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«Research commissioned by the Intellectual Property Office, and carried out by: Martin Brassell, Kelvin King This is an independent report ...»

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The human capital involved [in R&D investment] goes with the employee, and usually he or she will capture any residual value from that in the form of wages in future employment. Nevertheless, most of the knowledge generated by employees is often codified in the firm, such as with the creation of copyright whereby the knowledge becomes a business asset. Where this is not acknowledged by external financiers, it will lead to the firm being undervalued.

As well as highlighting the general issue of understanding value, the report also makes the

connection with the role of collateral:

In order to overcome problems of information asymmetry, banks typically require firms to provide collateral in order to provide finance – this provides a clear problem for firms with a high proportion of intangible assets, which are unable to as easily provide any… This preferential treatment towards tangible assets in banking business models is bad for innovation, and bad for growth77.

Taken as a whole, the evidence highlights that there is no lack of assets amongst enterprises to address both information asymmetries and the specific issue of collateral. Whether these are adequately registered at present is open to question; however, a requirement to explain IP and intangibles for funding purposes would represent a substantial incentive for businesses to ‘put their house in order’, to the benefit of all concerned.

77 Ibid, p7. This also references Evaluating Changes in Bank Lending to UK SMEs over 2001-12 – Ongoing Tight Credit?, BIS, 2013, showing that around 55% of SME term loans had collateral requirements.

126 The role of intellectual property and intangible assets in facilitating business finance

–  –  –

It starts by considering how current literature characterises the funding options open to businesses seeking to grow, summarising the ways in which these options may vary depending on development stage. The report then examines some highly relevant data from Experian research, originally conducted for Nesta, which calls into question the assumption that businesses which have the potential for high growth are necessarily high risk. Coupled with the link already demonstrated between high levels of intangible asset ownership and high growth, this builds a strong case for financiers generally to scrutinise IP with care.

–  –  –

The general issues presently facing SMEs seeking funding have been well documented in previous literature. For this report, it is important to understand whether IP provides better or additional routes to funding. Accordingly, the remainder of the chapter highlights some specific examples of funding where the company is either IP-rich, or has been able to leverage its IP in a direct and visible way to obtain finance. This is not always a straightforward process, as some of the case studies illustrate.

Available funding sources and costs Available funding sources and costs BIS Economics Paper 16, published in January 2012, summarises the different finance options BIS Economics Paper 16, published in January 2012, summarises the different finance options which which are theoretically available to businesses seeking These are capital. presentedareantypically are theoretically available to businesses seeking growth capital. growth typically These in 80

presented in an ‘escalator’lines of along the lines ofbelowone reproduced below78:

‘escalator’ chart along the chart the one reproduced the :

On the face of it, there are funding solutions available at each stage of development. However, the chart does of it, there arethe level of availability of eachstage of development. funding, the is it an On the face not reflect funding solutions available at each of these types of However, nor chart does not reflect the level of availability of each of these types of funding, nor is it an accurate accurate representation of thewhich these whichcurrently funds currentlycapital is a case in point, space in funds these operate. Venture operate. Venture capital is representation of the space in a case in point, with several interviewees a variety ofout thatexplained elsewherereasons explained with several interviewees pointing out that for pointing reasons for a variety of in this report, elsewhere in this report, will only get involved fundersunder only in exceptional circumstances.

this category of funders this category of in deals will £2m get involved in deals under £2m in exceptional circumstances. on one shown in BIS Economic Paper 16, provides a more nuanced The following diagram, based view of where the different types of finance sit in relation to each other with an overlay of the effective 81 cost to the business. However, this too only shows part of the picture, as it does not reflect the The following diagram, based on one shown in BIS Economic Paper 16, provides a more availability of any one of these funding routes to specific companies.

nuanced view of where the different types of finance sit in relation to each other with an overlay of the effective cost to the business79.represents the effective onlyof each funding of the picture, as it In the illustration below, the vertical axis However, this too cost shows part source, while the horizontal axis shows the typical range of amounts they are able to provide.

does not reflect the availability of any one of these funding routes to specific companies.

In the illustration below, the16: reproduced from Reshaping the Economy, Nesta, 2009 each funding source, From BIS Economics Paper vertical axis represents the effective cost of 80 81 The Provision of Growth Capital to UK Small and Medium Sized Enterprises, Rowlands (2009) while the horizontal axis shows the typical range of amounts they are able to provide.

78 From BIS Economics Paper 16: reproduced from Reshaping the Economy, Nesta, 2009 79 The Provision of Growth Capital to UK Small and Medium Sized Enterprises, Rowlands (2009) 128 The role of intellectual property and intangible assets in facilitating business finance

–  –  –

IP and business development challenges When considering the potential for IP and intangibles to inform funding decisions, it is important to acknowledge that the IP and intangibles themselves are not static. As a business moves through different stages of development, its IP is likely to diversify and mature, but may also become subject to increasing internal and external threats. for IP and intangibles to informdeterminedecisions, it is important When considering the potential Some of the considerations which funding the suitability of different forms of funding, insofar as these intangiblesand intangibles, arenot static. As a business moves to acknowledge that the IP and relate to IP themselves are briefly summarised below.

through different stages of development, its IP is likely to diversify and mature, but may also The foundation phase become subject to increasing internal and external threats. Some of the considerations which When an IP-rich the suitability of different forms of funding, from an as these relateato IP and intangibles, determine business is first established, it generally starts insofar idea, invention, market opportunity, or asummarised below.

are briefly new way of doing something. It is usually under-resourced in terms of people and assets. The idea itself may well need further research, is unlikely to be properly protected (it may not even be fully documented), and the business may lack the resources to develop or deliver it. However, The foundation phase since know-how is usually concentrated in a relatively small number of people, it is less likely to be stolen or compromised.

–  –  –

However, it is more likely that such a business will need to be supported by shareholders’ funds, by friends and family, and potentially by external equity investors. These are most likely to be found via crowdfunding sites or business angel networks.

The expansion and development phases Growing businesses face many challenges. It is widely accepted that many companies which do not survive are not necessarily lacking in market potential, but run out of cash before they can capitalise on it.

There is a substantial body of literature on the difficulties of getting a business (especially an IP or technology-based one) to a sustainable position, however promising the foundation phase of the business may have been80. A business that is initially reliant on personal resources, credit cards, friends and family, and even angel investors may struggle to make this transition. As

George Whitehead (quoted in Chapters 2 and 4) puts it:

As a consequence, you get highly innovative but chronically under-funded companies, which is not the way to build strong management teams and do great research and development work.

The pace of technological change means that many businesses have to innovate on a continuous basis. During this expansion and development phase, companies are often engaged in a particularly intense phase of product- or service-building activity, as they respond to the feedback of early adopters and seek to reach a more mature stage of development. They are investing primarily in intangible assets, which have significant potential value, as highlighted in the BIC report referenced in Chapter 5.

However, they may struggle to fund this activity from profits (as the need for development may prevent there from being any). As a result, companies at this stage can often face the ‘double jeopardy’ of having profits which are reduced by re-investment (thereby affecting debt serviceability and the overall business valuation), and making a type of investment that is not recognised by a financier (because even if it is reflected on a balance sheet at all, it will be ignored).

It is this group of companies which may benefit most from a better understanding of IP and intangibles. This will not be achieved by giving more credit to their balance sheets (since this only shows intangible expenditure, and cost is acknowledged to be a very imperfect predictor of value). It will be achieved by understanding what IP and intangible assets the company really owns and how they are helping it to generate turnover.

80 For example, one of the best known works exploring the challenges facing high-tech product businesses is Crossing the Chasm by Geoffrey A. Moore (1991), which looks at the difficulties of transitioning from early adopters of a technology to the ‘early majority’. This has parallels in the phrase ‘the valley of death’, used to characterise the problems of taking innovation from the workbench and translating it into a commercially viable product. This phrase was recently used as the title of a House of Commons report on technology commercialisation (Bridging the Valley of Death: improving the commercialistion of research, House of Commons Science & Technology Committee, March 2013).

130 The role of intellectual property and intangible assets in facilitating business finance Where term debt is available to businesses in this phase of growth, it is less likely to come from mainstream banking operations, and more likely to be available at mezzanine-style levels of cost. It may come from banks with the support of EFG. Generally, companies in this expansion and development phase that are lucky enough to have a choice of funding routes may still conclude that expensive debt is still significantly less expensive than equity. Also, if they have strong sales ledgers, such businesses may be able to access invoice finance to smooth some of the cash flow variations that can otherwise prove fatal.

–  –  –

If the intellectual capital of the business continues to have market traction, it will now have substantial value. However, this value may not be recognised by the business (not least because it is not explicitly acknowledged by financiers or by accountancy) and there is a risk that the company may fail to place sufficient emphasis on both the protection and the development of the assets that drive their revenue. As Chapters 7 and 8 explain, this represents a potentially significant exposure for financiers.

The relationship between high growth and high risk

In February 2011, Experian conducted analysis for Nesta on the performance of high growth firms81. This studied two cohorts of companies, one from 2003 and one from 2005, all with 10 or more employees: the first was studied ‘pre-recession’ between 2003-2006, and the second between 2008-2010. Each cohort was then divided between high growth (6-7% of the sample, which resonates with Nesta’s work82) and non-high growth.

For the purposes of the study, high growth was extrapolated from employment rather than turnover growth. Turnover data would have increased the sample size by about one-third, but the absence of this data from some smaller business’s accounts meant that this method would, in Experian’s view, have introduced a bias towards larger companies.

–  –  –

• In both 2003 and 2005 cohorts, the insolvency rate was lower amongst firms that achieved high growth than those which did not, across all sizes of business

• Experian applied its ‘pH Financial Megascore’, used to predict the probability of insolvency within 12 months, banded into five levels from A-E, “with As being very financially sound businesses and Es those that have severe weaknesses in their balance sheets.” This showed both cohorts to have similar levels of predicted insolvencies across high growth and non-high growth firms, but high growth firms then improved faster than non-high growth firms as this score was re-run – by a significant degree in the 2005 cohort, being measured during the recession.

Experian commented:

Interestingly, the Megascore value calculated at the end of the period in which High Growth is measured (Year X+3) appears to undervalue high growth businesses relative

to non-High Growth businesses:

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