Capital choices

Intangible in markets

IA for development and commercialisation As intangibles emerge as an purposes, even before start up. While funds class, financial firms are developing and firms often differ in structure, these a variety of mechanisms to utilise enterprises work with companies either to buy the IP/IA or invest in the company for them in the capital markets commercialisation of the IP/IA. Due to the private nature of private By Ian Ellis and Kenan Patrick Jarboe equity deals, many details about this group of firms and funds have not been disclosed. Over the past decade, has The large investment Deutsche Bank become foundational for many companies, (DB), however, announced publicly that it is while intangible assets – such as currently managing three IP funds totalling (whether , more than €150 million invested in IP , copyrights or trade secrets), assets. Partnering with IP Bewertungs AG, brand value, corporate reputation, franchises DB has identified and purchased IP assets and human capital – have emerged as a for further legal and commercial refinement valuable asset class. The capital markets and to be sold and/or licensed. financial system have responded to this Another IA-focused firm, IgniteIP, calls shift. Financial firms have invented new itself a “full-service IP placement vehicles and updated existing models to enterprise” that works with inventors, IP provide capital to companies with owners and investors to commercialise significant value in intangible assets (IA). and/or license IP. IgniteIP’s model differs Based on published reports, we have from the traditional VC model in that it has been able to identify examples of the array paid attention to IP development nearly of models for equity and financing independent of the business itself. In one targeting intangible assets. It should be case, IgniteIP developed a new licensing noted that the details of the cases below are model for a new mining technology after occasionally limited by the private nature of the inventors failed to develop business the transactions. Many of the firms engaged around the technology. in IA are solely private companies and therefore do not publish much Blended equity–debt models transactional information. A number of financial firms, such as Silicon Valley Bank, Square 1 Bank and IA-focused equity investment Sand Hill Capital, blend the early stage Large investment and boutique focus of the VCs with the lending firms alike have begun raising competence of banks. In most venture debt and investing funds targeted at intellectual cases, the investing firm establishes an property and other intangible assets. interest rate on the debt, taking into Broadly defined, these firms are targeting account the viability of the company and the traditional venture capital space, looking the current funding structure, as well as for promising early stage innovation and the reputation of the company’s current inventions. However, rather than looking for funders. On the equity side, the deal will entrepreneurs and start-up companies, also include warrants in the company to these firms are looking to invest in IP and buy shares at a fixed price.

56 Intellectual Asset Management May/June 2010 www.iam-magazine.com Capital choices

It is becoming more commonplace for IP assets to be written into the contracts governing broad asset-backed loans, either as a separate asset or as an integral part of overall company value

There is another set of private equity already well developed and take many forms. firms that target investments in companies Consumer loans, such as home mortgages with a critical focus on IP and intangible and auto loans for individuals, are the staple assets. These firms are not necessarily of the credit and banking system. Inventory targeting raw or undeveloped IP assets for and equipment loans for businesses are the purpose of monetising the IP itself available from either traditional banking through licensing. Rather, they look for sources or from specialised asset-based early stage or start-up companies with lenders. Specialised asset-based lending integral IP assets for the companies’ includes assets such as accounts receivable intended markets. In essence, these firms and extends from straightforward loans to screen their deals by looking for critical IP complex lease-back arrangements. and the overall cash flow the companies Similar to these transactions, intangible generate. These models also often utilise a asset–backed loans (IABL) use IP or other hybrid approach to equity investing, similar intangible assets to secure a loan. Such to the venture debt market. financing may be rare but has a long history. For example, Altitude Capital has The first trade secrets case in the United invested in 16 companies since the firm was States involved the debt on a bond secured created in July 2005. According to its in part by a secret chocolate-making promotional materials, it specifically invests process in 1837. In 1884, Ara Shipman in “portfolio companies that have valuable loaned Lewis Waterman US$5,000 to start a patents, trademarks/brands, copyrights, pen-manufacturing business, which was royalty streams, trade secrets, and other secured by Waterman’s . intangible assets, which will create a Much of intangible asset-backed lending competitive advantage in creating value”. may be invisible. Intangibles have always Altitude has structured a variety of been included in a blanket lien on all assets. transactions, providing common equity, In these cases, the IA is not explicitly preferred stock and subordinated or secured identified or incorporated into the terms of debt. For example, its investment in the loan. Thus, the collateral value of the Intrinsity Inc. used an equity–debt assets is not recognised and the borrower combination of Class E preferred stock and may not receive all of the capital they could senior secured notes with warrants. qualify for. Newlight Capital is another firm However, it is becoming more focused on IP venture debt investments. commonplace for IP assets to be written Newlight’s model focuses on intellectual into the contracts governing broad asset- property because, the firm’s materials backed loans, either as a separate asset or suggest, it is traditionally undervalued as an integral part of overall company value. compared with accounts receivable, durable For example, Smithfield Foods company goods, inventory and so on. After Newlight received a US$1 billion revolving credit values the IP, it issues a broad security facility from JP Morgan that was secured by package for a term loan with interest and first-priority liens in the company’s and its warrants in the company. US subsidiaries’ cash, intellectual property, equity interests in the subsidiary Intangible asset–backed lending guarantors, inventory, accounts receivable Pure debt financing deals are secured by the and other personal property. In other assets of the company; for our purposes, its words, intangibles were treated like any intangible assets. Asset-backed loans are the other asset. most straight forward debt instruments. Companies can also arrange funding Financial markets for asset-backed loans are through a dedicated amount of IA-secured www.iam-magazine.com Intellectual Asset Management May/June 2010 57 Capital choices

Figures 1. The intangible asset financing matrix

Equity Debt

Models Intangible asset equity Debt-equity blended Intangible asset-based investments models lending

Description Equity investments Flexible model that Traditional bank lending focused nearly utilises both debt and utilising intangible assets as intangible exclusively equity structures to collateral for loans on asset value provide proper balance of security and liquidity Example Deutsche Bank/IP Altitude Capital portfolio Cambridge Display Bewertungs Patent of investments include Technology financed Value Funds combinations of common commercialisation through a and preferred stock loan secured by CDT’s along with secured patent portfolio and subordinated debt Variations Commercialisation funds Venture-Debt model Securitisation or collateralising that purchase intangibles where debt can be a securitisation of an to commercialise IA transferred to equity intangible asset upon meeting certain milestones

debt within a broader lien structure, often a combined with the value of its real estate. with multiple financial Ultimately, KBC loaned Burn £31 million. institutions. For example, Toys ‘R’ Us has a But IA is not just an add-on financing complex debt arrangement that includes tool. Companies can secure loans based loans secured by its real estate subsidiary, a primarily on their IA as well. For example, secured-term loan based on the company’s Paradox Capital in August 2008 provided an intellectual property and a second lien on IABL to Snapware Corporation, which accounts receivable and inventory. specialises in storage and organisation The Toys ‘R’ Us example is a window solutions for the home and kitchen with into the barriers to IP-backed lending. A brands that include Snap ‘N Stack, Smart recent Fitch ratings report articulates the Store, mods, GlassLock, Airtight Canisters recovery prospects for its various tranches and Snap ‘N Serve. The financing of debt. The IP-secured term loan is listed relationship between Paradox and Snapware as less than 10% recoverable compared grew out of an initial IP-based loan with real estate debt, which is seen as 71% provided more than a year before the to 90% recoverable. The unsecured debt August deal. After the relationship proved was also listed at less than 10%. Clearly IP successful, Paradox Capital partnered with is still not seen as a highly recoverable New Stream Capital to close the IABL for asset; IP-secured loans are on par with Snapware, supported by the storage unsecured debt. On the other hand, using company’s strong and ongoing investments IP to secure part of its debt may have given in brand and product design. Toys ‘R’ Us access to otherwise Taking an example from the creative arts unavailable capital. sector, Intangible Business structured a deal IA can also be used to enhance the with Boosey & Hawkes to expand its original loan. For example, Belgium-based business publishing the rights to the works KBC Business Capital financed an IABL loan of composers. Boosey needed capital to for Burn Stewart Distillers Limited to purchase additional rights and Intangible expand its international business marketing Business agreed to provide the funding, whisky brands. KBC retained Intangible which was secured by the rights Boosey Business, an IP financial services firm, to already owned. value Burn’s intangible assets and Some firms specialising in IABLs will inventory, and was able to demonstrate the serve as a credit enhancement agent to a additional value of the brand assets when larger bank or firm that ultimately lends the

58 Intellectual Asset Management May/June 2010 www.iam-magazine.com Capital choices

Intangible financing from 30,000 feet

Although intangible financings are not as frequent as those backed by other assets, there is enough information out there to be able to come to some conclusions about them:

• IA financing vehicles require flexibility and however, conservative loan-to-value specialisation to account for differing and ratios, advance rates and other debt-and- unique factors inherent in intangible assets. equity protocols allow firms to account for • A robust market for IAs is necessary to the inherent imprecision of IA valuations. ensure appropriate and accessible • Intangible assets, as an asset class, liquidation events for financial firms with provide financial firms with flexibility in both debt and equity positions, especially structuring deals, allowing for both debt- in distressed situations. The recent and-equity vehicles and hybrid models. proliferation of IA licensing and sales, These vehicles can be adapted to address including auctions, has added depth to financing requirements for companies of this market. But with low recovery rates all sizes and needs. currently standard, greater awareness is • The securitisation market for intangibles, needed to ensure that companies’ and while currently suffering from the same financial firms’ IAs are valued correctly, problems plaguing the overall and licensed and sold at prices reflecting securitisation market, provides additional high return rates. mechanisms for companies with IA- • Intangibles are important assets to be licensing businesses. These companies secured in lending and compared with the can use a debt model to generate cash traditional assets of real estate, accounts flow for positive assets or, more likely, use receivable and inventory. an equity model for pre-commercial • Even financial firms specialising in IAs phase assets. rightly evaluate investment opportunities • The development of financial products within the broader view of the profitability based on intangible assets is not the next and growth potential of a target business. exotic financial vehicle. The financial These holistic due diligence processes, products discussed in this article are however, do not discount the independent some of the most basic financing value of many IA classes. mechanisms in business. The innovation • methodologies for IAs are is in recognising the value of intangible diverse and understandably imprecise; assets for corporate finance.

funds. These firms might partner with that supplies acoustic and thermal investment and commercial banks, and even insulation products to the automatic private equity firms, to secure a line of appliance and barbecue industries. The credit for the target company to provide the entire US$2 million loan by GMAC larger institution with additional Commercial Finance was secured by the protections to offset the complexity and company’s patents, trademarks and related uncertainty surrounding IA valuations. licensing revenue. The IABL was additional The innovative flat-panel display and separate from the working capital loans technology maker Cambridge Display secured by accounts receivable and Technology (CDT), for instance, secured a inventory, with only the IABL piece covered US$15 million loan from Lloyds TSB, fully by IPI’s credit enhancement guarantee. guaranteed by the credit enhancement firm IP Innovations (IPI) Financial Services Inc. Royalty financing According to published reports, IPI secured In recent years, a variation on IABL known the loan on the “strength of CDT’s patent as royalty financing arrangements have been portfolio, extensive licensing history, come increasingly useful, especially in the unprecedented upfront licensing fees, size pharmaceutical and biotechnology sectors. and growth trajectory of the market for the As Jeffrey A Jung and John P Tamisiea have products supported by the PLED patents, and pointed out in an article in The Deal the level of industry wide investment in the Magazine, these financings come in two commercialisation of the technology to date”. forms – royalty interest and revenue IPI financed a similar deal in 2004 for interest (or synthetic royalty) transactions. ATD Corporation, a Georgia-based company In these cases, the funding is specifically www.iam-magazine.com Intellectual Asset Management May/June 2010 59 Capital choices

backed by the current or prospective royalty investor pays the rights’ holder for part or stream, similar to a securitisation all of the prospective royalty revenue transaction. Unlike a securitisation, stream in exchange for the rights to future however, the loans are generally not bundled royalty pay days. and sold to the general public, but held by a According to Jung and Tamisiea, the speciality investment fund. number of these financing transactions has A royalty interest transaction allows a grown dramatically in recent years. In 2000, company to sell the rights to an investor for there was one publicly announced royalty cash up front or to sell a percentage of the interest deal and one publicly announced rights for cash up front while still retaining revenue interest transaction, totalling a partial right to future royalty revenue. US$145 million in investments. Contrast that Either way, the investor is attempting to with the 2007–2008 period, when there purchase the royalty revenue stream at a were 27 publicly announced transactions: 19 discount from what it will pay over its life. royalty interest transactions; five revenue The revenue interest model follows the interest transactions; and three hybrid same structure but is simply executed transactions using multiple financing earlier in the life of the patented or techniques including royalty financing. The copyrighted entity – for the purposes of value of all these deals was US$3.3 billion. this definition, before the royalties have Leading firms in this field include Capital generated any revenue. Because the royalty Royalty LP, Cowen Healthcare Royalty has yet to generate revenue, the investing Partners, DRI Capital Inc, Paul Capital institution generally negotiates more Healthcare and Royalty Pharma. favourable terms for itself due to the The story of XOMA, a human antibody greater level of risk, which may include an therapeutics technology company, illustrates equity position as well. Ultimately, the the process of the royalty interest version.

Online Registration 1 JUNE 2010 /// VIENNA /// AUSTRIA and programme details: www.irfs.at STRATEGIC SEMINAR USING IP AS AN INDICATOR OF R&D STRATEGY

Meet an exceptional Topics include: international panel of successful • The impact of Intellectual Property policies on innovation and competition - executives and managers. European and global perspectives: Manuel Desantes (Professor, former Vice-President of the European Patent Office) Explore Intellectual Property • Setting up a corporate IP department: Frank Cuypers (PricewaterhouseCoopers) policies and innovative • Promoting Innovation: Innovation management and IP audit: decision-making breakthroughs. Desai Narasimhalu (Director, Institute of Innovation and Entrepreneurship, Singapore Management University) Get updated over cost-effective • Assessing patents to measure the effectiveness of R&D: Holger Ernst (Chair for optimizations for managing Technology and Innovation Management, Otto Beisheim School of Management) the performance of your IP • Assessing the value of IP: Anthony Trippe (Director, IP Analytics, 3LP Advisors) department and R&D branch. This all-day seminar will be rounded up by a best practice session with presentations by Gerald Landl (Head of IP & Standards, voestalpine), David Walsh (Information Specialist for patent & chemistry, Pfizer), Pekka Sääskilahti (Senior Economist Legal and IP, Nokia Corporation) and Martin Bader (Managing Partner, BGW Management Advisory Group). Information Retrieval Facility The Strategic Seminar is organized by the Information Retrieval Facility in The Science and Industry Platform for a Sustainable Innovation Cycle collocation with the 3rd IRF Symposium. More information at www.irfs.at

60 Intellectual Asset Management May/June 2010 www.iam-magazine.com Capital choices

A royalty interest transaction allows a company to sell the rights to an investor for cash up front or to sell a percentage of the rights for cash up front while still retaining a partial right to future royalty revenue

In 1996, XOMA had negotiated an 2009 on Raptiva, linking the drug to a rare exclusive licence with Genentech for one of brain infection, all but eliminated XOMA’s its technologies. In 1997, Royalty Pharma royalty revenue from the Genentech purchased the patents and royalty rights, contract, which also affected the providing XOMA with immediate capital securitisation for the Goldman Sachs loan. while Royalty Pharma got the stream of XOMA subsequently restructured its royalty payments from Genentech. and paid off the Goldman loan in In 2006, XOMA entered into a five-year September 2009, in part through a US$25 loan facility with Goldman Sachs Specialty million buyout by Genentech of XOMA’s Lending Group, borrowing US$35 million. royalty interest in Lucentis. The loan was structured for an annual rate Despite XOMA’s recent struggles, its of six-month LIBOR plus 5.25% secured by case demonstrates the viability of a all rights to receive payments due to XOMA securitised intangible asset–backed loans: relating to XOMA’s drugs Raptiva, Lucentis, the company successfully securitised, sold, and Cimzia. Royalty payments received by and lent against its royalty revenue over the XOMA were to be used to make the semi- last decade. annual interest payment to Goldman, with any additional amounts used to pay down Alternate model – sale and lease back the principal at the lender’s discretion. Apart from the debt-and-equity financing In May 2008, XOMA refinanced its loan arrangements, the sale lease-back model is with Goldman to borrow US$55 million. worth considering for companies looking to The loan is secured by the royalty revenues raise capital for further innovation and XOMA receives from sales of the three business development. The sale lease-back brand-name drugs. Using proceeds from the is employed by some companies to secure new five-year loan, XOMA paid off the short-term funding by selling a portfolio of remaining US$22.1 million in principal from IP to a firm along with an agreement to the original 2006 royalty-based Goldman receive a licence for the IP to continue loan as well as transaction-related fees and commercialisation and . expenses. The company receives immediate funding to The story of XOMA’s creative financial reinvest in the business, and the licensing arrangements demonstrates the IA-based firm structures the contract to pursue financing options available to companies. continued monetisation of the asset. XOMA’s IP assets and associated revenues VocalTec Communications Ltd., an from its groundbreaking research and Israeli telecommunications company, for development (R&D) allowed it to enter into example, sold the rights to 15 of its 22 collaborative R&D and financing agreements inventions in January 2009 to raise cash to with Genentech and to make loan market its main internet phone software. arrangements with Royalty Pharma and VocalTec reported US$5.8 million in 2007 Goldman Sachs. revenue but decided to dispose of its However, negative developments consumer phone patents to focus on sales, relating to XOMA’s business show the flip using the money from the transaction to side of IP financing. An adverse public fund this business development effort. health advisory issued by the US Food and The VocalTec case demonstrates that Drug Administration (FDA) in February companies may consider it in their best www.iam-magazine.com Intellectual Asset Management May/June 2010 61 Capital choices

interests to jettison all or part of their IP in liquidation mechanisms and if a number of favour of a lump-sum cash payment. While mainstream financial firms get involved in most companies wish to retain their rights this exciting market. – whether for royalty revenues, technical The maturation of this market will market protection or brand preservation – prove to be a valuable innovation in finance. some will decide they will not suffer if they Today’s most promising companies are do not own their IP. built on intangible assets. This new wave of These alternative and hybrid models business growth requires the finance show the adaptability of financial firms to community to develop the robust financial structure IA-focused instruments to meet products to fund these companies. A the needs of companies. Intangibles are a market for IA-focused financial services is truly legitimate asset class that can be vital to foster continued innovation and treated like other asset classes, with economic growth. financial products of all structures able to be arranged to meet any given company’s capitalisation requirements.

A maturing market As we can see from these case studies, there is a place for intangible asset (IA) investments in the capital allocation Ian Ellis is a master of business process, even if it is not yet mature. administration candidate at the University IA-based finance will only develop if its of Chicago Booth School of Business. valuations can compete with other asset Kenan Patrick Jarboe is president of the classes, if it can rely on a variety of Athena Alliance (www.athenaalliance.org)

Your Experts for Intellectual Property

SKW Schwarz Rechtsanwälte – prosecution is an independent German law – trademark litigation ÄYT>LHK]PZL.LYTHUHUK – designs international clients of all in- – patents dustries nationally and, through – copyrights V\YUL[^VYRVMMVYLPNUSH^ÄYTZ – domain names HSZVNSVIHSS` – licensing – unfair competition law – competition/antitrust ¶ LTWSV`LLPU]LU[PVUZ

www.skwschwarz.de Berlin Düsseldorf Frankfurt/Main Hamburg München

62 Intellectual Asset Management May/June 2010 www.iam-magazine.com