Practical Lessons in Using Intellectual Property as Collateral

Practical Lessons in Using Intellectual Property as Collateral By Richard D. Crawford In a 2001 survey, Equipment Leasing Association members said they needed a better understanding of the intellectual property (IP) recovery process. Many lessors have been interested in using IP as collateral for their financing activities. This article summarizing the follow-on research project offers in-depth studies of two failed venture loans, along with lessons learned. In recognition of the growing importance of intellectual property (IP), the Equipment Leasing and Finance Foundation (the Foundation) conducted an electronic survey of ELA member firms in December 2001 to assess their experience using intellectual property as collateral for their financing activities. The overall results of the survey were summarized in an article titled Intellectual Property: The Leasing Industry s Future? in the Fall 2002 issue of the Journal of Equipment Lease Financing. Because ELA participants in the initial study stated that there was a need for more understanding of the intellectual property recovery process, the Foundation commissioned this follow-on research project last year. The project involved in-depth studies of two failed venture loans secured by intellectual property (computer software and biotech patents). The loans studied have been made into case studies in the case library of the Darden Graduate School of Business at the University of Virginia, Charlottesville, and are available for training programs of ELA members. (See note on page 27.) This article briefly summarizes the two loan situations studied and then reviews the lessons learned. In both the cases and in this article, the author has fictionalized the names of the companies and the cooperating ELA member. INDIVIDUAL COMPANY CASE STUDIES A Software Company The software company studied, SmartCard Systems Inc., was founded in 1997 to develop operating systems and applications for smart-

card systems. Smart cards are plastic cards the size of credit cards, which have integrated circuits (chips) embedded in them to allow numerous memory and processing functions to be programmed directly into the card. SmartCard Systems developed the industry s first open-architecture operating system, which enabled manufacturers of smart cards to develop new and more complex applications for smartcard users. Reflecting the potential of its technology, Microsoft Corp. had offered to purchase the company early in the latter s history. In its initial financing, a venture capital firm, Culbertson, invested $4 million in SmartCard Systems in return for 25% of the equity. Then Culbertson and another venture lender made a 36-month, $4 million loan for which Culbertson received warrants to increase its total return to approximately 30%. The loan was secured by a first priority interest in all assets of the borrower, including intellectual property currently owned or owned in the future. When SmartCard ran out of cash a year later, Culbertson made a $4 million bridge loan until equity financing for the company could be completed. The new loan resulted in Culbertson having total loans outstanding to SmartCard of $5.5 million. At the time of the new loan, the venture investor had estimated the minimum value of the company at $100 million. Culbertson relied on that estimate in its lending decision. The intellectual property that provided collateral for the loan was SmartCard s proprietary software. This had trade secret and copyright protection but had not received patent protection even though it had been applied for. If the patents were granted, SmartCard expected to have a lock on the open-system architecture for smart-card operating systems, potentially making it very profitable. When the company did not receive the expected round of venture capital, it went into bankruptcy and Culbertson foreclosed on the intellectual property. Unfortunately, Culbertson was not able to sell the software as expected and had to take a write-off of its loan. In essence, Culbertson discovered there was no market for the software separate from the company. Culbertson ended up making a deal with the CEO to license the software for its new company, with payment contingent on the future revenues of the company. (Effectively, Culbertson became an equity stakeholder in the new venture.) A Biotechnology Company The biotechnology company studied, Ravenna Technologies Inc., was a genomics platform company founded in 1994 to exploit a solidphase DNA chemistry invented at Massachusetts Institute of Technology. Genomics, the identification of genes and the analysis of their function in normal conditions and in disease, is a central focus of biomedical research as well as of pharmaceutical and diagnostic product discovery. Ravenna developed and commercialized products for genomics research and the gene-based clinical diagnostic markets. In addition, it had patented several platform technologies that improved the speed, specificity, and cost-effectiveness of DNA or other nucleic acid detection, purification, and amplification. In its initial financing, Ravenna raised $13 million in equity from four leading venture capital firms. This original venture capital was expanded by a $2.5 million bridge loan shared by Culbertson and another venture leasing company, with the intended takeout for the loan expected to be a new round of equity. Each lender received warrants on the stock of the borrower. These warrants would dramatically increase the yield on the loan to a potential high of 70% if the company proved successful. The loan was secured by a blanket lien on all assets including intellectual property, allowing carveouts from the lien for existing and future equipment financings and licenses of IP. At the time of the loan, Ravenna s five products were covered by a broad patent portfolio that included two issued U.S. patents, one allowed U.S. patent, and more than 20 other pending patent applications. In its decision to make the loan, Culbertson relied on the venture investors The intellectual property that provided collateral for the loan was SmartCard s proprietary software, which had trade secret and copyright protection but had not received patent protection. J O U R N A L O F E Q U I P M E N T L E A S E F I N A N C I N G FAL L 2 0 0 3 V O L. 2 1 / N O. 2 2 3

Ravenna shows that in the proper circumstances, intellectual property can be excellent collateral for a loan or lease, providing for full recovery of the amount financed in the case of a default. expectations that the company s existing intellectual property and platform technologies could be sold for the value of the company s debt and equity. When the additional venture capital investment did not occur, Ravenna went into bankruptcy and Culbertson foreclosed on the intellectual property. After foreclosure, Culbertson undertook an aggressive effort to sell the intellectual property that it had foreclosed on. This effort included involving the technical staff of Ravenna in marketing the IP and allowing them to move to the purchasing company to continue working on the technology that they had developed. To Culbertson s surprise, Ravenna ended up selling several patents that it thought had little commercial potential while receiving less than expected from the sale of what it anticipated to be the highest value patent. The two venture leasing firms were able to recover the full amount of their loans from sales of the IP with an additional residual payment to the equity investors. LESSONS LEARNED Ravenna shows that in the proper circumstances, intellectual property can be excellent collateral for a loan or lease, providing for full recovery of the amount financed in the case of a default. However, SmartCard illustrates that intellectual property may not be good collateral in all cases. The experience of Culbertson in the two cases was echoed in its broader portfolio. An internal study of 36 bad venture loans and leases showed that Culbertson recovered less than one-third of the loan on average when the bankrupt company s chief assets were used PCs and software licenses. However, Culbertson recovered the full amount of its loan when it had a lien on proprietary intellectual property that had value. The study concluded that loans and leases secured with liens on intellectual property were significantly less risky in a bankruptcy situation than other types of venture leases and loans, provided the intellectual property was properly handled from a legal standpoint and had a market. The two companies studied illustrate what works and what does not work when using intellectual property as collateral and some key issues concerning intellectual property as collateral. The central issue in the value of intellectual property as collateral in a bankruptcy situation is whether the intellectual property has asset value or enterprise value. Asset value is the value that intellectual property has when it is sold to a third party outside the enterprise that currently owns it. Enterprise value is the value that intellectual property has within the enterprise that currently owns it; it contributes to the overall value of the enterprise. Within an enterprise, intellectual property such as a trade secret can help to create great value for the enterprise, although it may have little value as an asset apart from the enterprise. Conversely, another piece of intellectual property such as a patent may have little value within an enterprise for example, if the enterprise doesn t have the resources or skills to commercialize the invention protected by the patent. Yet the enterprise may have great value as an asset separate from the enterprise for example, if the enterprise licenses the patent to another business with better resources for commercializing the invention. Asset value provides value in a bankruptcy situation because intellectual property with asset value can be severed from a company while still having value to another company. If the intellectual property has only enterprise value, it is less likely to be a source of repayment in a bankruptcy situation. The biotech patents belonging to Ravenna had significant asset value and allowed Culbertson to recover its loan. In contrast, the software belonging to SmartCard had enterprise value but little asset value, such that Culbertson did not recover its loan. These cases offer some practical lessons for lessors or lenders seeking to use intellectual property as collateral. A complete analysis of the company prior to making the loan should involve a business analysis of the company, a financial analysis of the company, and an independent 2 4 J O U R N A L O F E Q U I P M E N T L E A S E F I N A N C I N G F A L L 2 0 0 3 V O L. 2 1 / N O. 2

evaluation of the technology securing the loan. A key element of this technical evaluation is a determination of the asset value and enterprise value of the technology. In both these cases, Culbertson did not conduct a careful technology due diligence but instead relied on the opinions of the existing equity investors. In the case of Ravenna, Culbertson was lucky, but with SmartCard it was unlucky. No smart lender or lessor will make a decision about a loan or lease to a company if the technology secures the loan or lease without examining the technology carefully. SIX CRITICAL STEPS FOR THE INITIAL LOAN For a lessor or lender to effectively use intellectual property as collateral, it should take six steps in making the initial loan. 1. Make sure that the company has proper title to the intellectual property and it is seeking the highest degree of intellectual property protection. 2. Verify that the lender has first priority as the lien holder on the intellectual property. 3. Get an independent appraisal of the IP securing the loan prior to making a loan and taking a lien on the property. Be sure the appraisal makes the distinction between asset value and enterprise value and that the property securing the loan has significantly more asset value than the amount of the loan 4. Identify potential buyers of the asset securing the loan before making the loan. Keep this list up to date during the course of the loan. 5. Determine the interest of the technical team in staying involved with the technology, even if the technical team is moved to another company. 6. Determine how difficult the sale process will be and the real market value of the IP. The first and second steps address traditional intellectual property due diligence. Traditional intellectual property due diligence is legal in nature and involves cataloguing intellectual property assets, determining proper ownership, and identifying any legal missteps that would prevent enforcement of intellectual property rights. In this step, the lender s attorney should review patent applications, issued patents, trademark and copyright registrations, licenses, and contracts. The purpose of this review is to determine who owns rights to what, what technology has been licensed, and what kind of restrictions exists. The third step considers the value of the intellectual property (both asset value and enterprise value): the critical issue in using intellectual property as collateral for a loan or lease. In determining asset value, the key is to separate the asset from the business and then to determine what it is worth to others outside the business. In this context, valuing intellectual property for collateral purposes presents the same types of issues presented by other types of property. THREE APPROACHES TO VALUATION As with other types of property such as real estate, intellectual property can be valued in three different ways that ideally generate similar values. These three ways are: 1. the market approach, which looks at market comparables resulting from specific transactions, 2. the cost approach, which normally is associated with the replacement cost for the asset, and 3. the income approach, which normally is associated with the discounted present value of future cash flows. However, if the ultimate purpose of the valuation is to determine asset value, the focus should be on the market approach, which is most likely to determine the cash that will be received if the property is sold independently. In determining asset value, the key is to separate the asset from the business and then to determine what it is worth to others outside the business. J O U R N A L O F E Q U I P M E N T L E A S E F I N A N C I N G FAL L 2 0 0 3 V O L. 2 1 / N O. 2 2 5

In the biotech industry, small firms generally develop their intellectual property themselves and then sell or license their technology to larger pharmaceutical firms or form joint ventures with them. In determining enterprise value, the key to the value of the intellectual property is the contribution the intellectual property makes to the overall success of the business. Determining this value is a two-step process. The first step is to determine the overall enterprise value for example, by looking at its overall market valuation if it is a publicly traded enterprise. The second step is to determine the percentage of success of the business that is attributable to the intellectual property. For example, if the intellectual property is deemed to create 20% of the success of the business and the business as an entity is worth $10 million because of its success, the intellectual property could be calculated to be worth $2 million. This type of valuation is done frequently by a major drug company when the revenues and profits from a particular patented drug can make up 10% to 20% of the company s profits and revenues, and the company s stock price declines accordingly when the patent on the drug approaches expiration. Unfortunately, the value of the intellectual property in this context often cannot be extracted in cash by selling the asset separately because the value of the asset is unique to the enterprise in which it creates value. In other words, the revenues and profits associated with the drug are dependent on the marketing muscle the major drug company applies to the drug. The possibility that intellectual property will have asset value is partly dependent on the industry that the intellectual property is located in. For example, biotechnology is an industry in which intellectual property developed through research and development particularly if it has received patent protection is likely to have asset value separate from the companies in which they are located. In the biotech industry, small firms generally develop their intellectual property themselves and then sell or license their technology to larger pharmaceutical firms or form joint ventures with them. This routine partnership between small biotech companies and larger pharmaceutical firms provides a ready market for the sale of their patents. On the other hand, software is well noted for rapid obsolescence due to continual innovation and is usually devoid of patent protection. These two factors make software markets highly uncertain. DETERMINING POTENTIAL VALUE Several questions should be used to determine the key issue in a new technology: its potential value. Specific questions that should be asked include: 1. What are the characteristics and market for the technology? Is it a transforming technology? Will it last for a while? Is it a unique approach? What is the quality of technology team? Who are its competitors? What are its market lead and defenses? 2. How large is the market? 3. What is the company bringing to the market? These questions support a detailed assessment of the value of the intellectual property and address the issue of whether the lien on intellectual property assets will protect the debt on the downside. Realistic valuation of intellectual property can be time consuming and expensive, but it can pay off down the line, particularly when conducted by independent professionals having both technology expertise and an understanding of the business and related intellectual property issues. This process should also involve the technology staff of the borrowing company, who usually is the most familiar with the company s technology. Avoid Passivity Because of the time and cost, the lender should not undertake this process until it is satisfied that the company s basics and financial position 2 6 J O U R N A L O F E Q U I P M E N T L E A S E F I N A N C I N G F A L L 2 0 0 3 V O L. 2 1 / N O. 2

potentially support a financing. However, although the lender should seek help from both independent professionals and the technology staff of the borrower, it should not be passive in the process. It is important for the lender or lessor to understand how the value is arrived at and the dynamics of the technology. It should make sure that it is fully informed by the independent professional who performs the valuation with respect to how the professional arrived at the valuation and the key variables that could change the valuation substantially. In addition, the lender or lessor should spend enough time in conversations with the technical staff of the borrower to understand how the technology was developed and will be further developed by the borrower. Moreover, it is useful to understand the particular expertise and motivation of the key members of the technical staff. Lastly, the lender should recognize that the value of the asset could substantially change in the future and provide for that change in the loan documentation. The loan agreement should specify periodic reappraisals of the value of the asset during the course of the loan as well as require the asset to have a minimum value at the time of these reappraisals to protect the loan. The loan agreement should further stipulate that a failure of the asset to meet its minimum value would trigger a requirement by the borrower to pledge additional collateral until the minimum value is met. In a foreclosure on the intellectual property, two key issues must be addressed: getting clear legal title to the property and extracting cash from the asset to repay part or all of the loan. Reviewing the six steps a lessor or lender should take to effectively use intellectual property as collateral, we know that steps 1 and 2 deal with the issue of getting clear title to the property. Step 3 determines how much cash might be extracted. Steps 4, 5 and 6 deal with the issue of actually extracting cash from the asset. The lender should prepare for the potential sale of the intellectual property by determining the availability of potential buyers; the willingness of the technical team to support the technology; and, as realistically as possible, the nature of the anticipated sales process. Then the lender will be far better prepared if it must foreclose and has a greater likelihood of recovering the full amount of its loan from the intellectual property collateral. THE FUTURE OF IP SECURED LENDING The large and growing value of intellectual property makes it an increasingly likely form of collateral. Lenders will be increasingly comfortable with intellectual property as collateral as they gain increasing experience with IP, particularly patents, and become familiar with the ways both to effectively determine its collateral value and to recover that value when that loan goes bad. The six-step process outlined in this article is a step toward increasing certainty in the use of intellectual property as collateral. The author s biography may be found on page 46. Note: These cases are available for use in corporate training. For information contact the Equipment Leasing and Finance Foundation at (703) 527-8655. The loan agreement should specify periodic reappraisals of the value of the asset during the course of the loan as well as require the asset to have a minimum value at the time of these reappraisals to protect the loan. J O U R N A L O F E Q U I P M E N T L E A S E F I N A N C I N G FAL L 2 0 0 3 V O L. 2 1 / N O. 2 2 7