The Use Of Intellectual Property As Security For Debt Finance

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Introduction
Intellectual property is of considerable, and growing, importance to global economies. Many industries, notably electronics, software, healthcare, consumer goods, telecommunications, media and entertainment are substantially dependent upon these intangible assets.
The term “intellectual property” is broad, and is widely used to refer to intangible assets. More narrowly defined, it relates to the law covering ideas and innovations. There are various classes of intellectual property: patents, copyright and trade marks are perhaps the most prominent. Other classes include design rights, know-how and confidential information. Given the emphasis of this article on business issues, my comments may apply to intangible assets which are highly valuable to certain businesses but which do not fall within the strict legal definition of intellectual property. For example, depending on the specific terms of the licence, rights granted under licence either by government or regulatory agencies, or through contractual arrangements, might be suitable as security. Examples include television and cable franchises, airport landing slots, distribution agreements, and non-compete agreements.
Historically, despite their value, intellectual property assets have rarely been used as security for debt finance. Consequently, businesses have been denied access to wider sources of finance and beneficial financing terms, to the detriment of economic growth. Where security has been taken over intellectual property, this has typically been in addition to security taken over tangible assets. The emphasis has generally been on the value of the tangible assets, with little value attributed to the intangible assets charged as security. Financing based on intellectual property is, however, increasing. Interest in the area is also rising but activity remains low, reflecting in part the limited knowledge of both borrowers and lenders of the issues involved.
Previous writers have considered, for example, banking practices in taking security, intellectual property law, the financing of intellectual property-based businesses, and the valuation of intellectual property. This article necessarily draws upon their work. It is outside the scope of this article to consider these areas in depth. I have, however,  summarised my understanding of these areas here, to provide the background against which to consider the use of intellectual property as security.
Firstly, I would like to review the demand for debt finance by intellectual property-based businesses, and the supply by lenders of loan finance. The typical development of such a business, its associated requirements for finance including debt, and the concurrent development of its intellectual property  will be considered. The relationship between these cycles will determine whether intellectual property will be appropriate as security for debt, at the stage when debt finance is required by the business. The availability of secured finance and the use of security in raising debt finance will also be considered.
Secondly, technical issues pertinent to the use of intellectual property as security will be discussed in part II in the next issue of this journal. Also in discussion are  the characteristics of intellectual property, and intellectual property law, principally as they relate to valuation and security. There then follows a review of the extent to which intellectual property is used currently as security for debt finance.        
 
Financing Requirements of Intellectual Property-Based Businesses
Intellectual property-based businesses vary considerably, and it would be inappropriate to regard their lifecycles as uniform across the range. Broadly, however, they are involved in both the development of intellectual property and its subsequent exploitation in the marketplace. Within this framework, there are various stages of business development with an associated financing need. Not all intellectual property-based businesses will go through each of these stages ( and at any rate not with the same timing), but many will. In particular, businesses which develop intellectual property, and then sell or license it to third parties for exploitation, may have different financing needs.
 
These stages are consistent with those identified by other commentators. They are as follows:
  • seed;
  • development;
  • early growth; and
  • maturity
 
In the remainder of this section, I describe the characteristics of each stage, as well as the perspectives of owners and investors to the use of debt finance at a particular stage.
 
Seed
 
This stage is the period of conception. It involves the development of the new idea or product. Much of the activity in this period will be research and preliminary development, to the point at which the innovator feels able to make an assessment of potential commercial viability.
 
The owner’s perspective
In this early stage, innovators will seek finance which brings the least external obligations. For individual entrepreneurs, their own funds represent the best option. These are often enlarged by contributions from friends and family, restricting the need to seek external, commercial finance.
       In the context of new product research by existing organisations, similar funding requirements apply. With external finance comes present or future obligations, which the prospective returns from the research may not be able to fulfil. Cash flow from existing operations is likely to be the preferred funding option.
       Where external financing is sought at this stage of development, innovators clearly have a strong preference for equity. Equity brings a sharing of risk and an aligning of returns to future success: both these characteristics are critical at this stage. Neither is provided by debt financing.
 
The investor’s perspective
Prior to the launching of a product on the market, the external investor’s attitude to the most appropriate funding for intellectual property-based businesses matches that of the businesses themselves. Equity is generally regarded as the only acceptable method because the investments are high risk, with no track record and future success is uncertain. Even if future success is achieved, the timescales to profitability and investment returns may be lengthy. Only through the potential return from an equity stake can the investor’s risk be justified.
       The risk of individual intellectual property investments in the early stages of development results in investors, such as venture capitalists, looking to spread their exposure through a portfolio of holdings. In this way, a small number of highly successful investments cover the losses sustained on the majority of early stage investmsnts, to enable an acceptable overall return to be made. Only through equit investments in the early stages of development results in investors, such as venture capitalists, looking to spread their exposure through a portfolio of holdings. In this way, a small number of highly successful investments cover the losses sustained on the majority of early stage investments, to enable an acceptable overall return to be made. Only through equity stakes can this portfolio effect be achieved; debt financing does not offer the upside potential. The key conclusion within the context of this article is that in the early stages of  intellectual property-based business development, there is likely to be little demand for, or available supply of debt financing, be it secured or unsecured. The requirement is predominantly for risk capital and a willingness to take a long term perspective.

Development

Having concluded as to the product or idea’s potential, the development stage will involve advancing it to the point at which it is ready for market. The time covered by this stage can vary substantially, depending upon the ultimate product. At one extreme, the clinical trial process for new pharmaceutical products will take several years; at the other, new publishing ideas may be converted into titles within a matter of months. This development stage is relatively investment-intensive. The product will not be generating revenue, yet the development process itself will require considerable cash resources.

The owner’s perspective
As in the seed stage, owners of intellectual property look for funding which minimises their current financial obligations. Without revenues, they are unable to make the regular cost of debt service. This requirement points to a continuing preference for equity funding; co-investors who are prepared to take the same long term view of the product. A potential benefit of equity funding is that the investor may well bring skills and experience which are of value to the original innovator’s owneship (and thereby rights to the future potential profit stream). This advantage is, however, considerably outweighed by the advantages otlined above. The innovator will recognise that its product will be unlikely to come to market without substantial additional funding.

The investor’s perspective

The investor’s perspective is largely unchanged from the seed stage. Equity finance is regarded as the appropriate basis of funding.

Early growth

By this stage, the development of the product is completed and the revenue stream will have begun. It is likely, however, that the business will continue to have further funding requirements. The cost of market penetration will be substantial relative to the level of sales being made. In addition, the business will require working capital funding, as the volume of sales expands.

The owner’s perspective
Once a product is launched on the market, the attitude of intellectual property owners to funding options is likely to change. They will regard the exposure to development risk as having been extinguished, and the product as demonstrating a proven and growing market potential. At this stage, there may be a perception that further equity injections are not desirable, because much of the risk inherent within the business has been reduced. Existing investors will therefore look to protect their holdings from further dilution. At the same time, the business will be beginning to be able to meet the regular servicing charges of debt finance. Its ability to meet debt servicing costs, although improving, will nonetheless be limited. There will be a need for relatively low costs of finance and long repayment terms to reflect the timescale for the intellectual property to reach its full potential.
At this stage in the development process, intellectual property-based businesses are often significantly different from other businesses in the character of the asset base. For other businesses, equity capital is converted in a relatively short time scale into saleable assets, for example, buildings and machinery, raw materials and trading stocks. In contrast, intellectual property-based businesses will have invested much of their equity funding in the development of the intellectual property.

Intellectual property-based businesses may vary significantly in the nature of their funding requirements at this stage. Products, once lauched, will require ongoing marketing expenditure to enhance and maintain their positioning. In pharmaceutical companies, for example, this expenditure may well exceed the cash flows generated from sales. The funding requirements of such businesses are therefore for new projects, which have their own lifecycle. In other sectors, however, significantly higher expenditure may be required to maintain position. For example, in certain electronics and technology sectors, without constant development expenditure an innovation will only give short-lived market leadership. Unless and until longer term market dominance is achieved, much of the cash flow generated by sales may be absorbed by this expenditure.

The investor’s perspective
The implication is that investors may at this stage in the business’ lifecycle have a preference for debt, but only that which is geared to the business’ long term potential. However, in these situations, the assets available, and their prospective value, are intrinsically lonked to the future performance of the business. They do not, therefore, meet the characteristics of security which lenders conventionally seek.

The indication is that investors’ preferred funding route for intellectual property-based businesses in the early growth stage remains equity. While businesses moving through this stage may well be experiencing relative success, the investors’ attitude is that the businesses remain high risk, long term and sustainable profitability are unproven, and their cash flow record to date is insufficient to service the levels of debt funding their require for future growth. The difficulty remains that funding requirements run well in advance of cash returns. Venture capital investors may go through a series of financing rounds with a successful, growing intellectual property-based business before significant returns are achieved. From the perspective of potential investors, debt financing is unlikely to appeal.
In the United States, debt has been raised by intellectual property-based businesses, through the NASDAQ market in particular. A number of these debt issues have been unsecured, high yielding and deep discounted, with no cash interest being payable for equity. They bring high risk but offer substantial returns in the event that the issuer is able to achieve sustained growth.

The key factor which investors would consider in relation to possible debt financing for businesses such as this is the available cash flow both for servicing the debt and for achieving ultimate capital repayment.

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