Intellectual property and access to finance for high growth SMEs

Ref. Ares(2014)78083-15/01/2014 EUROPEAN COMMISSION DIRECTORATE-GENERAL FOR ENTERPRISE AND INDUSTRY Financing SMEs, entrepreneurs and innovators Intellectual property and access to finance for high growth SMEs Discussion paper for the workshop Brussels, 14 November 2006 European Commission

This document served as a basis for discussions during the workshop on Intellectual property and access to finance for high growth SMEs. 2

BACKGROUND The Lisbon strategy 1 aims at making European Union the most dynamic and competitive knowledge based economy in the world by 2010. In today s knowledge-based economy, intellectual assets such as intellectual property (IP), human capital and organisational capabilities play a crucial role in business performance and economic growth. An increasing share of the market value of young and innovative SMEs appears to be derived in many cases from their intellectual assets 2. In today competitive markets, the use and protection of these intellectual assets is therefore one of the key elements that make the difference between success and impending failure of a business. Firms are therefore managing these assets more actively to identify additional ways of extracting value from them. Technology is among the driving factor of economic growth, yet it is chronically underfinanced. If intangibles are of a great interest to big or well established enterprises, innovative small and medium-sized enterprises (SMEs) often lack internal sources of finance and have difficulties when they want to attract external financing. Technology-based start-ups have sometimes no other assets than their intellectual property and consequently need to use it to access equity or bank loans. Investors acknowledge the importance of IP strategy in ensuring a company s survival and success but for many of them, it comes well down in the list of factors they screen when making their due diligence process 3. Financial use of IP and valuation 4 The valuation of any type of asset, including IP asset, helps its owner to decide as to the most cost-effective way in which that asset may be used, protected, insured, sold, leveraged or exchanged in the market place. Most activities relating to planning, negotiating or managing business relationships or transactions require information on the value of the IP assets of a company. The need for proper valuation is further motivated by their expanding use in applications that extend beyond the firm 5. The need for monetary valuations becomes particularly relevant when they are used as financial tools by IP holders and as investment assets by financial institutions and venture capitalists. Financial analysts and 1 http://ec.europa.eu/growthandjobs/index_en.htm 2 A recent publication of the European Commission shows that between 2004 and 2006, the proportion of European innovative firms which belongs to clusters having registered international trademarks has risen from 14% to 29% and that the proportion of firms having applied for a patent has increased from 12% to 29%, Innobarometer July 2006. 3 Horwey LLP, Investor attitudes towards IP protection, 2001 survey. http://www.howrey.com/docs/uk_ip_survey0102.pdf 4 For further reading: Wes Anson (2006), Fundamentals of IP valuation: a primer for identifying and determining value, American Bar Association, 272 pg. 5 Otsuyama, H.(2003), Patent valuation and Intellectual Assets Management, Chapter 5, Patent Strategy Handbook, Chuokeizai-sha, Tokyo. 3

investors increasingly recognise IP as a key element in the value of a firm and as an indicator of its technological and other capabilities. For the financial sector, the valuation of a patent is consequently crucial; the lender or investor is only interested in highly fungible collateral. The lender is not interested in using the monopoly right. Its aim is to sell it or to license it. The potential of IP assets as a way to secure financing is a matter of great interest among investors, particularly if supported by reliable and innovative valuation methodologies. Valuation of intellectual property is therefore important because little knowledge about IP and even less experience in valuing and understanding the nature of IP can be seen as key obstacles in access to finance. Investors and lenders stand to gain a lot from more systematic valuation of intangible capital. For the moment, the IP capital market still lacks faith: as a result of insufficient experience of valuing intangibles, as well as inadequate inclusion of these subjects in training for analysts, there is still little confidence on the capital market in the results of these valuations. Investors could optimise their portfolio and increase their returns with more realistic company valuations. Suppliers of credit could lend their money on terms better in line with the risk. Besides boosting their average yield per loan they could also capture greater market share through better pricing, assuming they value intangible assets more efficiently and correctly than their competitors. That would moreover, give them an edge in an interesting market in the medium term. Companies lack information about returns on investments in intangible assets. While some large companies have successfully used their IP assets to raise finance, very few SMEs have done so, mainly because of lack of awareness. Other factors also help explain why SMEs often do not patent their know-how the process is seen as expensive and there is a perceived risk making information available to competitors. But high growth innovative SMEs are missing an important element of the image they wish to portray to investors, lenders and public sponsors as companies aware of their IP can better trade these assets or licences. Likewise, more systematic valuation of intangibles should lead more reliably to their most efficient uses. This would create better access to equity and debt for knowledge intensive companies. Improved information on intangible assets would render capital markets less volatile and investors would have more faith in them. Questions What approaches are businesses taking to value IP and which are the most effective in different contexts? What are, for instance, the advantages and disadvantages of quantitative/ qualitative valuation methods? How can evaluation approaches of different stakeholders inform each other and lead to improved valuation techniques? How can SMEs use IP reporting and specific self assessment tools to leverage finance for their development? Can innovation management certification be of an interest for them? Should the European Commission define common rules as regards IP valuation in the European Union? If yes, which ones? 4

Exploiting the value of IP assets: instruments and areas of actions for SMEs On the one hand, intellectual property assets may help innovative SMEs to strengthen their position when obtaining business finance. It signals both technological sophistication and a legal protection of competitive advantage. It can give important signals about start up firms and other SMEs that often have difficulties accessing financial markets. The potential of IP assets as a source of finance is on the other hand a matter of great interest among investors, particularly if supported by reliable and innovative valuation methodologies. IP assets have therefore been used successfully to leverage capital among different financial players and new instruments of actions are now emerging. Intellectual property can be used as collateral for bank loans. Companies can use their IP assets as loan collateral provided that they are able to prove their liquidity, value, durability and marketable power. In order to use IP as collateral it is therefore important to obtain an objective valuation of the identified IP asset. Moreover, the acceptance of IP assets as collateral needs to be supported by respective national laws. The Development Bank of Japan implemented a loan system that allows the use of patents and patent applications as well as copyrights of computer programs and contents as collateral 6. Since then, the Bank has granted more than 250 loans to venture firms, with the Bank assessing the present value of the cash flows to be generated by the IP. In Europe, few banks have used IP to develop SME loan portfolios; exceptions include the Landesbank Rheinland-Pfalz which has used technical documentation of research projects as additional collateral for the financing of development projects of mid-size companies. At the moment, there seem to be only few banks providing that service as many have difficulties to understand the market of intangible assets and they often take the value of the whole business as collateral from furniture to software to IP. In financing, banks typically do their own research to confirm that IP has been secured correctly. IP is therefore often seen as an unreliable form of collateral 7. Commercial banks do not have the necessary competencies to value technology and are generally oriented towards funding projects that have lower risk. Banks usually take into consideration the following two criteria when rating their customers' creditworthiness: counterparty risk (probability of default) and the loss to the bank in the event of non-repayment (loss given default). Collateral such as real estate and plant facilities are used in the assessment and research shows that intangibles play a minor role. In contrast, there is difficulty and/or a reluctance to invest or lend against an SME s future cash flow, specifically in this context the revenue that is likely to be generated by the exploitation of intellectual capital. However, an ever larger number of companies owe their success precisely to their intangible assets. Lenders unable to extend credit to such businesses are closing the door on large parts of the credit market of the future. It is all the more relevant to notice that Basel II also supports the valuation of intangibles in credit analysis. Lenders opting under Basel II for 6 For further information: www.dbj.go.jp/japanese/venture/venture_intellectual.html 7 For further information : Report European Commission project PRISM Policy research into innovation and measurement practice in the intangible economy Measures to increase the effectiveness of credit risk analysis in corporate lending through a better understanding of the role of intangibles - Work package 7 - http://www.euintangibles.net/ 5

the IRB (internal rating based approach) are required to include qualitative information also on intangible assets in their assessment of the counterparty risk, in addition to balance sheet data. The advanced internal rating based approach allows the recognition of IP as collateral. However, the demands of the relevant bank s experience with the valuation and realisation of such collateral are very high. If a bank opts instead for the standardised approach under the new capital rules, it must resort to external ratings by rating agencies. There is little evidence of any explicit consideration of intangibles in the rating agencies corporate ratings products. Securitisation (IP asset backed) is another way to generate financial income for a high growth SME. IP asset backed security can be defined as taking an intangible asset (such as a patent being licensed to a third party) and utilise the future cash flows from the license payments or royalties to secure current financing for the licensor. The so called Bowie bonds were regarded as the first ever music royalties securitisation based on future receivables, which give rise to IP securitisation as financial vehicle. The bonds had a 10-year average life and had a maturity of 15 years. The Prudential Insurance Company purchased the bonds, netting US 55 millions for Bowie. But IP-backed securitisation remains a small portion of total asset backed securitisation market in terms of total investment and number of deals completed. Of the reported securitizations of IP, the major ones have been in the United States and were based on the future music royalty streams of portfolio of songs of recording artists. Several factors account for its limited use, such as piracy risks, concerns over litigation, potential changes in legislation and technological obsolescence. IP backed securitisation may therefore require more substantial due diligence than conventional asset backed securitisation may require larger transaction scales to be successfully accomplished. As technology evolves, it may be difficult to predict how market forces might impact IP valuation and such uncertainty may temper the current enthusiasm for this financing technique 8. Venture capital and business angel investments are another financial tool that can help innovative SME to raise capital. VC funds and BAs frequently look for early-stage companies that have commercial potential, provided that adequate IP rights have been secured or can be secured to protect the underlying business. An attractive IP portfolio can increase the likelihood of investment. For VC s intellectual property is not the most important asset. The investment decision is based on the credibility of the company s management, employees and market prospects. VCs focus more on the overall evaluation of the company and the competencies of its management team and they assess the value of a patent portfolio always in relation to the business model. However, due to their business competencies, many investors seem to be better prepared for intangible capital valuation than lenders. They conduct intensive contact with top management and extensive first hand analysis. 8 P.Walsh, Fitch Ratings, Securitisation of Intellectual property an explosion still waiting to happen?. http://www.buildingipvalue.com/06intro/033_034.htm 6

Questions: How can IP influence investment criteria of private and public investors (e.g.: due diligence)? What importance to give to rating, credit assessment, and financial analysis in the field of intellectual assets? What are the main obstacles that refrain banks to use IP as collateral? What could be Basel II impact as regards credit operations for intangible asset based SMEs? How is IP used for securitisation purposes and accessing financial markets? Why are IP securitisation operations not so developed in the European Union compared to the US and what can be done to rectify this? How to reinforce links between financial resources providers and intellectual assets to create value? Attracting finance for SMEs with intangible assets: strengthening the environment and fostering communication between stakeholders. In order to create an Innovative Europe, the Aho report 9 published in 2006 mentioned that financial mobility required an effective venture capital sector and new financial instruments for the knowledge-based economy. The report clearly stated that banks and financial institutions had to become full players in the shift to a knowledge-based economy by recognising the importance of intangible assets and developing the tools and expertise that are necessary to invest in them. The increasing importance of IP in a knowledge based economy has started to change the way national, regional and local governments view intellectual property. Efforts have been made by different stakeholders to foster and promote the valuation and exploitation of patents and to encourage firms to make better use of them for improving competitiveness and European economic performance. But increased awareness of policy makers and SMEs support institutions on new fundraising financial strategies leveraging IP assets is needed. Understanding and incorporating intangibles into credit risks models by financial actors is a key element that will support high growth SME development. It is therefore important to examine current attitudes/practices of financial institutions, venture capitals and business angels towards intellectual property and the extent to which IP rights may be used by promoting exchange of best practices. The public sector needs to set an adequate regulatory framework for an IP based growth strategy and can also take advantage of its role in promoting private sector initiatives. The financial sector and entrepreneurs can be offered services, information platforms, and networks that communicate trust to the market. All these activities linked to intellectual property promote conscious investment culture and help raise awareness of the value of IP among investors and borrowers. 9 http://ec.europa.eu/invest-in-research/action/2006_ahogroup_en.htm 7

As regards extracting value from IP, the main objective should be to develop methods to more effectively provide innovation capital to European companies achievable through a more widespread understanding of intangibles as drivers of the corporate value creation process. Investigation of new business models for investment analysis which better incorporate intangibles in order to improve the flow to capital to those businesses most deserving it have to be found. Conception, development and implementation of training programmes for human skills and competencies relating to IP investment analysis have to be elaborated. Investigations into the demand for and feasibility of methods for improving the understanding and communication of intangibles within the business reporting system have to be implemented. Questions: How to strengthen communication between different stakeholders in order to promote investment in intangible asset based companies? What should be the role of the European Commission? Do networking activities (pan European plate-forms, exchange of best practices) need to be reinforced? Should the EC legislate on certain aspects of the subject? If yes which one(s)? How to define a common strategy with other international organisations like WIPO or EPO to overcome the problem? Workshop outcome Based on the considerations outlined above, Commission services have launched a debate on how to better use intellectual property to attract finance for high growth SMEs development. The Commission intends to work closely with the different stakeholders to pave the way for a growing awareness that intellectual property can be used to improve access to finance. In short, the aim of the workshop is threefold: identify and spread best practice in the financial community as regards using IP as collaterals to invest in young and innovative companies; discussing possible (new) banking instruments that use IP as collateral for the financing of development projects of mid-size companies ( e.g.: IP backed securitisation). better understanding the different financial players needs (banks, VC, BA) when investing in an intangible assets based SME. 8