Trade Secrets: What Are They Worth?

Owners of intellectual property are often rightfully curious as to the value of their IP.  Anyone who has tried to assign a value to patents outside of a litigation context and in the absence of robust licensing market for similar patents knows very well how challenging it is.  Figuring out the value of trade secrets, on the other hand, is not (always) as hard.  This is because what most trade secrets “are” on an ontological level are more readily ascertainable that patents.  What is in the bills of materials; who are on the customer list; the process for connecting the machinery; the history and results of failed experiments; and last year’s profit margins are all knowable by a company in a way that the scope of a patent is not.[1]  Because of this fact, it is much easier for a company to correlate a particular trade secret to the value-add that the trade secret brings to the company’s business.  Moreover, whether a trade secret is in fact a protectable right is much more in the hands of the rights-owner that a patent.  Patents, globally, have a high invalidation rate from third party prior art,[2] whereas whether trade secrets are generally invalidated only when the owner did adequately protect the trade secret as a secret.

What is involved in determining the value of a trade secret?  The first place to start is a determination of what the company believes the secret is worth based on how the secret is used by the company.  Such an analysis includes determining: (a) the cost to the company (today) to replace the trade secret if the company no longer had access to it;[3] (b) the historical cost of creating the trade secret; (c) the cost of maintaining the trade secret;[4] (d) the future anticipated income and present value of cash flows correlated to having the trade secret;[5] (e) the marketplace value of similar assets in transactions;[6] and (f) the value of the company without the trade secrets.   Once the company has a good sense of how much it values the asset, that valuation must be cross-referenced to the economic remedies available should that asset be misappropriated.

A good place to start the remedies analysis is by understanding those available under the Defend Trade Secrets Act (DTSA).  While not preempting existing state law, the DTSA created a unified standard for trade secret misappropriation remedies.  Building upon prior state law frameworks, the DTSA provides similar definitions and remedies (injunctions and damages) for trade secret misappropriation.  One new remedy the DTSA adds to the mix is civil seizure to prevent the spread of the trade secret in order to mitigate harm to the proprietor.

Under the DTSA, the court may also award damages for misappropriation based on (i) actual loss; (ii) any unjust enrichment not addressed in damages for actual loss; and (iii) “damages caused by the misappropriation measured by imposition of liability for a reasonable royalty for the misappropriator’s unauthorized disclosure or use of the trade secret.”[7]  The DTSA makes clear that remedies apply to unauthorized disclosure as well as use of the trade secret.  The DTSA also allows double damages for willfully and malicious misappropriation.  Finally, “if a claim of the misappropriation is made in bad faith, which may be established by circumstantial evidence, a motion to terminate an injunction is made or opposed in bad faith, or the trade secret was willfully and maliciously misappropriated [the court can] award reasonable attorney’s fees to the prevailing party.”[8]

What follows is some more detail on the three approaches to economic remedies: actual damages, reasonable royalties, and unjust enrichment.  When applying these theories to real world circumstances – for example in litigation or for tax accounting purposes – it is generally very useful to work with a qualified economist/accountant as well as an experienced attorney.  That said, a general understanding is very useful to non-experts as they get the right framework for further analysis.

Actual damages can include the owner’s lost (net) profits or the misappropriator’s profits attributable to the trade secret.  Other approaches are based on how the owner was affected by the misappropriator’s conduct.  For example, if the owner was formerly able to command a higher price for its product by using the trade secret, and disclosure eroded the price, the trade secret owner may recover losses attributable to price erosion.  The owner may also be able to recover any increased costs caused by the misappropriation, including marketing and advertising costs to recapture the market share taken by misappropriator.  Future profits based on historical data or the fair market value of the trade secret often, can also be recovered.

In some circumstances lost profits-type analyses may fail to reasonably compensate the trade secret owner for the misappropriation.  In such circumstances, a reasonable royalty might be used.  A reasonable royalty, as in patents, is constructing by imagining a hypothetical[9] negotiation for licensing the trade secret between the parties at the time infringement began.  Some or all of the following factors are used to determine the rate: (1) the owner’s royalties for (voluntarily) licensing the trade secret to other parties; (2) rates the misappropriator paid to license other comparable technology; (3) the nature and scope of how the misappropriator used the trade secret; (4) the owner and misappropriator’s commercial relationship; (5) any increase in sales of the misappropriator’s non-infringing products or services resulting from using the trade secret in infringing products or services; (6) the product or service that uses the misappropriated trade secret’s profitability, commercial success, and popularity; (7) any advantage that the illegal use of the trade secret provides; (8) how the infringer used the trade secret, and any evidence proving that use’s value; and (10) the portion of the profit credited to the trade secret, the manufacturing process, business risks or significant features the infringer added.  Using these factors, the court attempts to reach a royalty expressed either as a percentage of the misappropriator’s sales, a per-unit amount, or a flat sum.

Unjust enrichment seeks to return the benefit a misappropriator received from the unlawful misappropriation. Simply put, the trade secret owner receives the portion of the misappropriator’s profits attributable to the misappropriation. The trade secret owner must connect the trade secret to the misappropriator’s profits either in the production or promotion of the misappropriator’s product or services, and assess the net profits from the its acts.  Unjust enrichment can include compensatory damages as a substitute for—or in addition to—lost profits.  These include the costs to develop the trade secret; the time and costs saved by the misappropriator from not having to develop its own method (“head-start damages”); diminished value of owner’s business or stock; and a reasonable royalty, based either on the actual royalties paid to the owner or a hypothetical royalty as discussed above.  In some circumstances, the owner may recover damages for acts outside of the United States.

Establishing a value for a company’s trade secrets is an important component of a successful trade secret audit.  Once values are established, companies will better understand the sources of their competitive advantage.  Additionally, there are many ways that companies may be able to leverage the value of their trade secrets beyond their use in internal company products or services.   I will discuss various approaches to trade secret monetization in a future article.

David L. Cohen, president and founder of David L. Cohen, P.C. was former in-house counsel at Nokia and former Chief Legal IP Officer at Vringo.  His law firm focuses on outsourced IP counsel services including: SEP licensing; F/RAND and anti-trust compliance; offensive and defensive patent licensing and litigation management; IP and public markets concerns; outside counsel management; agreements; and trade secret auditing and protection.  Through Kidon IP corp., David also offers: IP and standards white-spacing to guide R&D, patent brokering, patent review and valuation services, IP services for M&A, and global IP portfolio building.

[1] Construing the scope of a patent’s claim is hard, and is usually the most contested part of any infringement dispute.  Even district court judges get it wrong.  A 2012 study notes that while US reversal rates are getting better, it is still the case that 20% of construed claim terms are reversed (down from 40% in 2004).

[2] See, for example this study finding a close to 80% overall invalidation rate in Germany.

[3] This is not the case of misappropriation.  Rather it postulates a situation where the secret is lost to all, e.g., the only computer storing a customer list is irreparably damaged; the sole engineer who knows how to configure the company’s manufacturing process passes away; etc.

[4] This includes costs associated with any best practices (e.g., security measures) to keep the secret, secret, but can also include costs required to keep the value current.  For example, with things like customer lists and competitive intelligence there is a cost associated with keeping the list current and relevant.

[5] This analysis is akin to an apportionment analysis in patent damages, but made much easier since it is applied to the owner’s own products or services.

[6] In fields where licensing is not common such an analysis may require making an analogy to products/services that are not direct substitutes for the trade secret, e.g., the cost to have a third party use its technology to manufacture a product or a third party to perform marketing services conduct marketing.

[7] Section 1836(b)(3)(B)(i)(I), (II), (ii).

[8] Section 1836(b)(2)(D).

[9] Hypothetical with a dose of fantasy, as the law presumes this hypothetical negotiation occurred and that the owner, who ordinarily would not license his trade secret to the misappropriator, did so willingly for a bargained-for price.