Asset-based lenders have grown increasingly accustomed to using high technology and consumer electronics inventories as components of a borrowing base. These assets, when carefully monitored for potential technological and economic obsolescence, are often a reliable form of collateral. However, maintaining and maximizing value is increasingly contingent on an entirely different asset class –- intellectual property (IP).

From smart toothbrushes to solar-powered contact lenses, an increasing number of electronics are connected to the cloud, enabling devices to do seemingly everything, from telling you which teeth to brush longer, to monitoring blood glucose through your eye. This convergence of hardware and IP has rendered traditional views of many high tech inventories obsolete because hardware functionality is increasingly dependent on data communication between the device and cloud-based services. Instead, lenders must value not only the hard assets but also consider whether to secure IP, how to maintain access to it and the expenses associated with managing it to ensure collateral coverage.

Most consumers are familiar with wearables from companies such as Fitbit and Garmin, connected speaker systems from Sonos and Bose, and personal assistant devices such as the Amazon Echo. But non-consumer connected devices are also gaining traction. Manufacturers from industries such as medical and point-of-sale equipment are increasing their product offerings that feature hardware with cloud services.

The advantages of these devices for an end-user are numerous, including the potential for increased functionality through software enhancements while using the same hardware. The downside, though, particularly in a situation of distress, is that without these cloud-based services, functionality of the device is often compromised or taken away entirely.

A recent example involved the discontinuation of service for the Revolv Hub, a device that, when used in conjunction with the Revolv App on either iOS or Android devices, allowed a user to control all home smart devices, such as Nest, Sonos and Philips Hue, from a single point. When Nest acquired the company, Revolv stopped selling the smart home hub in October 2014, though the Revolv team maintained the product and kept the app online. In June 2016, the $300 hub will cease functioning entirely as Nest announced it will discontinue the service, rendering the hub hardware useless. With that decision, Revolv became the latest example of the power cloud services have over hardware’s value.

This example illustrates a growing risk keeping high tech lenders up at night. But there are proactive steps that can be taken to ease the anxiety. Lenders considering an asset-based facility using an inventory of hardware dependent on cloud services should consider these key points to minimize risk.

1. Look for well-known products with a significant installed base. Consumer electronics from established brands with successful track records are a better option for lenders looking to maximize value and a return in a potential sale. An installed base of end users numbering in the millions would likely maximize the value in an assumed distress scenario since, in many cases, existing users would be likely buyers in a potential sale. Consumer products would likely be a more viable asset class in the current environment compared to enterprise or medical products whose function is of a more mission-critical nature.
2. Ensure access to the IP relevant to the services that are needed for hardware functionality. Without that, there is no assurance that needed services will continue, making a sale of the hardware extremely difficult. The IP needed to ensure the continuation of cloud-based services would include customer data and software, including the smartphone app. In certain cases, another lender may already have a lien against a company’s IP, making it problematic for a new lender to secure the IP needed to ensure continued cloud services. In those situations, lenders against the inventory should have a written agreement with the other lienholder addressing access to IP.
3. Understand the expense and practicality to continue cloud services. In many cases, the expenses to continue these services are manageable and securing the needed technological expertise is straightforward. Rather than host these services on their own servers, companies typically outsource hosting to a third-party provider, such as Amazon Web Services. Doing so lowers overhead costs but also allows for a smoother transition should the company falter. Depending on various factors, including the number of end users, third-party hosting can be expensive, but paring down the hosted applications and services to the minimum needed to continue service can reduce this expense considerably. Likewise, the software development resources needed to maintain the service are often minimal and the function can be outsourced to a software development vendor. Cooperation with the company is key to understanding what these essential services are and, ultimately, what cost per user the lender can expect to maintain the service.

In the coming years, there will be an ever-increasing number of devices dependent on cloud services, and asset-based loans will continue to be a crucial source of capital for high tech companies. However, lenders must adapt traditional lending practices to consider new risks. Partnering with an informed appraiser experienced in multi-asset class considerations can help you understand realistic exit strategies and will go a long way to relieving concerns.