Companies don’t always have steady sources of financing to scale their operations in lockstep with revenue. Sourcing funding outside of traditional avenues can also be mission critical at times. An IP portfolio can be a hidden source of collateral for a lender who is otherwise on the fence about whether to put forth a loan to a company in need.
The practice of securing IP as loan collateral has origins in the entertainment industry where “celebrity bonds” served as collateral against future royalties for albums. David Pullman is notable for creating the “Bowie Bond” in 1997 when which he turned music from David Bowie into an asset-backed security using the current and future revenue from 25 of Bowie’s albums. Investors bought into it. At one point, Moody’s even gave the Bowie Bond a AAA rating. This model for leveraging intangible assets as collateral is gaining traction as a financing vehicle in other industries as well, says Christian LaForgia, a patent attorney with Banner Witcoff, a boutique law firm specializing in intellectual property.
The best opportunity for this strategy is when the IP rights are generating revenue through licensing, patent assertion or sales, according to Laforgia. “Using IP as collateral in this sense may allow a company to further invest in building existing revenue streams into larger revenue streams.”
But for some startups, this may be a lost opportunity, says Sam Thacker, a partner with Business Finance solutions, which has secured over $400 million in loans for companies across many industries. He writes: “It is not likely that a pre-revenue company will be able to obtain a loan against patents, but it is possible for a company generating strong revenues to leverage their patents to eke a little more cash out of a loan request.” On the other hand, startups with strong backing from well-respected VCs and a deep bench of issued patents may have just what it takes to get into a loan security agreement with a bank willing to take a risk on the success of what could be the next big thing.
What Savvy Lawyers Know
Alongside the benefits of a line of credit, securitizing intellectual property carries huge risks — primarily, defaulting on the loan means jeopardizing precious IP and associated rights to control or monetize it over time. Proceed with caution and get the help of a patent attorney if there is no specialized expertise available in-house to provide guidance.
- Determine IP value
There are many different factors used to determine IP value and no standard methodology for calculating it. For instance, according to the World Intellectual Property Organization (WIPO), just one consideration is the context in which the IP is being valued: is it being valued in the context of being ‘alive and well’ and performing its job, or is it in a context where it is not being used? Similarly, in the case of liquidation, is it a forced liquidation or an orderly disposition of assets? The value will be different in each of these four situations, according to WIPO.
Due to the complexity of IP valuation, most banks don’t have the tools, skills or experience to valuate IP holdings for collateral purposes, says LaForgia. “Banks will often turn to specialists in IP transactions who can evaluate the creditworthiness of IP as collateral,” he says.
Procuring a patent valuation independently and providing this to the bank can also be beneficial but the costs associated with such a valuation and its potential credibility to a lender may not always flesh out. Sometimes boards ask that companies undertake a patent valuation and if this is being done anyway, it can be worthwhile to use the finished product for a starting point for a discussion around valuation of IP.
- Craft a sound security agreement
Documenting the transaction in the form of a security agreement is an involved process wherein in the bank gets comfortable with the state of the business. Much like any other corporate financing transaction, lawyers on both sides of the transaction review diligence, craft disclosures, and progress a draft agreement over the finish line. The loan security agreement will detail the requirements around the collateral including the maintenance and progression of the IP, unless there is prior written approval of the bank.
This means that failure to pay maintenance fees or trimming out patents without permission can trigger a default on the loan; therefore, it’s important to get in the weeds with the bank about the company’s plans for its portfolio. Try to get as many carve-outs built into the agreement as possible that mirror the company’s intentions so the legal department will not be unnecessarily burdened or slowed down by soliciting buy-in from the bank down the road. Once completed, the signed security agreement gets filed with the United States Patent and Trademark Office. Once the loan is paid back in full, the security agreement release must likewise be filed with the USPTO.
- Understand your risks
It may be difficult to find a bank willing to accept IP as collateral as banks tend to shy aware from the speculative and volatile nature of IP, and may not be comfortable engaging in this type of loan if they don’t have much experience or expertise in it. If you do find a willing lender, LaForgia recommends considering these downsides before jumping in:
- Default on the loan could result in a forfeiture of the IP rights, leaving your company with little or no assets.
- It’s a small market with a limited number of lenders/creditors, potentially making this a more expensive alternative to traditional financing options.
- Arriving at a sound valuation is difficult and requires outside expertise.
- You lose control in respect to strategy of the IP that collateralizes the loan. For instance, if you want to cut a patent because it no longer aligns with your business strategy, the lender can object and require payment of expensive maintenance and legal fees to progress the patent.
- There are limited options for liquidating IP assets once they are tied up as collateral.
Fierce competition in many sectors demands creative financing strategies. If a company has revenue-generating intellectual property or a robust portfolio, it may serve a vital role as bridge funding to a company when other financing avenues are not available or when the timing is not optimal. But before advancing into IP-back financing, be sure to map out the risks carefully and consider whether the potential loss of the IP, or loss of control over it, is worth the operating money.
Jennifer DeTrani is General Counsel and EVP of Nisos, a technology-enabled cybersecurity firm. She co-founded a secure messaging platform, Wickr, where she served as General Counsel for five years. You can connect with Jennifer on Wickr (dtrain), LinkedIn or by email at dtrain@nisos.com.