Saturday, August 11, 2012

What Apple's 2010 $30-per-unit licensing proposal to Samsung means for Android in 2012 and beyond

On Friday afternoon, AllThingsD's Ina Fried was first to publish a presentation of a licensing proposal Apple made to Samsung on October 5, 2010 -- six and a half months months prior to suing. This is the most spectacular revelation of the ongoing trial. The slide deck was referenced by Boris Teksler, Apple's director of patent licensing and strategy, in his deposition on Friday.

AllThingsD also published an August 2010 Apple presentation that listed dozens of patents Samsung allegedly infringed. Most of those patents have not (yet) been asserted in any litigation.

The structure of what Apple proposed in 2010 is pretty straightforward. Depending on the type of device, Samsung would need to license more or fewer patents. Apple was primarily interested in working out a solution for devices of the "mobile computer" category: iPhone-like smartphones and iPad-like tablets. For this device category, Apple proposed a $30 per-unit royalty, except that for the first two years, the per-unit royalty per tablet computer would have amounted to $40. Those two years have more or less passed by now anyway. Samsung was given options to lower the $30 amount by qualifying for "discounts":

  • 20% ($6) in exchange for a cross-license to Samsung's own patent portfolio

  • 40% ($12) for "Apple-licensed operating systems" (Windows); this is irrelevant to the operating system currently at issue in the dispute, which is Android

  • 20% ($6) for the use of processors with a license from Apple; the purpose of this discount would have been to avoid "double charging"

  • 20% ($6) for "not using Apple's most proprietary features (e.g. FaceView) & migrating its industrial design away from iPhone/iPad"

Relevance to ongoing trial

The offer was made under Federal Rule of Evidence (FRE) 408, which applies to confidential settlement negotiations and limits the ways in which Samsung can use this proposal in litigation. The fact that Apple was willing to extend a license at all can be used as an argument against Apple's claim of irreparable harm and the inadequacy of monetary compensation, but this doesn't mean that injunctive relief is 100% unavailable. In his testimony, Mr. Teksler stressed that there are patents that Apple is not willing to license at all because it believes only those making "knock-off" products would infringe them: "It's what we don’t wish to share and don't want others to mimic."

Samsung will probably hope that the jury is not going to award Apple a reasonable per-unit royalty for past infringement of a small number of patents that would represent a seemingly-disproportionate share of the $30/$40 portfolio royalty Apple proposed in 2010, but damages and settlements are different issues. The fact of the matter is that the parties did not strike an agreement on the basis of Apple's 2010 proposal, and Apple is not bound by it in any way today.

Discrepancy in Apple's valuations of its own portfolio and Samsung's

Here's a particularly interesting sentence from Apple's presentation (click on the image to enlarge or read the text below the image):

"Since Apple's paradigm of an advanced smartphone won -> Apple's portfolio will become the most important and most valuable part of the IP stack for the next decade."

By contrast, Apple notes in its presentation that two thirds of the patents Samsung brought to the negotiating table are standard-essential patents, and the others are (also) typical component supplier patents. In the ongoing litigation, Apple proposes a royalty of half a cent per standard-essential patent per device.

The "20% discount" that Apple offered Samsung in October 2010 for a cross-license appears bigger than it actually is. First of all, this is a typical bargaining chip. If Samsung had negotiated, Apple would likely have been willing to increase this percentage, which would have been more flattering to Samsung than anything else and enabled Apple to maintain a high price point for its own patents. Also, the proposed deal is structurally the opposite of a deal on an equal footing. A cross-license deal between partners that have portfolios of similar value would either be royalty-free or the parties would agree on certain per-unit amounts, in which case one party would end up the net payer but it would depend on actual volume who pays more. If a patent holder, as Apple did in this case, proposes a mere adjustment of a royalty stream going in only one direction, this is a clear indication of an unbalanced relationship.

To be clear, the 20% figure does not mean that Apple believes its own patents have five times the value of Samsung's portfolio. That would only apply if both parties had the same sales volume (and if the negotiating tactics mentioned in the previous paragraphs didn't play a role). The more products a party needs a license for, the more exposure it has to the licensor's portfolio. So let's look at it from the exposure angle:

When Apple and Samsung were discussing smartphones and tablets in October 2010, Apple's assumption almost certainly was that its exposure was going to be far greater than Samsung's. If, for example, Apple thought that it was going to build four times as many "mobile computers" (smartphones + tablets) as Samsung, then a discount of 20% on Samsung's royalties to Apple would actually mean that Samsung's patents are valued, on a per-device basis, at only 5% (one twentieth) of Apple's. That's because the 20% discount would provide Apple with a license to four times as many devices in need of a license. But Samsung has gained far more market share than was foreseeable at the time. If it's true that Samsung sold twice as many smartphones worldwide during the last calendar quarter as Apple (though anticipation of the iPhone 5 launch likely plays a role), then Samsung's exposure is now twice as much as Apple's in the field of smartphones. If volumes weren't affected by the license deal (I'll talk about impact on market share further below), the 20% discount would mean that Samsung gets a license for twice the number of devices, and this means that Apple's patents would be valued at 2.5 times the value of Samsung's, not 5.0 times. (For tablet computers, there's still much more exposure on Apple's side, but given that Samsung primarily asserts 3G patents against Apple, WiFi-only iPads wouldn't count, or at least not to the full extent.)

Proposal was based on unique partnership

Another important sentence from Apple's presentation is this one (click on the image to enlarge or read the text below the image):

"Because Samsung is a strategic supplier to Apple, we are prepared to offer a royalty-bearing license for this category of device"

Obviously, Apple could have told Samsung that this is a special deal only because of a unique kind of relationship, and could still have offered a similar deal to Motorola, HTC and others. Also, I think both Apple and Samsung are clearly more interested in their market shares and profits in the smartphone and tablet computer markets than in the supplier relationship. There would be some switching costs for Apple, and other manufacturers may not be able to beat Samsung on price and/or reliability, but ultimately, Apple could do without Samsung, and Samsung would rather lose Apple's low-margin component business and be the market-leading device maker under its own brand. Still, there's no question that Samsung is in a much better position than other Android device makers to get a deal with Apple at all. Others would have to bring powerful patents of their own to the table, or offer Apple a deal that is too good to refuse, also with a view to potential antitrust issues that could come up if Apple never licensed even its most fundamental multitouch patents to anyone in order to monopolize the market.

Strategic implications for market share

At first sight, all intellectual property licensing offers and deals are just about money changing hands, but the money that changes hands under such deals can have major strategic implications.

Let's assume, for the sake of the argument, that Samsung agrees to pay Apple $20 per Android smartphone, and let's furthermore assume that whatever Apple would pay Samsung for its mostly standard-essential patents would be a strategically negligible fraction of that amount. Let's also assume an average pre-tax reseller margin of 20%, and a sales or value-added tax (which varies from country to country, or state to state) of 10% on average (it may seem high by U.S. standards but is very low by European standards).

If Samsung wanted to pass the licensing cost on to consumers in order to maintain its per-unit gross profit, consumers would face a price increase of $25 ($20 + margin of $5) before sales tax, and of $27.5 after sales tax. Alternatively, Samsung could decide to reduce its margins to offset some or all of the incremental licensing cost.

If both companies sold an equal volume of products, Apple could reduce the price of each of its own products by $27.5 since its patent licensing income could be used to pay for R&D efforts that would otherwise have to be paid for by product sales.

As a result, an Apple product that used to cost the end customer $500 (a price point that suggests it is sold without a telephone contract) would cost $472.25, while a Samsung product that used to have the same $500 price point would cost $527.5. The relative price difference would amount to twice $27.5, or $55.

With that kind of difference, there can be no doubt that volumes would change unless Samsung has innovative features or other premium benefits to offer. If Samsung sells less, then the price difference between the two companies is less, but Apple will gladly sell more.

Another issue here is that if Samsung accepted this deal as the first Android device maker to do so, it would also become less competitive vis-à-vis Motorola, HTC, LG, Amazon and others. But if Apple successfully enforced some of its patents against those other device makers in court, the license deal could actually help Samsung expand its market share at the expense of other Android device makers.

It's key to consider that Apple isn't the only patent holder to claim that Android infringes his rights. Most Android devices sold in the U.S. come with a royalty-bearing patent license from Microsoft. Other large companies are also asserting intellectual property against Android. Last month I wrote that publicly-traded companies collectively worth more than $1 trillion are suing Android companies. From a competitiveness point of view, Apple would benefit not only from its own collection of significant royalties on Android devices but also from the fact that Apple will be in a better position than the Android adopters among its rivals to license patents from third parties at competitive rates. A company like HTC, for example, will likely end up paying more to Nokia, on a per-device basis, than Apple.

In strategic terms, only license deals involving a per-unit royalty (or a percentage on sales) are important. One-off payments such as $3 million to one patent troll and $10 million to another won't have serious impact because those figures are just a cost of doing business and don't affect product pricing to any significant degree. Most patent holders that start litigation in the United States are just interested in "nuisance value" (they will settle for less than the cost of litigation). The number of strategic patent holders who are in the position to collect significant per-unit royalties is fairly limited, so if Apple doesn't impose a significant per-unit patent licensing cost on Android, it can't count that too many others will do this.


The purpose of this post was not to try to estimate what Apple's demands and Samsung's position on them may be at this stage. There's no question that they are worlds apart, though one day they may indeed reach an agreement.

What can be said with certainty is that a lot of things have changed -- fundamentally, in fact -- during the two years since Apple made this proposal. It's still the most exciting disclosure of the ongoing trial. But it's also important to understand that some of the underlying assumptions, such as the parties' sales volumes, no longer apply.

The terms that parties finally agree upon are influenced by various factors. Negotiating skills can play a role, though it's a safe assumption that both Apple and Samsung have a level playing field in that regard -- and they do a lot of business with each other, so they know how to agree on pricing issues.

A far more important factor is the relative strength of the parties based on the state of litigation. Apple's dispute with Samsung is still in the early stages. The case that is on trial now may be the end of the beginning, but no more than that. Even in California, Apple has another litigation going already, and it has withdrawn patents from the first lawsuit without prejudice and can reassert them. This dispute started less than 16 months ago. By comparison, Apple filed its first lawsuit against HTC more than 29 months back. Even Apple and Motorola will soon (in less than two months) "celebrate" their second litigation anniversary. Apple's biggest problem in its disputes with Android device makers is that things take time, presumably an awful lot of time from Apple's perspective. In the two most important jurisdictions, there are different reasons. Patent litigation in the U.S. is generally slow, and the venues (such as the ITC) and judges (such as Judge Posner) that have so far been willing to adjudicate cases quickly weren't particularly plaintiff-friendly, while Apple's problem in Germany is that the courts, which are plaintiff-friendly and very fast, tend to have too much doubt about the valid scope of its asserted patents and have stayed most of Apple's cases for the duration of parallel invalidation proceedings (from which some of those patents may come back with a vengeance within a year or two).

If Apple's management gets nervous about the passage of time and decides to lower its demands at some point in order to be able to announce some settlements, the kinds of terms that Apple asked for in October 2010 won't be even remotely realistic. But if Apple stays its course, it may at some point be able to command similar terms, or it may even find that it's preferable to enforce more patents and ensure product differentiation rather than settle.

In strategic terms, Android is a much bigger problem for Apple today than it was two years back. And within the Android camp, Samsung has turned out to be the undisputed leader among device makers, though Google (following its acquisition of Motorola Mobility) may take some market share away from Samsung in the future. Also, Amazon's aggressive pricing poses a particular threat to Apple, especially in the tablet market.

Apple's October 2010 proposal to Samsung provides previously-unavailable insights into Apple's strategic approach to these issues. It also serves to show that analysts who claimed that companies like HTC could get a $5-per-unit deal done with Apple were completely off base. I believe many financial analysts will now also be more cautious about the royalty levels they assume for other deals, also as far as Microsoft's royalty-bearing license agreements are concerned. Finally, the publication of Apple's proposal supports my long-standing theory that Apple is primarily interested in market share, not patent royalties: as I explained in this post, a high royalty figure would also have an effect on a given licensee's competitiveness.

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