Intellectual property (“IP”) may not be thought of as the most obvious asset used as collateral in security-backed financing, but it has existed since the late 19th century. Famously, Thomas Edison used his patent on the electric light bulb to secure financing to start General Electric. Traditional asset-backed lending is meant to provide businesses with immediate funds and potentially ongoing capital based on a percentage of the value of the company's tangible assets, such as buildings and inventory. Funds from these loans can be used to finance future growth, day-to-day operating expenses, or working capital requirements: accounts receivable, inventory, and seasonal cash flows. These funds are typically accompanied by covenants, or indentures put in place by lenders to restrict certain activities by borrowers.1 In recent years, use of intangible assets, such as IP, as a consideration for asset-backed loans has become more prevalent.
This evolution in lending practices is driven by several factors. Primarily, patents have emerged as a legitimate asset class; in 2010, patents held by U.S. companies were valued at nearly $2 trillion.2 Today there are patent trading indices, patent investment funds, patent insurances, and various published league tables of patent activity.3 This should come as no surprise, as the last several decades have also seen a rise in the value of companies’ intangible assets with respect to their market value, as seen in the chart below:
Secondly, in a highly competitive lending market, creditors are feeling the pressure to differentiate in an effort to find yield and diversify their debt portfolios. As a result, we have recently witnessed not only niche investors but also major commercial financial institutions expanding their traditional asset-backed lending practices to include non-traditional assets such as intellectual property. Patents in particular have seen a rise in their use as collateral in the last two decades:4
Finally, companies are constantly looking for creative ways to raise necessary financing. In many cases, a company’s most valuable asset is their IP portfolio, and tangible asset-backed lending may not be sufficient to cover a company’s funding needs. IP assets can also provide a realization of research and development value, as patents can be used to secure funding for further development. This is particularly the case with early-stage technology companies and pre-revenue start-ups.
When utilizing IP as collateral, lenders are primarily concerned with the distressed sale value of the IP. In the potential scenario where a company defaults on its loan obligation and the lender is forced to seize and liquidate the asset(s), they are seeking assurance in their ability to recover their investment. Because IP is a newly recognized stand-alone asset class, the secondary market is still fraught with uncertainty, and for this reason, traditional financial institutions have remained somewhat slow to enter the patent lending arena.
For those lenders including IP as a collateral consideration, ensuring an accurate valuation is a chief concern. In order to effectively value intellectual property, there are certain risks that must be properly accounted for including invalidity, interpretation of scope of the claims, technological obsolescence, rate of technological adoption, impact of case law, and likelihood of success in licensing or litigation. A robust patent valuation is one that is rooted in objective analysis which carefully assesses the technological usefulness of the claimed invention within the context of both market and legislative trends.
As patents and other IP continue to gain traction as an asset class, it is likely that the interest in IP-based lending will continue to increase. Nevertheless, to date the practice remains controversial among most major commercial lenders. The use of appropriate valuation techniques can simultaneously provide previously untapped funding for early-stage companies or entities possessing strong IP portfolios, and ensure that lenders are able to assess investment risks to a necessarily thorough and sophisticated degree.
A special thanks to Nash Ream and Tristan Sieve for contributing to this blog post.