Intellectual Property: Collateral for Securitization or Lending By Daryl Martin and David Drews* – IPmetrics LLCIntellectual property management can be one of the most important responsibilities in anorganization. Recently, there have been several developments that help organizationsappreciate the full scope of flexibility available to them in terms of unlocking the value oftheir patents, trademarks and other intangible assets. One of the most overlooked methodsfor utilizing the value of IP is its use as collateral. This activity is becoming more commonas increased cash flows associated with the licensing of IP catches the eye of Wall Street.The highest profile examples of these transactions are probably the securitized royaltystreams on the copyrights owned by famous songwriters like David Bowie and JamesBrown. However, there have been numerous instances of valuable trademarks and highlyproductive patents being utilized in this capacity as well.RELEVANT STRATEGIESThere are a number of reasons why an IP owner might be interested in pursuing this kind ofstrategy. First, it can provide a method for transferring some of the risk associated withlicensing the intellectual property. If the financing is non-recourse, the risk of receivingroyalty payments from a licensee is transferred to the investors. Also, some of the riskassociated with infringement and obsolescence is transferred as well. Second, it mayincrease the return the owner earns on the IP through increased leverage. This is becausethe present value of impending royalty streams is being collected in a lump sum todayrather than spread out over the future. This lump sum payment can then be invested incurrent projects that feature an internal rate of return that is higher than the cost of thefinancing. Any upside potential residing in the IP is typically retained by the IP owner aswell.Third, it provides a source of capital that does not dilute the current equity structure. Withventure capital discounts typically in the range of 25% to 50%, this is very beneficial whencompared to equity sources of financing, especially for smaller technology companies. Anadditional benefit of this kind of financing is that the interest payments are tax deductible.This helps to offset a portion of the discount taken as a result of the present value analysisused to determine the size of the lump sum payment.For the purposes of this discussion, intangible assets fall into one of two categories: thosewith specifically identified cash flow (“Cash Flow Assets”) and those with implicit value. TheCash Flow Assets are typically assets such as trademarks, patents or copyrights that have* Daryl Martin is managing principal and David Drews is president of IPmetrics LLC, an intellectual property consulting firm. You can reach them at 858-538-1533, or by email at email@example.com and firstname.lastname@example.org, respectively.
Intellectual Property as Collateral been licensed. Under these circumstances, the royalty payments from the license agreements are directly attributable to the licensed assets. Alternatively, those with implicit value only may include trademarks and patents that are exclusively used internally or obscure intangible assets such as customer lists, non-compete agreements and proprietary packaging designs. While there are instances of lending against assets without accompanying royalty streams, usually only the Cash Flow Assets will generate any interest from investors. This is because the two primary concerns for an investor are that the funds loaned are secured by sufficiently valuable collateral and that there is sufficient cash flow available to service the repayment schedule. When financiers do lend against implicit value assets, they typically want to understand the value as it is used by the owner and also its potential liquidation value should the investor have to foreclose on the loan. CASH FLOW ANALYSIS When analyzing Cash Flow Assets for their possible use in securitization, there are several aspects that are important to understand. First, the financier will primarily be interested in the cash flow: How long has it taken place? Has it been consistent? Is it growing? What are the potential obstacles that may arise? Because the investors are focused on the cash flow and the likelihood of being repaid, it is the credit rating of the licensee that is of primary importance, not that of the IP owner. This is because the licensee is the ultimate source of the cash flow that will be used to repay the loan. In fact, a small entrepreneur that licenses to a large stable corporation with a great credit rating should arguably get a more favorable interest rate than a more established player that licenses to an organization without an exemplary credit history. Second, investors will prefer to have the assets reside in a wholly owned subsidiary that has a totally separate operation from the entity that is using the IP. Referred to as a Special Purpose Vehicle or Entity (“SPE”), these holding companies serve to protect the investors against the possibility that the IP user will file for bankruptcy protection. In many bankruptcy situations, the IP is still well-regarded in the marketplace even though the management of the overall operation has been problematic. If there is not a SPE already in place, setting one up should be one of the first steps taken. Third, similar to most financing activity, an escrow account will likely be required. With IP securitization, the escrow account will remain a vital part of the payment activity throughout the life of the financing. The mechanism is fairly straightforward. All royalty payments made by the licensee are paid into the escrow account. From these proceeds, the amount required to service the bond payments is paid to the investors. Any funds beyond that are paid to the SPE, which may then use them in the management of the intellectual property or may pass them on to the parent organization. It is important to note that the due diligence agenda associated with this kind of financing is likely to be much more extensive than other lending activities. It will likely consist of legal items such as title searches and patent validity, financial items such as valuation and cash IPmetrics.net Page 2
Intellectual Property as Collateral flow verification and analysis, and technical items such as obsolescence potential, current and potential competition, and product life cycle. All of these will have to pass a thorough inspection before the financing will go forward. INTANGIBLE ASSET VALUATION IN PRACTICE Intangible asset valuation for collateral verification purposes provides interesting challenges to the appraiser. Typically, a company seeking financing is looking to expand, acquire another company, refinance or cover seasonal shortfalls in working capital. For an IP valuation company, determining an accurate fair market value of the associated IP in a going concern is difficult enough because it requires an accurate forecast of future revenues and earnings of the company whose assets are being valued. However, the lender is not simply interested in the value of the IP in the context of a going concern, but in the context of a hypothetical future liquidation as well. This compounds the difficulty of determining a reasonable liquidation value for the IP. Intangible assets are usually valued at fair market value. Fair market value is the value of an asset to be sold in an arms length agreement where there is a willing seller and a willing buyer. An asset in liquidation, however, is sold under distressed circumstances, which tend to complicate the typical arm’s length transaction. In liquidation, there is usually a severe discount in value from the fair market value of the intangible assets in a going concern. With little history to fall back on, the IP valuation company must find new methods to calculate the liquidation value of the IP that at the time of valuation is still active and viable. Traditional hard asset appraisers have a distinct advantage over IP appraisers as hard assets have a long history of being liquidated in distress sales. There is extensive data available on the amount of discounting which could be expected for any class of asset sold in liquidation. Conversely, very little data exists on the value of individual intangible assets being sold in liquidation. Usually the intangibles are sold as a part of a company sale and, until very recent changes in standard accounting practices, there was no separate accounting of intangible asset values from the overall goodwill booked in the transaction. CASE STUDIES So how does an IP valuation company find a fair liquidation value of intangible assets that at the time of valuation were not in financial trouble? The following two case studies show two approaches for solving this problem. 1) A manufacturer of commercial equipment was looking to buy another manufacturer of similar yet complementary equipment. Each company was doing about $60M a year in sales. Both had good reputations in the market place. The acquiring company was looking to borrow $100M to complete the purchase and provide some additional working capital. The loan was going to be secured by a combination of hard assets, trademarks and technology. The first step for the appraiser was to perform a relative contribution analysis for the trademarks used by the two going concerns. Many relevant factors need to be assessed to IPmetrics.net Page 3
Intellectual Property as Collateral ensure accuracy, including market share, pricing premiums, longevity, awareness and the competitive environment. In this case, both of the companies were leaders within their respective market niches and together would dominate about 75% of the market. The following steps were employed to accomplish this: Five major customers were interviewed to determine why they purchase this particular equipment Several key employees were sent a survey to solicit their perceptions as to why the products sold The results of the interviews and the surveys were quantified to determine what percentage of a sale was attributable to the good name of the trademarks In a going concern environment the group of trademarks belonging to the two companies was extremely strong. However, in order to calculate a value in liquidation, a hypothetical company would need to be modeled. This hypothetical company would take over all existing trademarks and technologies and enter the market as a new company with the established trademarks and company name. The value of the IP in liquidation would then be calculated based on the new company’s ability to penetrate the market. A business model was then built for the hypothetical company, and a business valuation was determined taking into consideration projected market penetration, projected earnings, and capital costs to enter the market. To this business value the contribution percentage of the IP resulting from the surveys, interviews and objective relative contribution analysis was applied and the value of the IP determined. The concluded value of the IP in liquidation for the combined companies was added to the value of the hard assets, and the financing program was approved CASE I Business Value of Hypothetical New Entrant $200M Relative Contribution of IP 25% Collateral Value of IP $50M 2) In the second case, a leading car rental company was in the midst of reorganization. The company was experiencing severe cash flow difficulties and was entertaining offers to be acquired by one of its competitors. The company was looking to secure $100 million of interim funding to cover its short-term cash needs during the acquisition period. To fully collateralize the interim loan, the lender looked to the company’s intangible asset portfolio. To determine the extent of collateral available, a fair market value appraisal was performed on the intangibles as used by the going concern as a first step and was followed by the calculation of liquidation value --most lenders will want to understand the relationship between these two values prior to loan commitment. In this particular valuation, multiple assets having significant value were uncovered including IPmetrics.net Page 4
Intellectual Property as Collateral trademark assets, franchise rights, reservation systems, customer databases, and airport concession rights. After analyzing the various methods for valuing intangible assets, the Income Approach with a Relief from Royalty Method was chosen as the appropriate methodology for the going-concern valuation. Relief from Royalty is calculated by assuming that the business does not own the intellectual property and thus has to pay a royalty for its use. Essentially, the fair market value is the present value of those avoided royalty payments. This method was selected since the information required for its use is relatively accurate and readily available. To complete the analysis, the appraiser relied upon future revenue projections, comparable royalty rate and sale transactions, discount rate calculations, and estimates of remaining useful life for each of the asset bundles. To value these intangible assets in a liquidation scenario, comparable sales transactions for similar assets in distressed situations served as the primary methodology for the trademark assets and franchise rights. The cost approach was utilized to calculate the minimum replacement value of the reservation system and customer databases. Finally, the airport concession rights were determined to have no value due to the difficulty in predicting whether the airport authorities would approve assignability of the various agreements. CASE 2 Description Going-Concern Value Liquidation Value Trademark Assets $325M $63M Franchise Rights 82M 14M Reservation System 38M 4M Customer Databases 5M 2M Airport Concession Rights 12M 0 TOTAL VALUE $462M $83M In combination with the hard assets owned by the subject company, the value of the IP in liquidation proved sufficient to cover the interim funding collateral needs and the financing was approved. CONCLUSION Intellectual property value is more readily available for strategic use than ever before. Whether the IP owner is interested in a straightforward loan using valuable trademarks and customer lists as collateral, or in securitizing the royalty payments associated with licensed assets, there are options available today that will help to reduce risk, increase return and provide flexibility for resourceful owners of intellectual property. IPmetrics.net Page 5