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Banking on IP: An Insider’s Perspective

September 19, 2017, 07:00 AM

Traditional asset-based lenders look to asset classes such a machinery and equipment, accounts receivable, and inventory to form the basis of their lending. Many traditional asset-based lenders could consider intellectual property (IP) as additional collateral for more lending capacity for their customers. IP as an emerging asset class includes patents, trademarks, brands (and the goodwill associated with brands), copyrighted materials (e.g. computer code), designs (e.g. industrial design of products), and trade secrets.

The valuation of this asset class uses similar market-based resale appraisal assessments that traditional lenders are accustomed to, as well as additional methods considering actual or potential royalties or lease streams, or the outright sale of the IP assets or even the company as a whole to a competitor that values the IP. In the event a traditional asset-based lender is unable to leverage this IP asset class due to leverage line restrictions or covenants, an emerging marketplace exists of specialty IP lenders that can advance against this class and leave the other assets available for senior secured financing by their traditional lending compatriots.

Collateral for a New Age

Many smaller entrepreneurial companies struggle to secure the financing they need to grow. According to the 2017 Pepperdine Private Capital Markets Report, for instance, nearly 88% of privately owned businesses report having the enthusiasm to execute growth strategies; yet just 51% report having the necessary financial resources to successfully execute growth strategies.

One reason for the shortfall in finance has been the persistent retreat to a more risk-averse and conservative banking environment. Another reason that is often overlooked, however, is that our economy has been gradually shifting to one in which intangible assets represent a greater share of the overall value of job-creating companies. Lenders are still catching up to this reality. Commercial lending practices still favor businesses rich in tangible assets (such as machinery, raw materials, land, and buildings) to use as security. This is gradually changing, though.

In today’s “knowledge economy,” promising businesses are increasingly built on intangible assets, especially their patents and trademarks. Intangible assets are now estimated to represent at least 84% of the market value of S&P 500 companies. In many cases there is more value in the IP of a business than in its tangible assets.

Chart Showing Components of S&P 500 Market Value

Indentifying and Valuing IP Assets

Like any other form of property, IP assets may be collateralized to raise capital through either cash flow-based or asset-based debt financing. Many businesses simply don’t fully appreciate the market opportunities their IP assets possess, and therefore fail to leverage those assets to secure the finance they need.

For example, companies actively use on average just 10–15% of their patent portfolios, largely due to ineffective IP management. This means companies will often have valuable portfolios of unexploited, unlicensed patents that can be used as collateral for debt finance. IP lenders will be interested in leveraging both patents on products and technologies in active use as well as unused “Rembrandts” sitting in the corporate IP attic.

How is the value of an IP asset, such as a patent, calculated? It is essentially the earnings that can be obtained from licensing that IP asset to one or more other businesses or, alternatively, the market value of an outright sale of the IP asset.

Licensing is an agreement that transfers rights of use to a third party, without transferring ownership of the IP asset itself. Tremendous revenue in the form of a one-time payment or continuing payments, known as royalties, may be generated from such licensing, depending on the strength of the IP asset.

Third-party businesses in competing or non-competing industries may also be interested in purchasing valuable IP outright, as IP acquisitions can immediately enhance the commercial strength and financial value of a business. Currently, we are in a strong buyer’s market for patents, largely because of the bursting of the IP valuation bubble several years ago.

Patent licensing requires expert analysis of the legal and technical quality of a company’s patents, as well as of market conditions of the company’s industry. Some IP lenders employ specialist IP appraisers for the collateralization and securitization of IP assets. Appraisers are costly, though, typically charging between $40,000 and $100,000 for a valuation. Some IP lenders therefore prefer to rely on their in-house legal counsel.

An Insider’s Perspective

Leaders in the industry commonly offer two main asset-based loan structures where the IP assets are patents. The first is for an operating business actively selling products that has some cash flow or is expecting cash flow in the next 12–18 months.

When qualifying a potential borrower, IP lenders generally want to make sure they can implement forced licensing of technologies in the event of default.

The lender can thereby at least ensure the return of the principal. In the case of default by the borrower, IP lenders would prefer not to seek to foreclose on a business and liquidate its assets—although the ability to take control of the company and sell it in its entirety to recover the principal is an important consideration too. Rather, IP lenders generally want to keep the business running as a going concern. Their aim is to utilize the IP assets to generate income by either licensing those assets or, less commonly, by the outright sale of the IP asset or the company itself, without the necessity of going through a bankruptcy process.

The second kind of loan structure available is for patent litigation funding. Here the IP lender also utilizes the IP assets to generate income, rather than seeking to liquidate. The company may be seeking finance for a single patent  or single infringer case, or may be looking to secure multiple-patent, multiple-jurisdiction, multiple-infringer litigation funding. While this represents an important aspect of IP finance, it is not the kind of structure we are exploring in this article.

Minimum Deal Size and Finance Rates

For an IP business loan, the minimum deal size is generally $5 million, significantly higher than for an equipment loan or an accounts receivable loan. This is primarily because of the technical difficulty of understanding the IP asset and its value.

IP is a broad field with many different rates, based on risk, size, and business stage. A loan for accretive growth or acquisition would generally be structured as a four or five-year loan, and would be an interest-only loan in the first 12–18 months. The interest rate might typically be 8–10%. After the initial 12–18 months, the interest would increase, typically jumping to 11–15%, and the loan would amortize out as the company begins generating cash flows from its expansion.

In Conclusion

IP loans represent a complementary source of capital that can often provide greater availability for clients. Today’s promising businesses are increasingly built on intangible assets, especially their patents and trademarked brands. When insufficient availability threatens a deal, a suitable IP lender can carve out these IP assets to secure greater availability for clients.

IP lenders can provide IP-backed growth-capital term loans of $5 million upwards, even to pre-revenue companies and enterprises with negative cash flow, if their IP collateral is sufficient and their projected cash flow can meet debt service in a 12–18 month period. When a traditional asset-based lender may only be able to offer limited availability to an IP-rich client, collaborating with a suitable IP lender can help salvage the deal, by providing the additional availability needed while allowing any existing asset-based lenders to retain their senior positions.

Jeffrey Sweeney
Chairman & CEO | US Capital Partners Inc.
Jeffrey Sweeney is an investment banker and fund manager with years of experience in direct lending and corporate finance for small to lower-middle-market businesses. He is Chairman and CEO at US Capital Partners Inc. and founder of US Capital Investment Management, LLC, an innovative private financial group and fund manager headquartered in San Francisco, CA. US Capital Partners specializes in making traditional upper-middle-market banking products and services available to the lower middle market.
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