development costs and the future income potential of the Products.

      (d)  For each VRS product sold other than for use in land vehicles, 1.5% of net sales.
Based on all the information available, should Contair accept GNN's latest offer?   What changes and/or additions should Contair make in any counterproposal it makes in an attempt to get a better deal?  Isn't it true that "but for" the VRS software, GNN has no voice-controlled vehicle to bring to market at all?   What does that tell you about the economic value of VRS?

Draft Contair's counter-proposal to GNN taking into consideration legal, business and economic justifications that Contair's president could advance in negotiations to justify the counterproposal.  Assume that you have a market study that predicts GNN will increase its U.S. market share by 15% and its share of the foreign market by 10% as a result of having VRS-equipped vehicles.

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