The Emergence of IP Finance: A Bright Future Lies Ahead

Generally speaking, IP finance can be defined as any finance deal that derives its value and/or return from intellectual property. Although most IP finance professionals have heard about the “Bowie Bonds” more often than they probably care to, the role of IP in finance transactions has evolved beyond royalty securitizations to include bank lending, commercial finance company lending, bankruptcy sales, and sale/lease-back transactions.

IP finance transactions have been limited thus far by several broad challenges. First, the lack of an efficient market for IP means there is no easy way to verify IP value or to sell IP in a default, an inefficiency that necessitates more complicated due diligence and valuation processes. Second, the perceived inability to separate IP value from enterprise value has also hindered the growth of IP finance, as have difficulties associated with accurately predicting royalty streams.

The Future of IP Finance

Despite those challenges, there are several positive trends emerging that indicate that the market is beginning to adapt to overcome some of the difficulties. The recent sale of several patents on behalf of the estate of Commerce One, a bankrupt software company, for $15.5 million is not only an indication of the impact of those emerging trends, but it is hoped to be a sign of things to come.

Better Marketability

Of the several factors that have inhibited IP finance transactions, the lack of an efficient market for IP is perhaps the most significant. The lack of an efficient market can be tied in some ways to the fact that each IP asset is unique and therefore requires a greater level of support and commitment to the due diligence and valuation process, which has so far prevented the use of a standardized approach by which value can be assigned. Also, when IP assets are not being commercialized or are not actively/directly contributing to the generation of a pre-existing cash-flow, any analysis as to the value of the IP becomes more speculative. In those cases, broader assumptions must be made regarding the potential value of the IP asset.

One of the most recognized attempts at creating an efficient marketplace for IP Assets was The Patent & License Exchange (“PLX”), which attempted to provide the technology transfer community with a worldwide marketplace for intellectual property rights: patents, copyrights, trademarks, trade secrets and know-how. The PLX exchange ceased operations in 2002, but today there is a new movement underway by the state of Illinois' Center for Applied Innovation (“CAI”) to create the “next generation” exchange for commercialized technologies.

The CAI exchange differs from previous exchanges in that it is focused on “applied” technologies that have already been commercialized and therefore are actively contributing to a pre-existing cash flow. Also, the CAI exchange is based on a new model that uses IP investment bankers and investors to bridge the gap between IP owners (licensors) and IP users (licensees). According to Michael Lasinski, CAI's executive director, “The CAI marketplace increases the potential for the marketability of IP by creating a friendlier and more reasonable approach to technology deals.” To date, several major companies from the chemical and automotive industries have expressed interest in potentially participating in the exchange.

Time will tell if the CAI initiative is successful, but in the meantime it provides recognition of the need for a more efficient market for IP assets. If the exchange does succeed, it will most likely lead to the establishment of similar exchanges and a greater overall marketability of IP assets.

Increased Focus on the Value of IP in General

In addition to a lack of marketability and liquidity, there is a perception that the value of IP is heavily dependant upon the operations of the enterprise in which it is utilized. While this may be true for some IP assets, there are several reasons why IP assets can maintain significant value when separated from a business enterprise; specific evidence of this assertion includes the demand for patents and other IP as a defense against competition, the use of out-licensing to generate incremental revenue, and the use of IP in litigation defense and/or recovery. The recent emergence of IP acquisition companies like Intellectual Ventures and Acacia Research and IP merchant banks like ICMB Ocean Tomo and Paperboy Ventures are indicative of the potential for IP to maintain its value after being separated from the business enterprise. Finally, the purchase of the Commerce One patents by Novell, which was believed to be for defensive reasons, illustrates that patents can, and in many cases do, maintain significant value when separated from a business enterprise.

Increasing Focus on IP As an Asset Class

It has been said that you can't manage what you can't measure, and IP has historically not been adequately measured or managed. Recent accounting and regulatory changes have begun to help change that. Financial Accounting Standard (“FAS”) 141, for example, requires purchased intangibles to be allocated among categories such as marketing, customer, contract, artistic and technology-based intangibles. Only if an asset cannot otherwise be classified is it then put into the “goodwill” bucket. FAS 142, its sister guideline, requires impairment testing and write-downs for impaired goodwill. Apart from the greater clarity for investors that these guidelines are intended to bring, they will also help legitimize IP in people's minds as a separate asset class as managers and investors alike are forced to think about intangibles generally and IP specifically as separate and valid assets.

Also, much has been said and written about Sarbanes-Oxley (“SOX”), our government's attempt to enforce good governance. SOX has significantly raised the bar with respect to the responsibility of corporations and their top officers to understand what is going on in their companies and to actively and transparently manage the companies' assets. Meanwhile, there have been several lawsuits filed on behalf of shareholders alleging breaches of fiduciary responsibility by corporate officers for failing to adequately manage IP. The existence of these lawsuits is evidence that corporate stakeholders are increasingly focusing on IP as an asset class that must be managed. The personal liability that senior officers may face under SOX will serve as powerful motivation for corporations to act going forward.

Better Information

Because each piece of intellectual property is unique there is no “standardized” approach to the due diligence or valuation aspects of an IP finance deal. As a result, these parts of IP finance deals tend to take longer and be more expensive than those associated with other, more traditional, financing deals. Despite the challenges inherent in the due diligence and valuation processes, the increasing availability of information related to the value of intellectual property assets is likely to improve their overall quality. Specifically, the information disclosed under FAS 141, FAS 142, and SOX will provide greater transparency to the role of IP assets in a business enterprise and the value they provide. Additionally, newly evolving, independent patent valuation services such as PatentRatings and PatentValuePredictor and data providers such as RoyaltySource, Delphion, and Thomson Derwent will provide greater visibility into detailed metrics and information that can be used in assessing the relative value and quality of an IP asset. All combined, these and other potential sources of data will evolve to provide inventors, IP owners and investors with greater access to the types and quality of information that are required to adequately evaluate finance deals involving intellectual property.

An Excess of Investment Capital

The capital markets are awash in money. The Securities and Exchange Commission estimates that in the United States 6000 to 7000 hedge funds currently manage approximately $600 to $650 billion in assets and in the next 5 to 10 years hedge fund assets will exceed $1 trillion. Combined with money from private equity funds and other institutional money, then, it is no surprise that yields have fallen as investors compete for deals. Moreover, investors have been forced to seek out alternative investments and look for value in nontraditional places. In the second lien lending market, for example, hedge funds have been increasingly aggressive and have led a trend toward looking explicitly to IP as a way to generate an incremental return and/or as a way to guarantee a return if a deal goes “bad” and distressed debt funds have begun looking to IP as a source of hidden value in prospective investments. Said differently, investors are beginning to view IP as more than just boot collateral and are beginning to rely on it in when making underwriting decisions.

A More Receptive Finance Community

In the aftermath of Enron, WorldCom, and the many other scandals of the last few years, the pendulum of public opinion swung strongly toward tradition, transparency and clarity in finance transactions involving corporate America. Anything remotely esoteric or foreign to people's day-to-day lives became suspect. Special purpose entity (“SPE”) became a four-letter word and IP finance became an unintended victim ' “if it's complicated, then you must be hiding something” became the presumption. As memories of those times begin to fade, corporate finance professionals are becoming more open to discussing the potential role of IP in finance transactions. This general willingness to consider the role of IP in finance deals combined with the evolutionary changes discussed above provide reason to believe that a bright future lies ahead for the IP finance industry.

Marc Lucier, of River West Brands LLC, focuses on intellectual property-based finance and advisory services. Michael Milani is a director at I|C|M|B Ocean Tomo, an Intellectual Capital Merchant Bank specializing in the monetization of intellectual property assets.

A recent search of Amazon.com generated more than 2200 publications related to intellectual property. The publications covered a broad array of subjects including law, valuation, licensing, finance, management, and globalization. While this finding is illustrative of an expanding interest in intellectual property, the area of IP finance in particular is rapidly evolving and has the potential for significant growth.

There are several reasons to be optimistic about the future of IP finance including an increasing appreciation for the value attributable to IP, the recognition of IP as its own asset class, enhanced access to better information, and a more receptive finance community. In spite of these positive trends, the number and size of IP finance deals has been limited due to the unique nature of IP and the challenges associated with realizing its value. Recently, however, several new IP-focused initiatives and transactions provide evidence of an evolving marketplace that is adapting to overcome the challenges that have historically faced IP-based finance transactions.

History of IP Finance

Generally speaking, IP finance can be defined as any finance deal that derives its value and/or return from intellectual property. Although most IP finance professionals have heard about the “Bowie Bonds” more often than they probably care to, the role of IP in finance transactions has evolved beyond royalty securitizations to include bank lending, commercial finance company lending, bankruptcy sales, and sale/lease-back transactions.

IP finance transactions have been limited thus far by several broad challenges. First, the lack of an efficient market for IP means there is no easy way to verify IP value or to sell IP in a default, an inefficiency that necessitates more complicated due diligence and valuation processes. Second, the perceived inability to separate IP value from enterprise value has also hindered the growth of IP finance, as have difficulties associated with accurately predicting royalty streams.

The Future of IP Finance

Despite those challenges, there are several positive trends emerging that indicate that the market is beginning to adapt to overcome some of the difficulties. The recent sale of several patents on behalf of the estate of Commerce One, a bankrupt software company, for $15.5 million is not only an indication of the impact of those emerging trends, but it is hoped to be a sign of things to come.

Better Marketability

Of the several factors that have inhibited IP finance transactions, the lack of an efficient market for IP is perhaps the most significant. The lack of an efficient market can be tied in some ways to the fact that each IP asset is unique and therefore requires a greater level of support and commitment to the due diligence and valuation process, which has so far prevented the use of a standardized approach by which value can be assigned. Also, when IP assets are not being commercialized or are not actively/directly contributing to the generation of a pre-existing cash-flow, any analysis as to the value of the IP becomes more speculative. In those cases, broader assumptions must be made regarding the potential value of the IP asset.

One of the most recognized attempts at creating an efficient marketplace for IP Assets was The Patent & License Exchange (“PLX”), which attempted to provide the technology transfer community with a worldwide marketplace for intellectual property rights: patents, copyrights, trademarks, trade secrets and know-how. The PLX exchange ceased operations in 2002, but today there is a new movement underway by the state of Illinois' Center for Applied Innovation (“CAI”) to create the “next generation” exchange for commercialized technologies.

The CAI exchange differs from previous exchanges in that it is focused on “applied” technologies that have already been commercialized and therefore are actively contributing to a pre-existing cash flow. Also, the CAI exchange is based on a new model that uses IP investment bankers and investors to bridge the gap between IP owners (licensors) and IP users (licensees). According to Michael Lasinski, CAI's executive director, “The CAI marketplace increases the potential for the marketability of IP by creating a friendlier and more reasonable approach to technology deals.” To date, several major companies from the chemical and automotive industries have expressed interest in potentially participating in the exchange.

Time will tell if the CAI initiative is successful, but in the meantime it provides recognition of the need for a more efficient market for IP assets. If the exchange does succeed, it will most likely lead to the establishment of similar exchanges and a greater overall marketability of IP assets.

Increased Focus on the Value of IP in General

In addition to a lack of marketability and liquidity, there is a perception that the value of IP is heavily dependant upon the operations of the enterprise in which it is utilized. While this may be true for some IP assets, there are several reasons why IP assets can maintain significant value when separated from a business enterprise; specific evidence of this assertion includes the demand for patents and other IP as a defense against competition, the use of out-licensing to generate incremental revenue, and the use of IP in litigation defense and/or recovery. The recent emergence of IP acquisition companies like Intellectual Ventures and Acacia Research and IP merchant banks like ICMB Ocean Tomo and Paperboy Ventures are indicative of the potential for IP to maintain its value after being separated from the business enterprise. Finally, the purchase of the Commerce One patents by Novell, which was believed to be for defensive reasons, illustrates that patents can, and in many cases do, maintain significant value when separated from a business enterprise.

Increasing Focus on IP As an Asset Class

It has been said that you can't manage what you can't measure, and IP has historically not been adequately measured or managed. Recent accounting and regulatory changes have begun to help change that. Financial Accounting Standard (“FAS”) 141, for example, requires purchased intangibles to be allocated among categories such as marketing, customer, contract, artistic and technology-based intangibles. Only if an asset cannot otherwise be classified is it then put into the “goodwill” bucket. FAS 142, its sister guideline, requires impairment testing and write-downs for impaired goodwill. Apart from the greater clarity for investors that these guidelines are intended to bring, they will also help legitimize IP in people's minds as a separate asset class as managers and investors alike are forced to think about intangibles generally and IP specifically as separate and valid assets.

Also, much has been said and written about Sarbanes-Oxley (“SOX”), our government's attempt to enforce good governance. SOX has significantly raised the bar with respect to the responsibility of corporations and their top officers to understand what is going on in their companies and to actively and transparently manage the companies' assets. Meanwhile, there have been several lawsuits filed on behalf of shareholders alleging breaches of fiduciary responsibility by corporate officers for failing to adequately manage IP. The existence of these lawsuits is evidence that corporate stakeholders are increasingly focusing on IP as an asset class that must be managed. The personal liability that senior officers may face under SOX will serve as powerful motivation for corporations to act going forward.

Better Information

Because each piece of intellectual property is unique there is no “standardized” approach to the due diligence or valuation aspects of an IP finance deal. As a result, these parts of IP finance deals tend to take longer and be more expensive than those associated with other, more traditional, financing deals. Despite the challenges inherent in the due diligence and valuation processes, the increasing availability of information related to the value of intellectual property assets is likely to improve their overall quality. Specifically, the information disclosed under FAS 141, FAS 142, and SOX will provide greater transparency to the role of IP assets in a business enterprise and the value they provide. Additionally, newly evolving, independent patent valuation services such as PatentRatings and PatentValuePredictor and data providers such as RoyaltySource, Delphion, and Thomson Derwent will provide greater visibility into detailed metrics and information that can be used in assessing the relative value and quality of an IP asset. All combined, these and other potential sources of data will evolve to provide inventors, IP owners and investors with greater access to the types and quality of information that are required to adequately evaluate finance deals involving intellectual property.

An Excess of Investment Capital

The capital markets are awash in money. The Securities and Exchange Commission estimates that in the United States 6000 to 7000 hedge funds currently manage approximately $600 to $650 billion in assets and in the next 5 to 10 years hedge fund assets will exceed $1 trillion. Combined with money from private equity funds and other institutional money, then, it is no surprise that yields have fallen as investors compete for deals. Moreover, investors have been forced to seek out alternative investments and look for value in nontraditional places. In the second lien lending market, for example, hedge funds have been increasingly aggressive and have led a trend toward looking explicitly to IP as a way to generate an incremental return and/or as a way to guarantee a return if a deal goes “bad” and distressed debt funds have begun looking to IP as a source of hidden value in prospective investments. Said differently, investors are beginning to view IP as more than just boot collateral and are beginning to rely on it in when making underwriting decisions.

A More Receptive Finance Community

In the aftermath of Enron, WorldCom, and the many other scandals of the last few years, the pendulum of public opinion swung strongly toward tradition, transparency and clarity in finance transactions involving corporate America. Anything remotely esoteric or foreign to people's day-to-day lives became suspect. Special purpose entity (“SPE”) became a four-letter word and IP finance became an unintended victim ' “if it's complicated, then you must be hiding something” became the presumption. As memories of those times begin to fade, corporate finance professionals are becoming more open to discussing the potential role of IP in finance transactions. This general willingness to consider the role of IP in finance deals combined with the evolutionary changes discussed above provide reason to believe that a bright future lies ahead for the IP finance industry.

Marc Lucier, of River West Brands LLC, focuses on intellectual property-based finance and advisory services. Michael Milani is a director at I|C|M|B Ocean Tomo, an Intellectual Capital Merchant Bank specializing in the monetization of intellectual property assets.