«Research commissioned by the Intellectual Property Office, and carried out by: Martin Brassell, Kelvin King This is an independent report ...»
Debtors are vital because they are the ultimate source of repayment. Assuming that they wish to pay, can they? We like to see multiple high quality debtors.
On financials - have you got a business that is at least cash-positive, and what is the nature of the funding gap you are seeking to address?
If the nature of the supply is contractually complex, the more disputatious it may be, and the less attractive. But if we don’t overly like the debt, but have a strong financial story, we can do more – we don’t necessarily have to rely solely on the assets. For example, if we are dealing with a specific development project, we can start to bring other assets into play. This might involve bringing in colleagues from other parts of the bank – our skills are not about getting down to an EBITDA number and working through forecasts.
70 The role of intellectual property and intangible assets in facilitating business finance
PNC will use separate operational and financial covenants. The operational aspect governs the collateral itself, i.e. the revolving facility element, and the financial aspect deals with the overall business performance, i.e. the interest and/or debt service aspects. If an operational covenant is breached, the advance rates and lending formula may be adjusted: if a business gets into difficulties with its financial covenant, the consequences can be much more serious.
Danny Harrison, Director of Operations and Internal Control, highlights that PNC has experience
of lending in contexts where brands in particular are important:
Brands can be itemised and listed in a debenture. We regard them as boot collateral;
we don’t lend against them directly, but they do assist with control, so while they might not be a reason for doing the deal, they are a risk mitigant.
Where we are senior secured lender or sole senior lender, they give better control in the event of an administration situation and can be a key part of the recovery process.
Potentially, in one case, we wouldn’t have done the unsecured part of the deal without a fixed charge over the brand.
For PNC, an accounts receivable (A/R) or invoice discounting facility is a standard feature, and it involves the company’s income being paid into a designated account over which the bank has
direct control. As Harrison explains:
We’ll take an assignment of (A/R purchase) and a fixed charge over the A/R and a floating charge over assets being used in the ordinary course of business, because effectively they are like stock… We always have A/R customer receipts paid into a ‘blocked bank account’, because we need that control to perfect our fixed charge on the A/R and in a downside scenario.
Christopher Hawes from RBS Invoice Finance states that:
With asset-based lending (ABL), we are generally a bit less worried about over-trading risk and the thinness of the tangible net worth on a balance sheet (compared to a conventional banker). We will generally have an assignment of the debt and a fixed charge over it. In the ABL context, we will always have a debenture - fixed and floating.
We purchase the receivables in the case of SMEs, because it takes the asset outside the business (and outside any insolvency process).
Two of the ‘challenger’ banks are Aldermore and Shawbrook (referenced below). They have different strategies, but as far lending against assets is concerned, both are firmly in the asset finance rather than the asset-backed lending category.
Aldermore has five product lines for business – savings, property development finance, commercial mortgages, invoice finance and asset finance. Asset finance is offered both through Original Equipment Manufacturers (OEMs) and via brokers to Aldermore’s customers: these are typically small businesses with between 10 and 100 employees, with turnover generally ranging
from £1m to £25m (though some are larger). Chief Executive Phillip Monks explains:
72 The role of intellectual property and intangible assets in facilitating business finance
As a specialist business credit provider, Danny Harrison says that when assessing asset quality,
PNC Bank has its own ‘pecking order’ when it comes to collateral:
We are not as keen on property and will not do more than 75% loan to value; other banks have a lot they are earning interest on but can’t sell, and a lot of people are ‘underwater’.
We do fund inventory, but this can get somewhat more ‘racy’. The floating nature of the charge and the complexities in managing this aspect means that care is needed.
One of your biggest risks is the stock you can’t sell.
Experiences in dealing with IP Because they are accustomed to giving asset values careful consideration, many asset financiers interviewed for this study have had some dealings with IP, not least because it has been embedded in the assets they have financed.
Shawbrook is owned by a private equity fund which saw an opportunity to create a specialist savings and lending institution in 2009, and used its connections in capital markets to address the perceived issue of liquidity by focusing on savings. Shawbrook has grown partly through acquisition to build up specialisms in commercial real estate, asset finance, secured and unsecured lending; as such its involvement with IP is somewhat tangential, as Its Chief Executive
Ian Henderson (formerly of RBS/NatWest and Barclays Private Banking) explains:
We’re a secured lender, in the conventional sense of the word. There is an intangible angle to what we do, but it’s not overt, it’s more in the DNA of how we work. Our IP is about asset knowledge.
In secured lending, we have adopted niches. For example, we won’t take on large lenders for white van fleets, but we will fund new vehicles in specialist areas, and we are good at funding secondhand equipment. We are strong in precision engineering, medical equipment, ambulances, gamma knives and so forth – supporting businesses that have a lot of IP in them.
Often the assets are leased, so we do end up with the equipment to dispose of, and we’re good at finding other homes for it.
However, we do offer block discounting where we sell finance to other lenders who have specialist expertise in different types of asset. There is intellectual property in the financing sense for which Shawbrook’s funds are used.
We have big enough other markets to concentrate on without looking at funding intangibles more directly. There’s nothing wrong with them, but it doesn’t fit our model.
There are huge opportunities elsewhere!
74 The role of intellectual property and intangible assets in facilitating business finance Interviews for this report also revealed many instances where IP has come directly under
consideration, at least occasionally. Christopher Hawes’ comments are representative:
continuous system patch-ups. If you amortise the investment over a sensible period, it can be less expensive than the on-going costs of support.
As one of comparatively few asset-based lenders to fund consciously and deliberately against
IP assets, Syscap’s experiences in terms of risk are instructive:
Our experience has generally been positive. Whilst it has been constrained by the need to understand the customers and limited capital availability, our portfolio of all unsecured lending has outperformed the market even when our own capital is not being deployed, and that extends into the IP space.
We go quite deep into the product and the customer. We can deposit code into escrow, but we know that’s not much use if in the event of default we can’t realise it
- so we need, and obtain, a reasonable idea of where we might go if we have to mitigate risk or offset potential losses.
We are taking a mixture of end user credit risk and supplier performance risk.
Accordingly, we will not look to engage a new start ISV (Independent Software Vendor) with unproven technology in a new marketplace.
If we are funding an ISV there could be different mechanisms depending on their size.
If it is a modest ISV, with a modest requirement, who is looking to do more development or sell more, we would put in a simple loan facility. We would have no security, but we would have understood the reason for this and got comfortable with the levels of recurring or annuity income, because we would get an understanding of what they do.
If it is a larger ISV or a larger requirement, we will then put the code into escrow, do more ‘backstop research’ and take a fixed charge over the code itself. We seek to get a valuation on it because it won’t be on the balance sheet, and if it is it’ll show the cost not the value.
We need to think about the market value because we want to ensure that our lending is prudent and get appropriate coverage in a refinance situation, so we are trying to benchmark it against market values.
Cooper confirms that in the context of asset-backed finance, some clients do talk about their IP and intangibles and put them on the table, generally when they are seeking development rather than working capital. Sometimes, there are also IP assets on the balance sheet if they have been bought in or acquired as part of a larger transaction. He summarises the challenge of IP as being that of understanding what the real value is, in two contexts. The first of these is the
value to the business where it is currently:
Is it giving rise to superior cash flows? Does having the brand, for example, enable you to get a premium price? If so, in terms of the size of the facility we can offer, its effects on cash flow mean that it is already being taken into account in receivables financing.
76 The role of intellectual property and intangible assets in facilitating business finance
Notwithstanding its historical experiment with venture leasing briefly described above, Sam Geneen confirmed that as an asset finance company, Five Arrows does not fund intangible assets other than indirectly when they are associated with fixed ones - although this is increasingly the case in sectors such as print and broadcast (where control software is often involved). Also, the Five Arrows business does end up financing software purchases by companies and institutions. Accordingly, Geneen acknowledges that there is contingent risk in everything that
the company finances, but says:
Five Arrows does have some experience in having software tested and placed into escrow prior to a financing deal being finalised, as a safeguard against future difficulties, but normally works with far larger providers where this is not viewed as necessary.
There is often a tangible value to IP which can survive the death of the corporate which owns it. And when you get down to it, ABL is about lending against assets which have a value independently of the business that owns them. ABL, by its nature, lends itself to this sort of assessment.
We have to move towards a knowledge economy where business value will be based around IP; finding ways to lend against it would help to grow our business and help our customers, which we like doing. The issue is having a consistent way of assessing the asset value.
In terms of specific experiences, he recalls that:
I’ve done deals where the security position might be a bit weak, but we know that there is other asset value that we end up benefiting from, such as brand value. I
remember a pottery business which had a great history, and a museum attached to it:
if push had come to shove, the bank would probably have been paid back out of the IP.
Pattern books can also be valuable: in one instance we got money back out of a printing business because its customers wanted their artwork back.
There could be automotive sector opportunities around tooling, too. Tier 1 suppliers have an interest in establishing a more reliable supply chain, and tooling is one of the most important assets. It embodies IP in quite a hard, tangible way which is stable though of course there could be an ownership issue!
White explains how Syscap’s move into IP came about:
Historically, our approach to partnering has been to identify mission-critical applications that make or save money. It all comes down to the utility of the asset and therefore the client’s propensity to pay, which is what we need to align our investment with that of the business - if a company needs help to fulfil a contract it needs to meet, that’s a good incentive to repay.
IP is almost a natural extension of what we have done in the past. If we are prepared to fund software, understand it, and recognise that it is going to make or save someone money, then funding IP is not a long walk from there.
The challenges have been around valuation. If we fund 50 licences of a Tier 1 ISV product, we can see what the RRP is. For one-offs, the valuation has been challenging.
Typically, financing IP means you are financing an asset someone already owns, so it’s cash-raising. The question is: are they mortgaging the Crown Jewels to pay the bills?
Understanding of markets is very important. In the technology space, you always first have to think about the market (historical as well as current) and consider people’s cultural approach to lending.
78 The role of intellectual property and intangible assets in facilitating business finance
Kapur has personal experience of financing software during his time at Lombard Technology Finance, which was initially concerned more with hardware funding but has progressively moved
further into software: