IP-Backed Financing: A New Avenue of Alternate Financing

Posted on May 13, 2021

Co-authored by Naintara Bipin Balakrishnan and Tanya Garg*

What's Your Intellectual Property Worth? Chances Are You Don't Know - The  One Brief
Image Source: The One Brief

Intellectual Property protection makes intangible assets a bit more tangible by turning them into valuable exclusive assets that can often be traded in the marketplace.

– World Intellectual Property Organisation

Introduction

We entered 2020 with the speculation of another wave of recession. However, before that problem could be addressed, COVID-19 was thrown our way. After the WHO declared a pandemic, several countries sought to enforce a lockdown and caused the revenue stream of several businesses to come to an abrupt halt. 

Intangible assets play a vital role in determining the potential value of a company. Over the last two decades, companies have been in search of new techniques to maximize revenue generated from Intellectual Property (“IP”). In several instances across various industries, development and acquisition of Intellectual Property Rights (“IPR”) by companies has resulted in an overnight increase in their value. In times where the economy is crashing and businesses are desperately trying to stay afloat, the value of IP cannot be ignored. IP-backed financing is rising as the new trend to improve IPR holders cover cash flow shortages and improve liquidity. The fundamental characteristic behind such transactions is converting a creative idea into a financial asset. The multifaceted strategic use of IP beyond the current limited viewpoint, will assist in kickstarting a new marketplace for IP-backed financing.

The article, written as a two-part series, explores how widening the scope of IP would change the traditional business set up and potentially inject innovation and creation into the economy. This two-part series aims to analyse the significance of IP as a strategic asset, the various types of IP-backed financing, and finally, the approach taken by India vis-a-vis other countries. 

Customarily, tangible assets have been the scale for measuring the value of a company and determining its place in the market. However, of late, this dynamic has undergone a drastic change; there is an increasing reliance on intangible assets. Intellectual capital is recognised as the most important asset of countless large and powerful companies. It is the foundation for the market dominance and continuing profitability of leading corporations. 

The World Intellectual Property Organisation (“WIPO”) defines IP as creations of the mind which includes inventions, literary and artistic works, and symbols and images used in commerce. Therefore, every class of IP incentivises innovation, stimulates creativity, and boosts the economy by providing rights holders with an exclusive property right. IP equips individuals and companies with the ability to capitalise any creation in the form of a work, brand, or invention by excluding others from doing so, without authorisation, for a period of time. Software codes, innovative ideas are replacing the prized warehouses and factories as a source of income. The higher importance given to IP; the higher returns can be reaped. When protected and enforced properly, the commercial value in IP can be multifarious. Globally and domestically, laws have been implemented to protect IP. The deliberate act of government policy encourages creativity and promotes fair trading and commerce which helps contribute to economic and social development.

Despite the abovementioned, significant strides, the role of IPRs and intangible assets is inadequately recognised, especially in the business industry. According to the traditionalist approach, the core use of IP, in the context of businesses, is to create legal barriers and curb prospective market entrants and competitors. This outlook stems from the fundamental right of an IP owner to exclude others from exploiting the revenue from the asset without permission of the owner. Thus, IP allows businesses to increase revenue by collecting royalty and fees. 

The onset of the COVID-19 pandemic demands for change in the traditional outlook. Companies have been forced to halt several activities and consequently, business owners must tackle the problem of reduced cash flow and the inability to repay debts. In order to effectively overcome cash flow shortages, it is vital to develop IP beyond the confined and outdated scope of innovation, technological growth and competitive advantages. Legal framework must take a holistic approach to encompass and promote the plethora of leveraging options to employ IP assets as financial instruments and thus, an additional source of revenue. Recently, academicians, professionals and experts have discussed and debated the option of IP being used as primary collateral to avail loans. IP loans represent a complementary source of capital that can often provide greater availability for revenue. IP-backed financing refers to the utilisation of IP to raise finance by avail to credit facilities. Globally, more corporations and especially Micro, Small and Medium Sized Enterprises (“MSMEs”), are leveraging their IP in exchange for finance, and lending institutions around the world are considering IP as collateral when extending loans.

IP as a Strategic Asset

Generally, tangible assets such as real estate, equipment and inventory are used to procure asset-based loans. In countries around the globe, there is a paradigm shift towards a knowledge and innovation driven economy. As early as 2003, WIPO and the United Nations Commission on International Trade Law (“UNCITRAL”) have been working to modernise the existing legal provisions governing IP assets. IP is a powerful and valuable business asset and must be managed in a tactical manner. The logos of companies like Amazon, Coca Cola, BMW, etc are valued at billions of dollars. As of 2008, intangible assets have contributed to 31.2 percent of all wealth in Canada, and the proportion continues to steadily increase. In the United States, IP intensive industries account for over one-third of the national GDP.

In 2017, Uber acquired eighty-seven issued patents and five patent applications from AT&T; the amount of the acquisition remains confidential. This acquisition was considered ground-breaking as the acquisition gave Uber a portfolio of patents having priority dates pre-dating Uber’s formation in 2009, as well as most of the ridesharing industry in general. Moreover, the IP covered various technologies related to messaging, call handling, routing network traffic, and billing. The prime reasons for acquisition and ownership of IP is for legal and transferable proof of ownership of the most valuable assets of a company.

Exploiting IP is essential for maximising the IP’s value. Based on the desired strategic goal, a company may pick from an abundance of alternatives. Leveraging IP in exchange for finance and while extending loans, will pave the way to aid revival and injection of revenue into companies, especially MSME. Usually, tangible assets are considered to secure asset-based loans as they are considered safe and secure options. However, the collateralisation of IP will allow companies to enhance the credit pool available to an IPR holder. In situations where borrowers pledge their IP as collateral, their collateral pool increases in value and the potential for a successful loan may be increased. Licensed IPRs, where regular royalty payments are directly attributable to the licensed assets are the preferred asset category for investors since there is satisfactorily valuable collateral with ample cash flow for repayment.

The UNCITRAL Legislative Guide on Secured Transactions 

In 2010, the UNCITRAL undertook an elaborate exercise to prepare The UNCITRAL Legislative Guide on Secured Transactions: Supplement on Security Rights in Intellectual Property (“Guide”) in order to create a substantive framework to govern secured IP transactions. At the forty-third session, held in New York, the Commission considered adopted the Supplement by consensus. Subsequently, the General Assembly and the Secretary-General recommended that all States consider becoming party to the United Nations Convention on the Assignment of Receivables in International Trade (2001) (“Convention”) and implementing the recommendations of the Guide. The USA only became a signatory to this Convention in 2019. Given the current climate across the world, the Convention is considered to have a game-changing effect as it will allow businesses of each and every size to access more funding in support of international trade.  

The primary aim of the Guide is to encourage transactions with secured credit with respect to businesses that own or have IPRs and promote credit at a reasonable cost. Thus, by allowing businesses to use rights pertaining to IP without interfering with the legitimate rights of the owners, licensors and licensees of the intangible property, cash flow shortages can be covered more effectively. Additionally, the UNCITRAL has also approved a model law on secured transactions for adoption by the member countries. It is vital for India to consider the adoption and enactment of the model law based on the UNCITRAL model, applicable to all secured lenders.

Methods of Valuation

Valuation of IP is a transdisciplinary area of study and focuses on the doctrines of finance, economics, law and competition. Traditional lenders use a market-based resale appraisal assessment to guarantee  accurate valuation of IP. This method of valuation, coupled with additional methods like considering actual or potential royalties or lease streams or the outright sale of the IP or even the company to a competitor that values the IP, helps assess the accurate value.  

The fundamental rule of commercial valuation is that the value of something cannot be stated in abstract, it is stated with reference to the prevailing market conditions.  In an ideal situation, there will be certain established and recognised universal valuation tools in order to create uniformity in various contracts. While independent experts may prefer to determine the market value by reference to comparable market transactions, it becomes challenging as two IP assets cannot be uniform, thereby making it next to impossible to have two transactions that are precisely comparable. Therefore, while determining the value of an IP the search for a comparable market transaction becomes almost futile.

When undertaking IPR valuation, the context is all-important, and the valuation expert will need to assign a realistic value to the asset. The ownership and grant of an IPR is a precondition to valuation and allows monetisation of the intangible assets. Furthermore, the valuation of a company’s IP depicts the competitive advantage it holds over others in the industry.  The valuation of an IP indicates the sum total cost for which the ownership of an IPR is transacted between the IP holder and buyer. Therefore, the price is the monetary amount at which an asset trades in the market.

Types of IP-backed financing 

IP as Direct Collateral

Internationally and specially during COVID-19, IP-backed financing transactions where IP is permitted to be pledged directly as collateral in a loan agreement, and monetising its value under distress situations, is being extensively advocated for. Since the IP assets will be conferred with equal status as tangible collateral, the lender of such loan will have lien on these assets. In case of the asset owner’s inability to repay or defaults on the loan, the assets can be seized or sold, in accordance with the applicable laws. Therefore, companies can secure a loan from the flow of income resulting from various IP licensing agreements. These agreements usually involve portfolios of patents and/or other classes of IP. With the introduction of the National IPR Policy (“IPR Policy”) in India in 2016, a whole new market opened as the ability of IP to be used as collateral was recognised.

Securitisation

Asset securitisation is the practice of converting an asset or a stream of cash flows into marketable securities; it is relatively new to the realm of IP. According to WIPO, the securitisation of IP is the new trend. In 1997, David Bowie was in search of new financing options, with an objective of raising lump sum cash. This is how Bowie Bonds were introduced. Due to this, IP securitisation gained traction and was recognised as a financing vehicle. Therefore, rather than entering into new traditional distribution agreements at the expiration of his existing one, Bowie bonds were formulated to meet the need for upfront and immediate cash. Taking inspiration from this, several others followed in Bowie’s footsteps. Several published articles have theorised that the possibilities for securitisations include portfolios of trade secrets, trademarks and domain names as well. In this kind of debt offering, the underlying IPRs would be used to secure the bonds. If there is a default on payment obligations to bondholders, the IPRs are permanently transferred to the bondholders. Subject to any conditions agreed upon or security interest held by bondholders, the IP asset(s) will remain with the IPR holder until a default occurs. Once the obligations of the bond are met, the copyright owner holds the IPR free of the security interest. However, the details of such transactions are usually kept confidential. Among the famous transactions in the field of IPR are the securitisations, the trademark of the Domino’s Pizza chain and the patent on the HIV drug developed by Yale University.

Sale and Leaseback

One of the lesser explored IP financing options is Sale and Leaseback. As the name suggests, under these transactions, the IP asset is sold and subsequently, leased back for use over a considerable duration.  Financing transactions using sale and leaseback, allows the IP owner to achieve instantaneous liquidity and continued usage of the IP asset without being the actual or real owner. Thereafter, the company leases the same asset back to its former owner under payment of fee structure, which corresponds to the loan interest. When the leasing contract period ends, the lessee is given the opportunity to buy back the ownership of the asset at a fixed price. Sale and Leaseback is a tool that aids in securing short term funding and provides transparency as the link between the secured assets is clearly demonstrated.

Venture Debt

Under the Venture Debt financing model principles of debt-equity funding are employed. As of this date, the Fortress Investment Group and Silicon Valley Bank are two institutions that offer this model of financing. Just like in ordinary venture debt financing options, the IP owner’s firm, the firm requesting funding is granted capital as a loan, on which a predetermined interest rate is levied. The investment by such institutions can take on one of two forms: Equity or Debt. Equity refers to investment for stock and debt refers to collateralized loans. Collateralised loans have already been covered; therefore, this section will focus on equity. In such transactions, since the company’s assets qualify the potential value generated by IP, the relationship between the investor and the assets of the IP owner’s firm is subject to the type of investment agreed upon.

When the firm issues warrants for equity in the company, they are acquired by the lender. IP represents a key asset to facilitate these deals, but this kind of loan is typically backed by a blanket lien or a claim on all the assets of the firm in case of default. Venture debts are comparatively more difficult to obtain in the IP field.

While choosing between the above mentioned methods, it is prudent to establish the short-term and long-term objectives of the company. The prevailing market conditions must also be taken into consideration. Thereafter, a conscious and comprehensive decision be taken.

Conclusion

Assessing the value of IP assets and promoting the benefits of doing it is an exhaustive task. It will take time to spread awareness and build a comprehensive and trusted legal framework. However, it would be foolish to entirely overlook the benefits of IP valuation. IP administrators must engage banking and financial specialists in the regulation of IP asset valuation so that it becomes a widespread, standardised practice. To achieve this, a global and holistic approach to valuing IP must be developed. This will reduce the risk of these assets being overvalued by the financial sector.

The next part of this two-part series shall examine the advantages of IP-backed financing and provide a comparative overview of the framework adopted across different jurisdictions.


*Naintara Bipin Balakrishnan is a technology law enthusiast with a keen interest in data protection and privacy law.

Tanya Garg, on the Executive Board at IntellecTech Law, completed her B.B.A. LLB. (Hons) degree from Symbiosis Law School, Pune (Batch of 2020) with specialization in dispute resolution, intellectual property, technology and antitrust laws.

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