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Focus on Life Sciences: Generating Value Through IP-Backed Financing

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ATTENTION IP OWNERS: Your ability to unlock value through intellectual property (IP) backed financing is increasing. Lenders are becoming more willing to use IP as collateral in secured lending again.
April 21, 2014

ATTENTION IP OWNERS: Your ability to unlock value through intellectual property (IP) backed financing is increasing. Lenders are becoming more willing to use IP as collateral in secured lending again.

IP loans can be utilized in lieu of selling equity and may be a cheaper source of financing, enabling an entity to lower its cost of capital and increase value. Like other forms of secured loans however, the ability to monetize and utilize IP as collateral will be driven by the type and value of the IP asset you can provide as security.

How IP Value is Determined

The value of any asset can be viewed through different lenses. Essentially, the value is going to be a function of the asset’s (or collection of assets’) ability to generate future cash flow. In other words, the value of the asset today is the present value of a future stream of cash flows generated by that asset. However, the same asset or collection of assets can have very different values.

Value depends on the perspective of the owner or potential owner. A potential owner considering the purchase of an asset used in a related line of business that he or she is already in (e.g. a horizontal merger) will value that asset differently than a potential owner who has no related operations or activities.

This difference in perspectives is an example of a strategic buyer versus a financial buyer. A strategic buyer will consider not just the cash flow generating capacity of the stand-alone asset, but how that asset fits into its existing activities and generates additional value. Some examples include cost savings or the ability to tap into new revenue streams (these sources of additional value are often referred to as “synergies”).

A financial buyer, on the other hand, considers value strictly from the cash flow generating ability of the stand-alone asset. Thus, it is easy to see that depending on the perspective of the potential owner (i.e. buyer/investor) the same asset can sometimes have drastically different values.

A related concept is market value versus investment value. Market value is determined by a “market” transaction, where there may be multiple potential buyers for an asset, and the nature of the market for that asset will influence its price. The specific perspective of any single market participant will matter to the extent they participate in and influence the “auction” process for that asset.

Investment value is the value to a specific owner. It is determined by contemplating that specific owner’s situation and the specific set of cash flows that will accrue to that owner. Generally, there will be only one market value, but there can many different investment values.

So why does any of this matter? In IP-backed lending, the lender’s perspective will drive the valuation of the IP collateralizing the loan.

Understanding IP-Backed Financing

IP-backed financing has historically been cyclical, but use of IP assets as collateral has been increasing again (see RubinBrown’s earlier E-Focus introducing this topic). The increasing awareness of IP value and IP’s displacement of traditional, tangible property as drivers of cash flow and value is increasing lenders’ comfort with IP collateral, and as a result IP lending is increasing.

Initially, IP-backed loans focused on music and film rights as security. More recently pharmaceutical patents and know-how have begun to be used as collateral, and in this current cycle, the type of IP securing loans is expanding.

Most often, it is investment banks and other types of alternative lenders (hedge funds for example) that are facilitating and providing these loans. However, perhaps as commercial lenders become more comfortable with IP valuations and the ability to collect on IP assets, they will become more willing and able to lend on them.

Most likely a lender will not be a strategic owner. Even if it was, the lender would be unlikely to use that perspective to value the collateral.

In the unfortunate event of a loan default, the lender will take ownership of the IP collateral and will usually look to liquidate the assets in order to recoup loan funds. From a lender’s perspective, the value that can be generated through liquidation of the collateral is what will ultimately determine the value of the IP, and the amount that a borrower can receive utilizing that IP as collateral.

This does not mean that strategic and financial perspectives do not matter. The market value of the IP, derived in an auction setting, will still be determined by the nature of the market.

Estimating IP Value

When estimating the value of IP as collateral, it is wise to consider the lender’s perspective. However, many traditional valuation considerations will still apply.

What is the nature of the market? In valuing IP, you must consider the potential buyers who may want to own these assets.

  • Number of buyers: Determining how many buyers exist, and whether those buyers are strategic or financial buyers, will be highly relevant and determinative for value. All else equal, more buyers indicate higher demand and therefore translate into higher value.
  • Types of buyers: Strategic buyers will most likely have a higher investment value than financial buyers and therefore will exert positive influence on the market price.

What is the state of the IP assets? Specific considerations regarding the IP itself are just as relevant.

  • Stage of development: All else equal, the more developed the IP, the higher the value. As development progresses uncertainty is reduced, increasing value.
  • Market acceptance: If the IP is fully developed, then the extent of market acceptance, and ultimately commercialization, matters. Commercial success will have a significant positive impact on value.
  • Type of IP: The type of IP, legal rights, costs to maintain, and related factors will influence value.
  • Package of IP / know-how collateralized: Often a collection of assets, in particular complementary assets, will increase value, as they can be used in combination to generate economic benefit. For example, a business method patent covering a software application, combined with the copyrighted software code and the trademark on the software application will often be more valuable together, than the sum of the component pieces are individually.
  • Remaining economic life: The remaining economic life of the IP (i.e. how long will it generate economic benefits) is positively correlated with value.

Time to market / auction the assets: The marketability of the assets will impact value. Highly marketable assets will command higher values.

  • Time to liquidate: Generally, the longer time to market and complete a transaction will negatively impact value. In addition, if the seller has to take a large discount to sell quickly (e.g. a fire sale loss), that will be viewed as a negative against IP value.
  • Piecemeal or as a collection: The ability to sell all the collateral at once (without a significant impact on value) is more desirable than a piecemeal sale. Selling piecemeal will likely increase the cost and time to liquidate the collateral, and be a more distracting process.

This is not an exhaustive list of considerations, but will give you an idea of what a lender will consider when making a loan with IP as collateral. In cash flow based loans, these, plus the actual historical cash flow generating capacity of the IP assets become relevant. However, for most early and development stage companies, historical cash flows will not support any sort of meaningful lending relationship.

When IP owners are contemplating raising funds, IP backed loans deserve consideration. IP loans are an alternative to selling equity and may provide an opportunity to lower an entity’s cost of capital. When making these decisions, the type of IP, IP value, loan-to-value ratios, and the number and type of lenders will determine how much, and at what terms, IP owners can be financed at.

RubinBrown has a dedicated Life Sciences Services Group specializing in serving life sciences and technology based companies, including in the valuation of IP and consulting on IP management and strategy.

 

Under U.S. Treasury Department guidelines, we hereby inform you that any tax advice contained in this communication is not intended or written to be used, and cannot be used by you for the purpose of avoiding penalties that may be imposed on you by the Internal Revenue Service, or for the purpose of promoting, marketing or recommending to another party any transaction or matter addressed within this tax advice. Further, RubinBrown LLP imposes no limitation on any recipient of this tax advice on the disclosure of the tax treatment or tax strategies or tax structuring described herein.

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