New Financial Concepts in Patents

The bear market, the uncertain economy and pre-war jitters caused companies to seek to increase their cash reserves and to look aggressively for opportunities to increase their revenue. Certain advanced financial strategies recently used in financial markets may offer companies the opportunity to do just that. In particular, in-house patent attorneys and consultants should seriously consider recommending patent monetization as an alternative to standard patent licensing. The emerging monetization strategies that provide alternatives to licensing are founded on the growing appreciation that patents are actually an asset class in a financial sense as compared to a mere asset from an accounting sense. An asset class, as distinct from an asset, comprises a collection of assets that have in common systematic or macroeconomic drivers of price and risk.

The evolution of patents into a bona fide asset class enables a range of new strategies for patent monetization through collateralization, securitization, and a variety of other innovative investment vehicles.

Monetization Through Patent Collateralization

'I am getting more and more inquiries from companies interested in finding ways to leverage IPR as collateral,' observes John M. Brosnan, an attorney and Director, Intellectual Property Group for Aon Risk Services in Chicago. The challenge in fulfilling these requests, according to Brosnan, is perceptual. Traditional institutional sources of capital are unfamiliar with the risks associated with the patent asset class and are consequently demanding insurance products and other risk transfer solutions. Robert W. Fletcher, an attorney and President, Intellectual Property Insurance Services, Inc., Louisville, KY, shares this belief and therefore argues that non-conventional financing is the more prudent strategy. He believes that the IPR collateral will be used for alternative class financial vehicles resulting from creative financial engineering. 'Conventional loans from traditional financial institutions were typically backed by receivables and tangible 'bricks and mortar' assets,' says Fletcher. IPR, which is becoming a bona fide alternative asset class, will soon serve as the basis for collateral that will enable securitization. Only time will tell, however, if borrowers can obtain sufficient credit enhancement to satisfy the demands of lending institutions, or if borrowers will bypass these institutions for more sophisticated financing through securitization.

Monetization Through Patent Securitization

Securitization is a relatively recent financial tool in which the risks and cash flows of similar assets, such as loans or mortgages, are aggregated into negotiable securities such as bonds. Also known as structured finance, securitization is a mechanism to reduce both the risk to investors and the cost of capital to issuers. Of the $218 billion in asset-backed securities issued in 2000, $70 billion were backed by mortgages and another $100 billion were backed by auto loans and credit card debts. Only a handful were backed by IPR royalties (see Goldman Sachs primmer on Asset Backed Securities, October 2001). 'Don't kid yourself into thinking that the investment banking community, the commercial banking community and the private equity community aren't spending a whole lot of time trying to figure out how to structure financial products to capture [the implied] value [of a patent portfolio] and to monetize it,' advises James Malackowski, a CPA and CEO of Duff & Phelps Capital Partners (DuffCap).

DuffCap offers corporate clients a means for selling their later stage IPR and creating immediate liquidity while still maintaining relevant IPR control through a cost-of-capital advantaged back license. Robert J. Block, an attorney and Director of Risk Management with Technology Option Capital, LLC (TOC), Pittsburgh, PA, offers structured financial solutions to help those same corporate clients maintain IPR control while leveraging R&D resources for early stage technologies. TOC's approach is to aggregate IPR into technology-specific portfolios and control the portfolio rights through options. Both structured solutions integrate tax credits with credit, legal, commercial, and technology risks to deliver financial benefits at an affordable cost to clients while minimizing risk for the
financiers.

Structured finance, by removing institutional hysteresis brought on by several layers of management and cost, and by dispersing risk, makes capital more accessible. Its impact on the entire R&D and technology commercialization process will be substantial. Those who take early advantage of these opportunities and adopt leading edge financial strategies will be pleasantly surprised by their lower capital costs.

Measuring Patent Risk and Value

Financiers are adept at measuring and managing credit risk but are uncomfortable assessing the integrity and value of collateral. 'It's analogous to the real estate finance market,' Brosnan explains. A lender will offer a mortgage loan secured by real property such as a home and its underlying property. The lender will look at the borrower to determine credit risk. But the lender will also demand assurance and validation from a third party that the estimated asset value of the collateral is reasonable and is protected for the term of the loan. The lender typically will demand title insurance, a home owner's policy and fire insurance.

Based on their unique relationships and knowledge of both IPR and the insurance markets, insurance market makers are in a position to offer IPR-based structured solutions. The financiers of such vehicles can measure and manage credit risk, but they are inexperienced in measuring IPR integrity or value. Thus the insurance markets are being called upon to limit the financial risk of diminishing IPR collateral value whether such loss is due to 'title' issues, such as infringement or right to practice, or from commercial risks, such as lost markets and obsolescence. Fletcher, a pioneer of insuring intellectual property, is confident that the insurance markets will learn to be comfortable with commercial risk
in due time. 'Many commercial risks are already implicitly covered through existing insurance products,' notes Block.

At the heart of the commercial risk issue is the need for a reliable measurement of IPR value. Despite the implementation 15 months ago of the Financial Accounting Standards Board, FAS 142, that sets guidelines on memorializing the book value of patents, and analogous international guidelines that call for regular intangible asset valuation, 'people are still struggling,' observes Bruce Lehman, a former Commissioner of the USPTO, and now President and CEO of the International Intellectual Property Institute. While the value of patents is often demonstrated in the damages phase of infringement litigation, the work of expert witnesses and other valuation consultants remains largely proprietary and out of the reach of the corporate front office, adds Lehman. Building on the real estate model, Lehman notes that the regular public recordation of transactional value following home sales has been extremely helpful in promoting transparent valuation and liquidity. He indicates that the USPTO was considering a suggestion that patent assignment recordation might not only be enforced but that transactional value data might also become part of the public record.

Such disclosures, however, would probably be opposed by the patent-holding community because the information would also provide great competitive intelligence. The ultimate resolution of the expected debate on the USPTO initiative will rest on the apparent balance between the benefits and risks of financial transparency to overall business practices and competitiveness.

Credit Ratings Constrain Monetization Opportunities

For the larger IPR holders and for industrial concerns with adequate credit ratings, IPR's evolution into a bona fide alternative asset class should be accompanied by the ascendancy of patent collateralization and securitization, which will rapidly surpass conventional licensing as the most efficient patent monetization strategy. For firms without adequate credit ratings, monetization choices will be more limited. For these firms, venture capital markets have long been a major source of capital and liquidity. But the National Venture Capital Association recently reported that in 2002, U.S. venture capital firms raised $6.9 billion for 108 new venture capital funds, down from $40.7 billion for 331 new funds in 2001. In light of the fact that 26 firms in 2002 cancelled $5 billion in already committed funds, only $1.9 billion was actually raised ' the lowest amount since 1991. Since most private equity venture capital funds are capitalized at levels, or by investors, that require a three to four year liquidity horizon, early-stage companies will be at a significant disadvantage for the foreseeable future. Furthermore, because the aims of venture capital remain to seek maximum returns on equity, if it were available, it would be one of the most expensive sources of capital. In contrast to the equity markets, debt-based financiers such as TOC that offer structured financial solutions are less expensive. However, the debt-based solution is a double-edged sword in that the mechanisms that reduce volatility and risk to the financiers also tend to place a cap on the returns to the IPR originators.

Financing Assertion Licensing

For those patent holders for whom immediate liquidity is not a primary consideration 'assertion licensing' may be an acceptable monetization strategy. Assertion licensing combines elements of venture capital with elements of contingency litigation practice. For example, one company, TechSearch, LLC, assumes 100% of the risk of enforcing promising IPR where the expected value of an asserted license, adjusted for the risk of prevailing in litigation, yields an acceptable return on invested capital. In this case, monetization is largely insensitive to public equity markets, but is sensitive to trends in litigation awards.

Financing Conventional Licensing

Even traditional 'carrot' licensing is transforming as patents evolve into their own asset class. Hideki Otsuyama, an attorney, President and COO of PLX K.K., and Director for SBI Intellectual Property Co., LTD, finds himself at the vortex of two merging cultures: the traditional world of IP; and the constantly evolving world of business markets. SBI-IP is a joint venture of financial market innovators: Softbank Finance Corporation and Softbank Investment Corporation. This new operation, formed early in 2002, combines IP with different aspects of business. For example, SBI-IP provides software for IP asset management, financial tools for alternative risk transfer, IT systems for supplementing labor-intensive IP brokering, investment capital for seeding and supporting new ventures, and incubation services for providing managerial support.

Conclusion

Several years ago, the acronym IAM meant either intellectual or intangible asset management. At that time, the acronym implied a host of administrative or legal activities such as portfolio culling, valuation, prosecution, and licensing.
Today,  IAM is evolving into intellectual or intangible asset monetization as intellectual property rights evolve into a distinct asset class with fungible components. Financiers are innovators: At this very moment they are probably developing patent-pending IPR monetization solutions.

Nir Kossovsky, MD, MBA is CEO of Technology Option Capital, LLC in Pittsburgh, PA. E-mail: [email protected].

The bear market, the uncertain economy and pre-war jitters caused companies to seek to increase their cash reserves and to look aggressively for opportunities to increase their revenue. Certain advanced financial strategies recently used in financial markets may offer companies the opportunity to do just that. In particular, in-house patent attorneys and consultants should seriously consider recommending patent monetization as an alternative to standard patent licensing. The emerging monetization strategies that provide alternatives to licensing are founded on the growing appreciation that patents are actually an asset class in a financial sense as compared to a mere asset from an accounting sense. An asset class, as distinct from an asset, comprises a collection of assets that have in common systematic or macroeconomic drivers of price and risk.

The evolution of patents into a bona fide asset class enables a range of new strategies for patent monetization through collateralization, securitization, and a variety of other innovative investment vehicles.

Monetization Through Patent Collateralization

'I am getting more and more inquiries from companies interested in finding ways to leverage IPR as collateral,' observes John M. Brosnan, an attorney and Director, Intellectual Property Group for Aon Risk Services in Chicago. The challenge in fulfilling these requests, according to Brosnan, is perceptual. Traditional institutional sources of capital are unfamiliar with the risks associated with the patent asset class and are consequently demanding insurance products and other risk transfer solutions. Robert W. Fletcher, an attorney and President, Intellectual Property Insurance Services, Inc., Louisville, KY, shares this belief and therefore argues that non-conventional financing is the more prudent strategy. He believes that the IPR collateral will be used for alternative class financial vehicles resulting from creative financial engineering. 'Conventional loans from traditional financial institutions were typically backed by receivables and tangible 'bricks and mortar' assets,' says Fletcher. IPR, which is becoming a bona fide alternative asset class, will soon serve as the basis for collateral that will enable securitization. Only time will tell, however, if borrowers can obtain sufficient credit enhancement to satisfy the demands of lending institutions, or if borrowers will bypass these institutions for more sophisticated financing through securitization.

Monetization Through Patent Securitization

Securitization is a relatively recent financial tool in which the risks and cash flows of similar assets, such as loans or mortgages, are aggregated into negotiable securities such as bonds. Also known as structured finance, securitization is a mechanism to reduce both the risk to investors and the cost of capital to issuers. Of the $218 billion in asset-backed securities issued in 2000, $70 billion were backed by mortgages and another $100 billion were backed by auto loans and credit card debts. Only a handful were backed by IPR royalties (see Goldman Sachs primmer on Asset Backed Securities, October 2001). 'Don't kid yourself into thinking that the investment banking community, the commercial banking community and the private equity community aren't spending a whole lot of time trying to figure out how to structure financial products to capture [the implied] value [of a patent portfolio] and to monetize it,' advises James Malackowski, a CPA and CEO of Duff & Phelps Capital Partners (DuffCap).

DuffCap offers corporate clients a means for selling their later stage IPR and creating immediate liquidity while still maintaining relevant IPR control through a cost-of-capital advantaged back license. Robert J. Block, an attorney and Director of Risk Management with Technology Option Capital, LLC (TOC), Pittsburgh, PA, offers structured financial solutions to help those same corporate clients maintain IPR control while leveraging R&D resources for early stage technologies. TOC's approach is to aggregate IPR into technology-specific portfolios and control the portfolio rights through options. Both structured solutions integrate tax credits with credit, legal, commercial, and technology risks to deliver financial benefits at an affordable cost to clients while minimizing risk for the
financiers.

Structured finance, by removing institutional hysteresis brought on by several layers of management and cost, and by dispersing risk, makes capital more accessible. Its impact on the entire R&D and technology commercialization process will be substantial. Those who take early advantage of these opportunities and adopt leading edge financial strategies will be pleasantly surprised by their lower capital costs.

Measuring Patent Risk and Value

Financiers are adept at measuring and managing credit risk but are uncomfortable assessing the integrity and value of collateral. 'It's analogous to the real estate finance market,' Brosnan explains. A lender will offer a mortgage loan secured by real property such as a home and its underlying property. The lender will look at the borrower to determine credit risk. But the lender will also demand assurance and validation from a third party that the estimated asset value of the collateral is reasonable and is protected for the term of the loan. The lender typically will demand title insurance, a home owner's policy and fire insurance.

Based on their unique relationships and knowledge of both IPR and the insurance markets, insurance market makers are in a position to offer IPR-based structured solutions. The financiers of such vehicles can measure and manage credit risk, but they are inexperienced in measuring IPR integrity or value. Thus the insurance markets are being called upon to limit the financial risk of diminishing IPR collateral value whether such loss is due to 'title' issues, such as infringement or right to practice, or from commercial risks, such as lost markets and obsolescence. Fletcher, a pioneer of insuring intellectual property, is confident that the insurance markets will learn to be comfortable with commercial risk
in due time. 'Many commercial risks are already implicitly covered through existing insurance products,' notes Block.

At the heart of the commercial risk issue is the need for a reliable measurement of IPR value. Despite the implementation 15 months ago of the Financial Accounting Standards Board, FAS 142, that sets guidelines on memorializing the book value of patents, and analogous international guidelines that call for regular intangible asset valuation, 'people are still struggling,' observes Bruce Lehman, a former Commissioner of the USPTO, and now President and CEO of the International Intellectual Property Institute. While the value of patents is often demonstrated in the damages phase of infringement litigation, the work of expert witnesses and other valuation consultants remains largely proprietary and out of the reach of the corporate front office, adds Lehman. Building on the real estate model, Lehman notes that the regular public recordation of transactional value following home sales has been extremely helpful in promoting transparent valuation and liquidity. He indicates that the USPTO was considering a suggestion that patent assignment recordation might not only be enforced but that transactional value data might also become part of the public record.

Such disclosures, however, would probably be opposed by the patent-holding community because the information would also provide great competitive intelligence. The ultimate resolution of the expected debate on the USPTO initiative will rest on the apparent balance between the benefits and risks of financial transparency to overall business practices and competitiveness.

Credit Ratings Constrain Monetization Opportunities

For the larger IPR holders and for industrial concerns with adequate credit ratings, IPR's evolution into a bona fide alternative asset class should be accompanied by the ascendancy of patent collateralization and securitization, which will rapidly surpass conventional licensing as the most efficient patent monetization strategy. For firms without adequate credit ratings, monetization choices will be more limited. For these firms, venture capital markets have long been a major source of capital and liquidity. But the National Venture Capital Association recently reported that in 2002, U.S. venture capital firms raised $6.9 billion for 108 new venture capital funds, down from $40.7 billion for 331 new funds in 2001. In light of the fact that 26 firms in 2002 cancelled $5 billion in already committed funds, only $1.9 billion was actually raised ' the lowest amount since 1991. Since most private equity venture capital funds are capitalized at levels, or by investors, that require a three to four year liquidity horizon, early-stage companies will be at a significant disadvantage for the foreseeable future. Furthermore, because the aims of venture capital remain to seek maximum returns on equity, if it were available, it would be one of the most expensive sources of capital. In contrast to the equity markets, debt-based financiers such as TOC that offer structured financial solutions are less expensive. However, the debt-based solution is a double-edged sword in that the mechanisms that reduce volatility and risk to the financiers also tend to place a cap on the returns to the IPR originators.

Financing Assertion Licensing

For those patent holders for whom immediate liquidity is not a primary consideration 'assertion licensing' may be an acceptable monetization strategy. Assertion licensing combines elements of venture capital with elements of contingency litigation practice. For example, one company, TechSearch, LLC, assumes 100% of the risk of enforcing promising IPR where the expected value of an asserted license, adjusted for the risk of prevailing in litigation, yields an acceptable return on invested capital. In this case, monetization is largely insensitive to public equity markets, but is sensitive to trends in litigation awards.

Financing Conventional Licensing

Even traditional 'carrot' licensing is transforming as patents evolve into their own asset class. Hideki Otsuyama, an attorney, President and COO of PLX K.K., and Director for SBI Intellectual Property Co., LTD, finds himself at the vortex of two merging cultures: the traditional world of IP; and the constantly evolving world of business markets. SBI-IP is a joint venture of financial market innovators: Softbank Finance Corporation and Softbank Investment Corporation. This new operation, formed early in 2002, combines IP with different aspects of business. For example, SBI-IP provides software for IP asset management, financial tools for alternative risk transfer, IT systems for supplementing labor-intensive IP brokering, investment capital for seeding and supporting new ventures, and incubation services for providing managerial support.

Conclusion

Several years ago, the acronym IAM meant either intellectual or intangible asset management. At that time, the acronym implied a host of administrative or legal activities such as portfolio culling, valuation, prosecution, and licensing.
Today,  IAM is evolving into intellectual or intangible asset monetization as intellectual property rights evolve into a distinct asset class with fungible components. Financiers are innovators: At this very moment they are probably developing patent-pending IPR monetization solutions.

Nir Kossovsky, MD, MBA is CEO of Technology Option Capital, LLC in Pittsburgh, PA. E-mail: [email protected].