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Alternative financing solutions: Intellectual property-backed loans

Sep 2, 2020

As the world begins to adjust to the short and long-term impact and implications of the COVID-19 pandemic, many companies are seeking ways to preserve cash on their balance sheets while simultaneously raising funds to ensure a continuation of operations.

One option to consider is using the company’s intellectual property (IP) portfolio as collateral for funding.

Typically, companies looking at this IP-backed funding option have more than 10 IP assets in their portfolio and generate meaningful revenue with positive, projected cash flows (which are most strongly correlated with the company’s IP portfolio itself). This type of funding can be a good fit for companies that have valuable IP, but a lack of tangible assets. In the case of start-ups with venture capital or private equity sponsors, IP-backed loans provided through a pure-debt structure can allow the company to generate cash without diluting current equity investors’ ownership by bringing in new investors.

IP-backed loans

In the case of more conventional asset-backed loans, lenders typically turn to physical assets, such as manufacturing equipment, or real estate, in determining possible loan sizes and terms based on a percentage of the company’s overall portfolio of equipment or property (and usually, the lender’s ability to liquidate such assets in the event of default). The borrower then grants a UCC-1 security interest in these assets to the lender as collateral against the loan.

IP-backed loans are similar to these asset-backed loans in the sense that a company can borrow a percentage of the value of its IP portfolio, using the IP assets themselves as collateral. IP-backed loans differ from traditional asset-backed loans in two key aspects.

First, internally-developed IP is not typically recognized on a company’s balance sheet; instead it appears as an expense on the company’s cash flows statement. This contrasts with tangible assets such as manufacturing equipment, in which the assets are capitalized and amortized on the balance sheet.

Second, IP-backed loans may have an insurance component to them. Similar to mortgage insurance on real estate, an insurance company underwrites an insurance policy covering the company’s IP in order to protect the lender in the financing transaction who is relying on the IP as collateral. Examples of IP that can be insured include the most common forms of IP such as federally registered trademarks, copyrights and patents, but can also include assets such as common law trademarks, unique and proprietary business processes, trade secrets and data. Thus, firms who have experts that specialize in structuring and valuing IP transactions can assist banks and other alternative asset-based lenders to determine the value and strength of a company’s IP portfolio, and can establish a floor value upon which to determine lendable IP collateral advance rates.

The terms of the insurance policy for the IP collateral align with the terms of the corresponding IP-backed loan, with the typical term of this kind of insurance coverage being no more than five years.

IP-backed securitization

There are ways to achieve funding similar to IP-backed loans, but which involve the company securitizing its IP assets, or in a more extreme case, selling and licensing back the use of its IP assets.

In the case of IP securitization, which is similar to auto and mortgage loan securitization products, the company assigns a portion of its future revenue from licensing its IP portfolio in exchange for upfront, lump-sum funding or more favorable terms for a longer-term IP-backed loan. In addition, the cash received upfront for the future IP licensing revenues (sometimes called royalties) do not show up on a company’s balance sheet as a loan, allowing the royalty monetization to be recognized on the cash flow statements for the company’s current fiscal period.  Note that off-balance sheet treatment is contingent on accounting structure and should be assessed carefully before entering into a transaction.

In the case of IP sale and license-back financing, which is similar to the sale-leaseback technique commonly used in the real estate industry, a company’s IP assets are purchased by a third party and assigned to a licensing company (the back-licensor). The back-licensor then enters into a licensing agreement with the company that originally owned the IP (now the back-licensee) for negotiated royalty payments during a specified term. The arrangement can have a purchase option whereby the back-licensee can exercise the option to buy back the ownership of the asset at a fixed price at the end or during the back-license term.

The key difference between these financing methods compared to an IP-backed loan is that the company is not borrowing money, but rather it is selling or licensing back a stream of anticipated future cash flows that would otherwise accrue to the company directly. The stream of future cash flows may also be insurable under royalty protection insurance, which can be used to provide the investor (or investment bank) assurances of payment from those future streams of IP-based revenue beyond the company’s previous operating history.

Risk-benefit analysis

Putting aside particular costs of various forms of financing, one notable risk in entering into these IP-backed funding is the danger of the company defaulting and then losing the ownership and, consequently, the use of its collateralized IP and the associated revenue streams. This risk is particularly pernicious for companies that rely on the revenue from their IP to continue as an operating concern.

In the current cash-constrained environment caused by COVID-19, there can be a number of benefits provided by IP-backed funding. First, as discussed above, IP-backed financing provides a pathway to funds that may not otherwise be available, does not dilute existing equity holders, and may be less expensive than certain other alternative financing options. These advantages could be particularly important to start-ups that have recently conducted an equity round of financing, or companies in emerging areas, that might not have full access to traditional bank lending products.

Conclusion

IP-backed financing options allow companies to unlock the value of their IP portfolios by creating access to debt financing options. For fast-growing companies, companies in non-traditional industries or companies seeking non-dilutive financings, especially in this time of COVID-19 cash crunches, these techniques could be an invaluable means of surviving and even thriving despite the current marketplace’s challenges.

Special thanks to Brian Hinman, Chief Innovation Officer at Aon Intellectual Property Solutions and Richard Rothman, Resident Sales Director of Aon Tennessee, for their contribution to this report. 

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