IP-backed lending: the long view

Banks are again attentive to supporting business growth rather than mere survival, and IP is back in the spotlight. Martin Brassell looks at the past, present and future of IP debt finance

The use of intellectual property as security for loan finance is older than you might think. One of the earliest recorded transactions dates from the late 1880s, when Thomas Edison used his incandescent light bulb patent to secure financing for what would eventually become the General Electric Company.

Interest in IP to obtain finance started to grow substantially about a century later, when the value of licensing streams became apparent. This was fuelled by better analysis of the cash flows generated by high-profile corporations, and by a series of high-profile music industry transactions featuring Jimi Hendrix, The Beatles and David Bowie.

Around the same time, the assets that drive value in many businesses began to shift. Now, it has reached a point where the composition of all world indices of top-performing listed companies is virtually unrecognisable compared with the 1980s. This is the biggest takeaway from “Intangible Asset Market Value Study,” Ocean Tomo’s oft-quoted research into the shift in intangible value over the intervening period.

The use of IP to raise finance is now an emerging global trend, with many interesting developments in Asia – particularly in China, Korea, Japan, Malaysia and Singapore. As one example (following initial experiments in Shanghai back in 2006), WIPO’s recent Country Perspectives report on China, “Unlocking IP-backed Financing Series: Country Perspectives - China’s Journey,” shows a rapid expansion of IP pledge activity in recent years, principally against patents, with 26,000 businesses recorded as having received such loans in 2022 totalling 401.5 billion Chinese yuan. This growth has been facilitated by a wide-ranging policy agenda covering new and updated registers, guarantees for banks, subsidies for innovators and increased availability of insurance.

Clearly, we mustn’t get ahead of ourselves. Deeper analysis suggests that in China, for example, IP is rarely the sole source of security for these loans. This situation reflects not only local market conditions, but also the continued unfamiliarity of the asset class to lenders, arising in part from its lack of balance sheet visibility (and historical bank mistrust of the reliability of accounting entries concerning intangibles).

Globally, these issues boil down to the two main challenges that have stopped IP finance from moving from the margins to the mainstream, which are:

• high transaction costs; and
• a lack of confidence in recoverable value.

The two barriers

High transaction costs start with the lack of accommodation for intangibles within banking regulatory frameworks. The Basel III rules that govern capital adequacy and liquidity provide standard approaches that deliver capital relief on lending against familiar tangible assets like real estate and automobiles, but not for IP.

This means a bank lending to a small- or medium-sized enterprise with no hard assets typically must put aside capital representing 100% of the loan value, with no offset from the value of the IP taken as security. Add on the historical costs of valuation and due diligence and it is easy to see how many of the theoretical attractions of debt-to-fund growth – the absence of dilution and lower economic cost – can be nullified.

Few banks or even specialist lenders have engaged sufficiently with IP to know how to recover value from it. They are accustomed to dealing in assets that are, to a greater or lesser extent, commodities.

Of course, as IAM readers know well, the whole point of IP is that it is not a commodity – therefore, it follows that it cannot be re-sold like one (it requires match-making, not simply advertising). Nevertheless, banks are quite correct in observing that intangible value is context-sensitive and so it is not unreasonable for them to fear that if a business fails, buyers for its IP will be hard to find.

Attractions of IP

In part, IP finance is worth pursuing simply because IP has a direct connection with cash flows. The fact that fewer and fewer businesses even own the types of tangible property assets lenders have traditionally dealt with is also a major driver. Furthermore, while IP has risks, they are very seldom correlated between companies in any given loan portfolio, even within a sector.

There are other factors at work too. These include a growing body of evidence that IP is associated with better business performance and higher survival rates, from research reports published in the US, Europe and Australia. Equally, it is apparent from recent press reports of business failures that IP and intangibles such as brand-related assets, data and databases, and software systems are the things that can be transacted most quickly and effectively. The demand for commercial real estate has fallen sharply, and few buyers have any interest in acquiring old stock.

It has always been difficult to obtain good data on the relationship between IP and loan performance, simply because so few lenders routinely capture information on intangibles at the time of credit approval. However, government guarantee portfolios provide an opportunity to address this information gap.

The paper “Using Intellectual Property to Access Growth Funding,” jointly researched by the UK Intellectual Property Office and the British Business Bank in 2018, found that where IP was present, guaranteed loans had broadly a 40% lower probability of default and 50% lower losses given default. Hard evidence like this has played a part in encouraging UK lenders to engage with IP as an asset class, as noted below.

Enabling measures

The rise in IP finance activity stems chiefly from the realisation that change is necessary (and, as explained above, inevitable). Some growth markets, such as China and Korea, have been driven by policy initiatives. In Western countries, government involvement (where present) has generally sought to facilitate progress rather than legislate.

As a result, we have seen:

• better access to data;
• the emergence of new technology platforms; and
• guarantees and insurance solutions that can provide lenders with a safety net.

Before any of these steps can make a difference, IP first needs to be recognised in law as a legitimate asset class. Over recent decades, the World Bank has supported many countries in updating their legal regimes and establishing registers for movable assets, putting many of the essential preconditions in place. Backed by local reforms to facilitate leverage of IP’s value – reviewed in “Making effective use of registries and intangibles - a case study approach,” by OECD SME and Entrepreneurship Papers – this at least gives lenders the option of obtaining an effective security interest over these assets.

Lending against IP: the three C’s

Catch-all provisions

Many contemporary loan agreements already incorporate standard wording that purports to provide security over IP. Typically, these are “catch-all” provisions that do not specify the assets in question and are therefore unlikely to be very effective in insolvency. In the US, these standard measures may go further and record, for example, itemised patents subject to a lien, but this is because the Article 9 regime encourages this practice, and US copyright law requires it.

For finance to be IP-based, it is surely a requirement that some value must be given in exchange for the security taken. As we see it, this generally takes one of two forms.

Comfort to lend

Firstly, it may be that the IP gives a lender enough comfort to extend credit, or offer more credit, where it would not otherwise have done so. Here, IP fills the information gap left by the business balance sheet, explaining the nature of the assets that drive performance and have left their mark on accrued costs.

An enforceable security interest is important, not so much because the lender is relying on a recoverable IP value but because having recourse in a default scenario drives better borrower behaviour. IP-intensive firms know that without these assets, they no longer have a business at all.

Collateral

Secondly, a lender may take the view that some IP is good enough to be used as collateral – it has value that could be recovered even if the current business fails to realise its potential.

To satisfy the usual tests that would be applied by banks, such assets must be:

• capable of being separated from their owner;
• saleable (credible, identifiable buyers must exist for them); and
• strong enough to survive a buyer’s due diligence – even if, in practice (at least in commercial lending), refinancing or restructuring is a more likely recovery route than an independent asset sale.

The more often assets can be identified that pass these tests, the stronger the case becomes for better regulatory recognition, as referenced above.

Current initiatives of note

In the UK, two lenders are now expressly considering IP asset value when lending to high-growth companies, as noted in the recent WIPO country report, “Unlocking IP-backed Financing Series: Country Perspectives - The United Kingdom’s Journey”.

Since 2022, HSBC UK has offered a growth lending proposition providing facilities of £5 million to £15 million to help businesses bridge to profitability, separately from its venture debt products. All companies have their IP valued for comfort and security interests are registered against specified assets at both the UK’s Companies House and the UK IP Office.

NatWest Group has gone further and since January 2024 is now using IP assets as sole collateral. In this case, the IP directly determines the amount of value the bank will attribute to the security it registers. Its High Growth IP Loan is available from loan sizes as low as £250,000 to £10 million. All loans are monitored post-drawdown with the IP assets subject to annual revaluation.

It is important to stress that neither of these products is seeking to re-write the basic rules of lending. Both require the borrower to be cash-generative and able to show that they can service debt. For that reason, these loans are not suitable for start-ups or non-practising entities.

These are purely commercial initiatives, but the last few years have also seen some interesting public-private initiatives. The Canadian development bank BDC created IP finance capacity by bringing private sector specialist expertise in-house and has now started lending to IP-rich growth businesses. In Korea, a buyback fund for IP taken as collateral was initiated in 2019, funded by the country’s leading financial institutions, and supported by Intellectual Discovery since 2020.

In Jamaica, the Inter-American Development Bank has been the lead sponsor of an IP financing pilot including measures to train lenders and other stakeholders in valuation techniques, according to Unlocking IP-”backed Financing Series: Country Perspectives – Jamaica’s Journey” by WIPO. The wide range of countries now engaging with the topic reflects IP’s close connection with innovation and growth, and hence the near-universal attractiveness of leveraging IP value for finance.

Updating the rules

Government-backed activity designed to enable progress has continued in other markets. In Japan, the JPO has continued to make IP valuation reports available to its regional banks. Having previously operated an IP financing pilot scheme from 2014 to 2018, the Intellectual Property Office of Singapore has led an initiative to introduce a national intangibles disclosure framework.

The reason Singapore has taken this step is because there is an elephant in the room (or perhaps, missing from the room) concerning the lack of visibility of intangibles in company accounts. In this respect, recent confirmation that the International Accounting Standards Board (IASB) has initiated its comprehensive review of accounting requirements for intangibles is a positive development. Clearly, there will be challenges in finding the right way to recognise assets that arise from internal development (as most IP does) and we should not expect a quick outcome.

On the valuation question, the International Valuation Standards Council (IVSC) published its updated standards in January 2024, intended to be in force from 2025. While the standard for intangibles (IVS 210) is largely unchanged, a substantial amount of general guidance has been added which may help build confidence in the quality of IP valuations for financing purposes.

It is also notable that the organisation responsible for administering global IP treaties – WIPO – is now in the second year of its IP finance initiative. Its workstreams centre on raising the profile of this activity, explaining what is happening on the ground, and creating toolkits to assist lenders, companies, and intermediaries.

Looking to the future

Two developments have clear potential to facilitate the much wider use of IP assets soon. The first is insurance, as a solution to a lack of confidence in recoverable value. This provides a commercial alternative to government guarantees and subsidies, and a means of structuring transactions in such a way that capital relief can be obtained.

Collateral protection insurance (CPI) justifies an article in its own right. At present mainly a US-based initiative, it provides cover to lenders against losses from partly or wholly unrecoverable defaults. Like any form of insurance, it needs a spread of risk to operate efficiently and become affordable, which unique IP assets do well (though to date CPI has been concentrated in a small number of high-value transactions).

The second is big data and the efficiency and insights it can deliver, when the right questions are asked of it. Just as CPI has been facilitated by new data insights, so also the NatWest product referenced above is only possible because of the steps taken to streamline and standardise the IP assessment and valuation process. AI will doubtless further transform the amount of information that can be brought to bear on decision-making – though we are not yet at the point where AI is explainable enough for lenders.

To close: in the past, I have predicted that “someday, all lending will be done this way”. The necessity for IP scrutiny seems obvious: how can anyone properly understand the substance of any growth business, if they do not look beyond the apparent thinness of its balance sheet to the assets that really drive scale and value, which will inevitably be intangible?

While there is still some way to go before this type of consideration becomes mainstream, the direction of travel is clear. Recognition of the collateral value of IP in finance has come of age.