Cambridge Display Technologies' Key Stone 4 active matrix display: the company is one of those attracted to the new vehicle of collateralisation. (Picture courtesy CDT)
When Cambridge Display Technologies needed $15 million to finance its initial public offering late last year, the Cambridge, UK-based company wanted a loan. But traditional banks would not open their doors to CDT because they wanted hard assets as collateral, and CDT’s assets are of the softer variety.
"Conventional lendors wouldn’t loan to company like us whose assets are purely intellectual property," says Stephen Chandler, vice president of legal and intellectual property at CDT, which has over 200 patents granted and pending for its light-emitting polymer technology used to make electronic displays. Still in the development phase, CDT technology will not be in large-scale manufacturing for another two years. "We turned to intellectual property (IP) collateralisation because it’s the only way for early-stage firms to get debt financing," says Chandler.
How it works
CDT is one of a growing number of small and medium-sized technology companies attempting to turn their intellectual property into hard cash. To put it plainly, companies can opt for two financing vehicles to monetise their patent portfolios: collateralisation and securitisation. The first, which involves using patents as collateral to guarantee a loan, is the most common. The second, still relatively rare in the technology sector, is based on the classic concept of pooling assets with regular revenue streams - such as mortgages, car loans or credit cards – to create tradeable, rated securities. Only in this case, the assets are patents that produce licensing revenues or royalties.
"Some companies, especially early-stage technology firms, don't seem valuable from an operational point of view, but their IP might be worth something," says Bowman Heiden, deputy director of the Centre for Intellectual Property Studies at Chalmers University of Technology in Göteborg, Sweden. Instead of using a patent portfolio to attract venture capital investors, which commonly demand a large chunk of a company’s equity in return for investment, securitising or collateralising are far less dilutive ways to raise capital, Heiden says.
Technology companies that have a few licensing deals under their belts are the best candidates for these financial operations. Most very early-stage startups have not signed enough contracts to enable dealmakers to put a value on future revenue streams for the purposes of collateralisation and securitisation. At the other end of the spectrum, established technology companies do not need to put up their patents to obtain cash because their high profile allows them to raise money in more traditional ways, such as share issues or loans backed by real assets like products and factories.
The concept of monetising intellectual property emerged in 1998 when singer David Bowie issued a security backed by the projected future royalties on his music recordings. Since then, movie studios, fashion labels and musicians have used their IP as collateral and security on a regular basis, but technology firms have only just begun to catch on to the idea. Most deals are happening in the US, where a web of boutique investment banks, IP-aware law firms and clued-in rating agencies is starting to spring up, though deals have also taken place in Europe, Japan and Taiwan.
"The 90s was about venture capital, but now we are moving into an era of extracting residual value from intangible assets," says Keith Bergelt, president of IP Innovations Financial Services of Charlotte, North Carolina. Bergelt’s company is one of just a handful of financial firms focusing solely on the collateralisation and securitisation of intellectual property. The company has done four deals to date, two of them in technology.
Collateralisation
Bergelt's company mostly serves as a guarantor for loans in the IP collateralisation market. A company comes to IPI looking to raise a loan. Much like a potential venture capital investor, IPI investigates every angle of the company, including all existing and potential markets for its IP, and assigns a valuation to its portfolio of patents. Then IPI works with a bank to secure debt financing for the company and guarantees the loan using the implicit value of the patent portfolio as collateral. If the company defaults on the loan, IPI owns the intellectual property and can sell it in order to pay off the debt.
Though IP collateralisation deals are still far from common, they are relatively straightforward. The banks that loan money in IP-backed deals are reassured that a third party, such as IPI, acts as a guarantor, while companies that take out the loans are happy to raise capital without turning to venture capitalists. Because of this win-win scenario, most observers expect an onslaught of technology firms to take advantage of IP-backed loans in the next few years.
However, the concept is not without risk. Bruce Berman, president of Brody Berman Associates, a New York-based consulting firm that advises companies on intellectual property issues, says the default rate on IP-backed loans is about 1 in 20. "Sooner or later, you’re going to have problems, and it’s not yet clear how easy it will be to unload or resell a package of IP," says Berman.
Securitisation
Securitisation of IP assets, especially in the technology sector, may take longer to catch on. The securitisation market has been around for decades and was worth $875 billion in the US last year, according to Thomson Financial. Any kind of financial vehicle that generates regular revenues - from credit card receivables to mortgages and car loans - gets bundled into bonds. Institutional investors expect a return of 7-8 per cent on these bonds, which are bought and sold on the secondary market. But securities backed by technology patents are more complicated to structure and involve higher risk for buyers.
"Securitisations based on technology patents are very difficult," says Mark Adelson, head of structured finance research at Nomura Securities in New York. "The problem with most technology patents is you can't project cash flow out very far and we need to see a tangible and reliable revenue stream," says Adelson, whose bank has not yet backed any technology securitisations. In addition, with any innovative technology, there is the risk of obsolescence. "Who knows if people will want to use the chip or the gizmo two years out?" he says.
"IP securitisation is in the early stages and it’s hard to say when the idea will mushroom," says Richard Rudder, global head of securitisation at law firm Baker McKenzie in New York. Rudder has been advising clients in the securitisation market since the 1970s, but has only just begun to see the concept of securitising technology patents. "People are convinced there is a huge amount of wealth tied up in IP assets, but because the idea is new and complicated, transactions are small and few and far between," says Rudder.
One technology sector where securitisation does work is the pharmaceutical industry. Because drugs have predictable royalty streams, it’s fairly easy to group a bunch of those royalty streams together into a security that can be rated by a rating agency.
Still not mainstream
Turning intangible patents into hard cash is a tempting prospect for many IP-rich technology firms. But the reality is that most early-stage companies - and even large, mature corporations - do not have a handle on their intellectual property. Obtaining patents is only the first step to monetising those inventions; a company that wants to use its IP as collateral needs to have a deep understanding of all of their assets and how they work as a whole.
"Intel has 12,000 patents, but they aren’t all necessarily worth something," Berman points out.
In addition, the companies that structure financial transactions, such as investment banks, rating companies and the law firms that serve them, are not yet fully comfortable with using intangible assets to back deals.
"IP securitisations are not as simple as a boiler-plate mortgage setup," says Joseph Tuczak, senior director at Fitch Ratings in Chicago. Fitch has rated a few IP-backed securities in the fashion and movie industries, but has not yet rated a technology or biotechnology deal. "New technology deals are still uncharted territory for us and we haven't been comfortable enough to give any of them an investment-grade rating."
Plastic Logic, a five-year-old company that has patented a technology for printing electronic circuits on plastic to make flexible displays, is one company that will not be putting up its IP on the line to secure funding anytime soon. The company does not fully understand how using its patents to raise cash would fit with its overall licensing strategy, says Bridget Kerle, CFO and general counsel of Plastic Logic. "We are aware of this funding stream and we don't rule out any source of funding, but at this stage, we don't feel it is appropriate," says Kerle.
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