A primer for IP-backed finance for growing companies

Intellectual property-collateralised lending is a game-changer for companies that are IP-rich and need growth capital, writes IP finance advisor Aaric Eisenstein

Financial engineering used to be a term that was only applicable to major corporations. The market has evolved, though, and there are now a seemingly limitless number of acronym-rich funding options, from SAFEs to VC, from SBA to PE. For growing companies with intellectual property assets, there’s a new option: CPI. Collateral protection insurance wrapped around a loan with IP as collateral can be an absolute game-changer for companies that have specific goals for growth, preservation of equity, and utilising previously illiquid assets to fuel opportunities.

What is IP-collateralised lending?

At the simplest level, we are talking about a loan. IP-backed lending is non-dilutive debt financing available to companies whose assets are intangible – like patents and trade secrets – instead of buildings and equipment. Traditional lenders usually lend only against collateral in the form of hard assets; intellectual property wouldn’t qualify as collateral. So how does a company, IP-rich but hard asset-poor, get a loan? That is precisely the scenario that IP-backed lending aims to address.

To make these deals work, insurance companies have collaborated with private credit lenders. IP-backed loans actually work very similarly to the scenario where a home buyer purchases homeowner’s insurance at the same time they close on their mortgage.

Two things happen simultaneously in an IP-backed loan:

1. the lender makes a loan to the borrowing company; and
2. the borrower purchases an insurance policy for the benefit of the lender.

This policy pays the lender back in the event of a default on the loan, just like homeowner’s insurance pays off the mortgage if the house burns down. The borrower uses part of the loan proceeds to pay the insurance premium and closing costs. The remainder of the loan can then be used by the borrower as operating capital for the business.

Figure 3: Participants in an insured IP-backed lending deal

Who uses IP-backed loans?

Companies pursuing this kind of financing can be in any industry and may have different strategic goals. But there is one important commonality: they are all successful companies with cash flows that allow them to support the debt. In that sense, IP-backed lending is just like any other loan. The lender’s primary consideration is how to get their money back. The underwriting process for these loans consists of two parts: the regular business and the IP collateral. In broad strokes, the main consideration is that the business can pay back the loan with cash generated from operations, and the IP serves as a backstop in the event that things have to be salvaged.

Every lender will have its own underwriting checklist and criteria for the regular part of the business, and the intention here is not to provide a comprehensive list. The items below, though, are representative of any lending scenario and illustrate how similar this process can be to getting traditional third-party financing.

Familiar underwriting factors include:

• financial projections (balance sheet, income statement and cash flow statement) reflecting what the company will do with the borrowed funds;
• historical financial statements, tax returns, and bank statements; and
• risk factors like customer concentration, industry trends and regulatory issues.

On the IP side, an important disclosure: IP-backed lending is a relatively nascent market. Extensive data on IP foreclosure sales do not yet exist, unlike the home mortgage market where there is a long history with foreclosing on collateral and then reselling it in the secondary market. That said, there are certainly established markets for IP transactions, and much of the lender’s underwriting will be like current transactional markets.

Unique underwriting factors include:

• legal analysis of validity, patentability, prosecution history and more; and
• valuation analysis based on the IP’s cost to reproduce, value in the market, potential revenue from enforcement and salability.

The cast of characters

There are several parties involved in assembling these deals. Some will be interacting with the borrower at every step of the process; others will be in the background, and the borrower may well never speak with them. The primary on-going relationship will be between the borrower or their advisor and the insurance broker. Consequently, a critical decision for a potential borrower is working with the right insurance broker.

In the early stages of determining whether an IP-backed loan is a viable possibility, it makes sense to speak with multiple insurance brokers and get a sense of what they can offer. But once the borrower has determined to move forward, the borrower must select only a single broker with whom to work. The insurance carriers require that there be a single, signed-up broker for any given loan opportunity.

• Insurance brokers: The insurance broker is engaged by the borrower to act as its agent. The broker has multiple roles:
  • assess the opportunity for general fit;
  • work with the borrower to prepare a submission package to sell the deal to insurance carriers; and
  • help arrange financing via introductions to potential lenders.
• Insurance carriers: These are the large financial firms which write a policy that pays out in the event of a loss, protecting the lender.
• Lenders: These firms loan money to the borrowing company to pay for the insurance premium and fees, and the net proceeds can be used for operating capital.
• Outside counsel or underwriters: Insurance carriers and lenders will typically have outside counsel and financial underwriters evaluate these opportunities as part of their diligence process. These entities advise in the background and typically will not have direct interaction with the borrower.
• Borrower advisor: Advisors represent borrowers and guide them through the entire process. For example, my company, ASE Monetization, is a borrower advisor working for third-party clients. A good advisor is active in the market, knows the players and their concerns, and can use their expertise and experience to streamline the process, saving both time and money. These deals also require a significant amount of project management and cat-herding. That’s often the advisor’s role.

Doing the maths

The first thing to acknowledge about the numbers is that every deal is different, and every set of terms can be negotiated depending on what is important to the borrower. The purpose of the example below is to show the various components of a deal and give a sense of relative sizes. This is a dynamic market, and pricing moves around, but these are real numbers as of the time of writing.

Table 4: Compensation of IP-backed loan participants

Table 5: Example maths on an IP-backed loan deal

One important piece of background information before diving in: all the expenses below are fully contingent. The early-stage analysis work by insurance brokers (and advisors) is done at their own risk. Borrowers can find out a great deal about the suitability of their company for this kind of financing before having to make any financial commitment.

The borrowing company enters two simultaneous transactions. Part one is the loan, and part two is the insurance policy purchase. The two are sized to be complementary, and loan proceeds are used for all the expenses below, including the transaction costs.

The loan

• $12 million principal amount
• Four-year term
• 13% interest
• Partially amortised over the term, with interest-only in year one
• One-year interest reserve

The insurance policy

• $10 million policy
• 15% premium

Transactions costs

• $100,000 to $150,000 legal
• $100,000 underwriting
• $45,000 taxes
• $200,000 to $400,000 advisory fees

Based on the assumptions above, Table 5 shows the back-of-the-envelope maths on how a deal like this pencils out.

What’s the process?

So what is involved in putting a deal like this together? The process is like a regular loan. Wrinkles and complications will inevitably creep in, but that is to be expected. Working with experienced people who have seen these things before – and overcome them – can make an enormous difference.

Timing for every deal is different of course. It’s not unreasonable to expect a start-to-finish of four to six months. The typical slowdown occurs because the borrower is doing a deal like this for the first and only time in their company’s history. These can be large transactions, in the eight-figure range, and so it makes sense to move at a pace that avoids mistakes. Good guidance is also a worthwhile investment, particularly if it can save months of effort by internal teams. The insurance and lending people do these deals as their bread and butter, so there is definitely an education component as they work with potential borrowers.

Elements of a deal include:

1. Data room: Every deal needs a data room with necessary documentation to understand the opportunity. At this early stage, the documents really focus on the purpose of the loan and the ability of the borrower to pay it back. So expect to provide historical and projected financial statements, information about your patents, a pitch deck and the like.
2. Broker conversations: The borrower or its advisor will begin preliminary conversations with multiple insurance brokers. The insurance brokers will ask questions about the borrower, the IP and the business case. Remember that insurance brokers get paid only if a deal consummates, so they act as a gatekeepers at this point, providing the first level of diligence analysis. If they do not think this is a doable deal, they will say so at an early stage.
3. Preliminary conversations:
   1. Insurance carrier conversations – These are informal conversations between brokers and the carriers. No names are used. The idea is to get a general sense of whether there is currently an appetite for the deal and if so, what contours it might have. How big a policy is available? With what terms?
   2. Lender conversations – In parallel, the insurance broker will also speak with potential lenders. They may ask: “If there were a policy for $12 million, how much would you be willing to lend and on what terms”? Lending is a very dynamic market influenced by everything from lenders’ capital allocation models to global interest rates.
4. Initial financial modelling: The borrower now has sufficient information to put together a financial model. This will show the cash flows and timing for the insurance policy and the loan. This stage needs creativity. There are all kinds of tweaks that can reshape each party’s economics. Everything in these deals is custom and negotiable, so financial engineering expertise is critical here.
5. Broker engagement letter: This is the first point where the borrower needs to make a commitment. The borrower can engage only one broker. Obviously, the expected deal terms, above, will influence that decision. So too will the borrower’s comfort level of working with the broker and confidence that a deal can be pushed across the finish line. Broker engagement letters will typically include a break fee at this point that says if the broker brings a bona fide offer with terms as good or better than agreed to in the engagement letter, then the borrower will either proceed or pay a break fee.
6. Secondary conversations:
   1. The insurance broker will now be working directly with the insurance carriers to get a nonbinding indication letter. In very broad strokes, with plenty of caveats, this generally means that the borrower will be able to get an insurance policy with the described terms, subject to final diligence of extraordinary factors like fraud. The normal business items have passed muster.
   2. In parallel, the borrower will be negotiating with potential lenders for debt terms. Unlike the insurance broker relationship, the borrower can be shopping multiple debt providers all the way until making a final selection. Insurance brokers can introduce potential lenders, and borrowers can approach any other lender they want.
7. Final diligence: Insurance carriers and lenders will retain outside counsel and valuation analysts to review the company and its IP collateral. The borrower will be charged for these services as a transaction fee and should expect to pay $150,000 to $200,000.
8. Closing: Once deal terms have been agreed, it is up to the scriveners to get things down on paper. The closing for the insurance and lending will take place simultaneously.

Conclusion

The introduction of collateral protection insurance has created an entirely new set of financing opportunities for companies whose assets wouldn’t qualify them for a traditional loan. These deals are more complex than regular business loans, but for companies willing to put in the work or bring in an advisor, the payoff can be very material. Companies with intellectual property are inherently generative and creative, and now the insurance and financial markets are complementing those efforts with their own financial engineering.