Friday, December 10, 2004 o Volume 3, Issue 4
Using Intellectual Property to Grow
The Beacon (Chicagoland Entrepreneurial Center)
By James E. Malackowski

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Within the last quarter century, intellectual property (e.g. patents, trademarks and copyrights) (collectively "IP") has emerged as a leading asset class within corporate America, and early stage companies are uniquely positioned to profit from the increased importance of these assets. In response, a new generation of merchant bankers with a specialization in IP assets has arisen -- predominately in Chicago.

The term "merchant bank" stems from leading merchants of the early 1800's, whether trading in grain, paper or steel, who transitioned from merchanting to banking when they had built up a sufficient reputation for soundness, reliability and wealth which warranted their colleagues' trust. The profits from banking the commodities of the day were greater and the risks were lower. Early examples of merchant banking often involved international trade due to the shear period of time required to contract, ship and receive goods. Financing trade gave merchant banks the opportunity to deal in commodities on their own account. Merchant banking and its dealing in commodities is distinct from investment banking dealing in securities. The merchant banker's role evolved in the 1920's when leading firms became heavily involved both in advising and in financing their clients.

Recent and anticipated changes in accounting rules and securities reporting will only further the recognition of IP assets. The growth in the value of such intellectual capital can be seen when evaluating the market capitalization of the S&P 500 as shown in the following chart.

For the U.S. economy, the shift from manufacturing to services is all but complete. We have now entered a new phase of economic development where services are being commoditized and value is captured only through IP and the proprietary position it offers. Emerging businesses must have a thorough understanding and recognition of IP as a leading asset class responsible for significant business growth. Although much more research needs to be done, available quantitative analysis supports the scale of the IP opportunity.

• 87% of the public market value of the S&P 500 is represented by intangible assets.
• Over $100 billion annually collected in IP licensing income.
• Over $200 billion annually written-off from IP impairments
• Over $300 billion annually in unpaid infringements (mostly innocent).
• Only 10% of all technologies are licensed to third parties.

Not only does intellectual property represent one of the largest of corporate assets, history has shown that investment in companies -- both large and small -- with strong intellectual property outperform all comparable benchmarks. CHI Research, Inc. reports on the leading S&P 500 companies in the May issue of the MIT Technology Review.

Ocean Tomo has done original research to show that venture capital investments in companies with intellectual property have a significantly greater chance of raising additional capital and half the risk of default.

Such IP activity is strong in Illinois. Moreover, Chicago has an established leadership position as the focal point for intellectual property professional services. Elements of such include:

• Best-in-class IP Expertise -- Chicago is home to the premier IP valuation and strategy firms and the national IP leaders of the "Big 4" accounting firms
• Patented innovation -- Chicago Metro Area ranked 3rd in the U.S. for number of patents granted over the past decade.
• Corporate Research and Development -- Chicago is ranked 4th in R&D expenditures.
• Academic Research and Development -- Chicago's universities and colleges rank 5th in the US for Total R&D expenditures.
• Strong Investment Base -- With sophisticated local investment and leveraged lending capabilities, Illinois has the investment strength to provide the resources necessary to capitalize on its position.
• Middle-market Companies -- Illinois is one of the nation's manufacturing leaders and is representative of the Midwest industrial manufacturing base. About three-quarters of the State's manufacturers are located in the Chicago area, with nearly half of Illinois approximately 18,000 manufacturing plants located in Cook County

Ocean Tomo is pleased to assist clients of the Chicagoland Entrepreneurial Center (CEC) with the resources and services to grow their IP as a necessary element of their business. Through these services focused on entrepreneurs, the CEC will continue its positive economic impact on the Chicagoland region and local economy.

About James E. Malackowski
James E. Malackowski is the President and Chief Executive Officer of Ocean Tomo. Building on its legacy of innovation, Ocean Tomo is today managed by the nation's leading intellectual capital managers and advisors -- intellectual capital merchants. This intellectual capital merchant banc presents an integrated offering of asset management, advisory and financing services, many of which can be traced over 100 hundred years to comparable offerings of the most well-known of merchant banks. Contact Jim at jmalackowski@oceantomo.com.

Owned-Pool Contribution: When holding patents in a heavily patented technology field, and if that field requires standards in order to obtain market acceptance, then becoming a member of a member-owned patent pool likely makes sense. Patent pools such as the MPEG pools or GSM pools are well known and have had success. Members of these pools contribute patents and then divide the resultant royalty income based on a variety of revenue sharing formulas. While these pools have the advantage of increasing the probability of obtaining licensing revenues, they are also more complex to create than an in-house licensing program.

Donation: Patent donations became a popular method of deriving benefit from IP in the mid-to-late 1990's because of the resulting tax write-off. A corporate entity donates patents, and usually some cash and know-how as well, to a qualified charitable organization like a university. The company is then able to take a tax deduction for the total value contributed. Publicly reported donations have been known to exceed $50 million. Unfortunately, the very popularity of this technique is drawing increasing scrutiny by Congress and the IRS. Proposed changes in the donation laws may curtail or eliminate favorable conditions for donation. The IRS is also acting on a new policy of close examination of patent donations, and the majority of valuations for recent patent donations have been adjusted downward.

Securitization: Securitization does not actually generate extra cash, but instead accelerates the collection of cash from the future to today. A patent holder with an existing royalty stream "sells" that stream of cash flows for a fixed sum today. The entertainment industry has historically completed numerous copyright securitizations, and patent license securitizations are just now beginning to appear, especially in the pharmaceutical industry. Deals in this area can be sizeable, with reported transactions as large as $100 million. The implicit rate of return demanded by lenders, who are the purchasers of the cash flows, is often lower than that of mezzanine financing. Key to a securitization is the quality of the expected cash flows, both in terms of the expected licensing revenues and the credit worthiness of the licensees.

Sale/License-Back: Modeled after the sale/leaseback transactions of the real estate world, Sale/License-Back (SLB) transactions seek to exploit the advantages of patent pools in a tax-favorable way. The patent holder sells one or more patents to a third party, which then licenses those same patents back to the original patent holder. The patents are also placed in a pool of similar technologies for out-licensing to other parties. Depending on the transaction structure, some of this additional out-licensing income may be rebated to the original patent holder. The two main advantages of the SLB include reduced cost of funds and increased probability of licensing due to pooling effects. The two main disadvantages of the SLB are a loss of control of the patents and a typical need for certain tax assets in order to begin the transaction. Currently, SLB transactions are being heavily discussed within various industry and consulting groups. Several transactions labeled as "SLB transactions" have occurred over the last few years, but these are more similar to securitizations than true SLB transactions.

Technology Option Capital: This cash generating method, often referred to as TOC, aggregates both patents and early-stage know-how of competing R&D programs. Multiple companies each contribute their competing IP on a project, and in return each party receives equity in the project and an option to repurchase the ending technology. Outside debt capital provides cash for operating expenses, and debt insurance reduces the bondholder risk. As development efforts continue, "Survivor"-type votes are used to select the surviving technology. Cash comes back to the initial patent contributors via their equity (in the event one company exercises its option purchase rights or the technology is successfully commercialized). TOC deals are currently being reviewed by several Fortune 500 companies, though no known transactions have been completed.

Risk Management: A new area of patent monetization involves using patents as partial payment for various risk management (i.e., insurance) policies. In the long run, generally tax-deductible policyholder premiums are paid today in exchange for generally nontaxable insurance claims to be paid back in the future. Using patents to pay a portion of the premiums is a way to "flip" the payment stream. Patents and cash are used to pay the premiums, while the policy holder receives a license back for its own use of the patents. The license fee is variable, based on the occurrence of a loss. In the event of a loss the policyholder receives a tax-free cash payment from the insurance company, with the licensee fee for use of the patents then increasing. There is no limit to the type of risks that can be covered with this method. Using patents as cash for risk management techniques is only just now beginning to be considered by IP professionals.

Summary Chart: The chart below gives a brief overview of some of the parameters of each cash generation method. "Prevalence Today" describes how common each transaction is today. "Relative Transaction Size" gives an indication of the typically expected size of each deal. Whether the original patent owner keeps control of the patents for defensive cross-licensing purposes is noted by "Control of Patent Rights". Transactions that obtain their initial cash benefit largely from tax savings are indicated in the "Tax Advantage Structure" column. "Transaction Time" gives an indication of how long it may take to perform a typical deal. "Transaction Difficulty" aggregates the external and typical internal impediments to finalizing a transaction. Finally, "Lifecycle Stage of Patent" shows if young or old patents tend to work best within the indicated structure.

The monetization methods outlined above mix corporate finance driven goals with traditional patent holdings, a combination which has yet to be fully proven to the market. It will take time for companies and financial institutions alike to explore the potential with each of these new methods and grow any transactions. Other types of financial vehicles, like junk bonds and mortgage-backed securities required several years to move from the fringe to acceptance. As future articles explore the above transactions, watch the headlines for examples - you may become a witness to ground-up development of a new frontier of IP monetization.

Andrew W. Carter (acarter@oceantomo.com) is a Managing Director and co-founder of Ocean Tomo, an intellectual capital merchant banc. Fayth A. Bloomer (fbloomer@oceantomo.com) is an Analyst in Ocean Tomo's Chicago office.

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