Recipes for success in IP-backed finance
There is a long history of big IP finance transactions involving patents, trademark, and copyrights, and they come with risks and mitigation, write IP experts Greg Campanella, Tom Simone, Dan Principe and Ryan Zurek from Ocean Tomo, a part of JS Held
Intellectual property finance can broadly be defined as loan agreements that feature IP assets as collateral. Herein, we focus primarily on patent, copyright and trademark collateral. Specifically, we trace the history of IP finance, notable transactions, benefits of IP finance and collateral, and IP finance risks.
Finally, we include a section on risk mitigants in IP finance transactions, which includes a summary of factors contributing to success as it pertains to patent-based loans.
History and overview of IP financing
Collateralising IP in raising debt is not a new concept. One of the first and most cited examples of IP financing dates to 1997 when David Bowie securitised the future royalty revenues earned from his pre-1990 music catalogue. It was not until the early 2000s that the strategy gained more traction with borrowers and not until after the 2008 financial crisis for it to gain more acceptance with lenders, according to the Financial Times.
While there are certainly examples of some high-profile copyright and trademark securitisations, historically, infringed patent portfolios were considered the worthiest collateral in capital raises of this sort. This is because most lenders only saw risk protection in IP collateral as far as they could enforce it against infringers, thereby recouping their investment via litigation or licensing. This drastically limited the number of companies and lenders willing or able to engage in this form of financing.
However, the economy has continued its shift from a manufacturing-driven market to a technology-driven market, wherein innovation drives value creation and competitive advantage. This shift solidified the intrinsic value of owning the right to commercialise groundbreaking innovations.
While many companies that own IP have pledged some form of intangible as collateral at some point (whether patents, trademarks, copyrights or data), IP has historically comprised only a small portion of overall collateral bases, which are dominated by tangible assets such as property, plant and equipment, accounts receivables, investments, and cash reserves. This trend has been reversing in recent years given the increased recognition of IP as an asset class with its own intrinsic value.
Figure 1: Notable transactions
The past decade has seen a significant shift in perception, with IP assets now being recognised not just for their defensive value but also for their potential to generate revenue and drive business growth. Lenders are now paying more attention to IP as primary collateral, even when there are limited opportunities for enforcement. The introduction of collateral protection insurance only accelerated this shift by boosting the creditworthiness of IP collateral and allowing more traditional lenders to underwrite the asset class effectively.
Patents as collateral
IP-based financing can allow companies that would otherwise not meet minimum lender criteria to access non-dilutive financing (typically at a lower cost of capital than venture debt or other comparable financing solutions). For lenders, returns on IP investing tend to be uncorrelated with the broader market, offering alpha or hedging opportunities in times of economic uncertainty. Further, IP-based debt is typically priced at a premium to other ‘asset-based lending or credit structures. Finally, we are often seeing situations where lenders are taking IP as collateral not only as security for lending but also as a mechanism to provide greater leverage over other lenders in distressed situations.
Collateralising patents is especially beneficial for companies that allocate significant resources to R&D and have extremely valuable, patent-protected innovations as a result. For example, where a drug developer holds patents for pharmaceuticals that are currently (or are likely to be) FDA-approved, those patents can hold immense collateral value. Beyond healthcare verticals, patents covering inventions in highly disruptive technology sectors that have the potential to block competitors from achieving a meaningful market share can also be extremely valuable.
Separately, as previously mentioned, patent assets that are being infringed by third parties are typically viewed by lenders as the most attractive form of IP collateral. In the event of loan default, stakeholders would seek to enforce the patents against infringers, recouping their investment through licences, settlements or damages awards.
Collateralising trademarks
Collateralising trademarks is beneficial for companies whose brand names or logos hold remarkable goodwill in the form of awareness, authenticity, and applicability to other products and industries. That is, where a mark is very well known, carries authenticity and reputability, and can easily be licensed to third parties willing to pay royalties in exchange for use of the trademark, it can hold significant collateral value.
Historically, trademark litigation has rarely resulted in damages awards. This meant that trademark collateral monetisation rarely took place via enforcement, as the barriers to infringers making slight alterations to their branding were quite low. However, “there are recent cases that suggest a growing trend of substantial verdicts being awarded to plaintiffs in trademark infringement lawsuits”, reported Crowell in 2023. A common example of a trademark-based loan is that of Airwalk in 2001, where Congress Financial made a distressed debt investment in the shoe manufacturer secured by its trademarks and licensing agreements.
Copyright loans
Copyright-based loans are most common in the film industry. Since 2008, it is estimated that 35% of loans in the film industry included some sort of intangible asset as collateral, according to WIPO. It says furthermore that the US Copyright Office saw between four and six records of security interest for each registered film title over the last 40 years. The most common form of copyright in these film financing are typically scripts, screenplays and film reels. However, it should be noted that copyright collateral seldom comprises a large portion of overall collateral bases in pre-production film financing.
Royalty factoring
Finally, any type of IP that is generating revenues via royalty payments can be collateralised through royalty factoring. These agreements allow IP owners to receive their future receivables from royalties in a lump sum of debt. IP owners then service this debt through their royalty payments over time, while still maintaining ownership rights to their IP in most cases.
Royalty factoring is mostly leveraged by IP owners in the entertainment space who receive steady cash flow from copyright royalties. A classic example is that of Bowie Bonds (mentioned above in notable transactions), where David Bowie in 1997 securitised the future royalty revenues earned from his pre-1990 music catalogue.
IP finance risks
The primary risk in any IP-backed financing transaction is ensuring that the dominoes fall in the order expected if, for some reason, the transaction or company were to enter bankruptcy or if the lender had to take possession of the collateral.
Additional risks are also present when dealing with IP versus tangible asset classes. Risks include:
- IP is still a relatively illiquid asset class and is notoriously difficult to appraise, creating issues determining loan-to-value ratios. In a liquidation scenario, the IP collateral must be monetised, which can be a more resource-intensive, complex process in comparison to liquidating many tangible asset types.
- IP portfolio values can be compromised over time due to inadequate maintenance of rights and unfavourable licences or encumbrances, among other factors. Therefore, an extra layer of due diligence to ensure appropriate legal rights ensue is an important step for lenders and borrowers, especially considering that difficulties perfecting security interests in IP financing agreements are a well-documented concept.
- When the collateral is to be monetised through legal enforcement, the adverse effects of invalidation, damaged relationships between plaintiffs and defendants, and the inherent uncertainty of favourable litigation outcomes can be especially detrimental.
Risk mitigants in IP finance
Most traditional lenders do not possess a deep understanding of the financial, legal and regulatory risks surrounding IP, making it difficult for them to get comfortable lending against it. This creates opportunities for specialist insurers with technical expertise to wrap policies around IP portfolios, transferring risk from lenders to insurers in exchange for a cash premium. In a default scenario, the policy will cover a portion (or all) of the principal outstanding and sometimes a guaranteed minimum return to the lender. It is then the burden of the insurers to recoup their losses by monetising the collateral.
In the absence of IP insurance, another notable risk mitigant is partnering with professional advisors who have a track record of advisory in IP finance deals, thereby supplementing the capabilities of lenders that do not traditionally operate in this space.
As a result of Ocean Tomo’s experience advising companies on raising IP-based financing, we have developed an understanding of the factors contributing to a high probability of a successful transaction. We can bifurcate these factors into two buckets:
- one relating to the intrinsic value and quality of the relevant IP; and
- one relating to the characteristics of the business seeking financing and its market.
A successful transaction not only describes a deal that closes, but ideally, a deal that does not result in loan default. Or in the unfortunate event of default, success means a deal involving IP collateral that can easily be monetised or liquidated to allow lenders and insurers to recoup their deployed capital.
As an illustration, and assuming a patent-backed transaction, Figure 2 on page 23 showcases the most important factors that help boost the probability of a successful transaction. We should note that some of the factors hold more relative importance than others, although we do not follow any particular ranking system in the graphic or the commentary below it.
Special purpose vehicles
As the breadth of the IP asset class utilised in IP-backed financing increases, so does the nature and complexity of the deals. While IP-backed financing can take the form of a traditional secured asset-backed loan, the malleable nature of IP makes way for complex deal structures.
A recent trend includes a strategy where the company pledging its rights to intangible assets will transfer them into one or more special purpose vehicles (SPVs) whose shares are also pledged as collateral. These SPVs then serve as the grantors of the security interest and license the IP back to the company on an exclusive basis.
Figure 2: Patent finance success matrix
“By virtue of the exclusive licensing back, the company is kept in largely the same position; meanwhile, depositing the intangible assets in the special purpose vehicles provides the secured parties with an enhanced ability to protect and foreclose on the collateral in the event of default, especially if the special purpose vehicles, through their respective jurisdictions of incorporation and organizational documents, are designed with bankruptcy remoteness features,” said a Chambers article in 2023.
Ocean Tomo has recently been engaged to work on transactions where an operating company moves a finite-lived IP asset, such as software, into an SPV along with associated research and development and ongoing maintenance activities with the intent to license the software back on an exclusive basis, thus increasing the life of the IP as the software is continually updated and improved.
As of mid-2023, the USPTO had recorded more than 62,000 patent assignments pledged as debt collateral. In addition, the American Bar Association has noted that a review of the USPTO’s trademark assignment database reveals an accelerated increase in the number of security agreements recorded against unique trademarks in recent years.
Some of the most prominent IP-backed financings of the past decade occurred recently during the covid-19 pandemic when United Airlines and American Airlines secured multi-billion dollar loans backed by customer loyalty data, Forbes reported. In fact, American Airlines set a new record in 2021 for the largest-ever financing transaction in aviation history with a total of $10 billion backed by the IP and cash flows associated with the AAdvantage programme, according to HBR.
Clearly, as investors gain more confidence in valuing and analysing intangible assets, we are likely to see continued interest in this space.
