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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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5. IP markets and IP financing could be facilitated through infrastructure improvements.

The development most likely to transform IP and intangibles as an asset class is the emergence of more transparent and accessible marketplaces where they can be traded.

This is a domain where services must stand or fall on their commercial merits; however, the available infrastructure needs to support rather than impede their establishment.

In particular, as IP and intangibles become clearly identified and are more freely licensed, bought and sold (together with or separate to the business), the systems available to register and track financial interests will need to be improved. This will require the cooperation of official registries and the establishment of administrative protocols.

On-going management of IP and intangibles should also be supported. IP does not 6.

stop being important once credit is granted. The asset class is unfamiliar, and lenders will need assistance in understanding it, monitoring it and encouraging businesses to use and protect it so that risk is reduced. There could be a role for the introduction of ‘milestones’ (as used in equity and venture debt) and impairment tests to ensure that businesses are well informed and motivated to adopt appropriate IP management practices.

Affordable risk mitigation strategies are to be encouraged. Alongside certain 7.

guarantees, access to appropriate insurance policies to guard against unforeseen events could greatly increase banking confidence in adding further weight to IP and intangibles within the lending decision. There is private sector appetite to provide these if lenders are willing to create the demand; more detailed dialogue on the requirements of both parties is urgently required.

Asset-based financing techniques should be adapted for IP and intangibles. Recent 8.

financial upheavals have triggered something of a return to first principles in lending and a greater emphasis on assets for business finance (reflected, for example, in ‘challenger’ bank activity). This greater emphasis on assets needs to be extended to include IP.

Alongside mainstream lending, where EFG is an obvious area of focus, asset-based finance and alternative financing methods should therefore be targeted for IP-backed finance interventions; these are the parts of the finance industry most accustomed to understanding and assessing individual assets and their value.

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

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Chapter 1 Introduction: brief, scope and methodology Introduction This project was commissioned in February 2013 by the Department for Business, Innovation and Skills (BIS) and the UK Intellectual Property Office (IPO) to investigate the barriers to the broader use of intellectual property rights (IP) and related business intangible assets (intangibles) for debt and equity fundraising, and identify possible solutions to address these problems.

Whilst the difficult economic conditions of the past few years have led many companies to rein in their plans for investment and growth, the balance of evidence suggests that there remains an underlying element of market failure1 in the financing of micro-businesses and Small and Medium Enterprises (SMEs), and that this is limiting the growth and recovery potential of the UK economy, especially given the disproportionate role high growth businesses play in economic growth as a whole2. This market failure has been partly attributed by BIS economic research to “imperfect or asymmetric information” between finance providers and small businesses3.

The Government has a role in working with banks, industry associations and professional bodies to address problems which may exist in the supply chain of finance to SMEs4, a role which includes understanding and addressing both funding needs and market failures.

In 2012, the Breedon Report estimated the scale of the prospective gap over the coming five years at between £84bn and £191bn5. The most recent research published by BIS also indicated a shortage of finance for SMEs, “reflecting banks’ attitudes to risk and their own pressures to

delever combined with banks’ market power in the SME sector.” This concluded that:

If the situation is not resolved, output, investment and employment will be lower than would otherwise be the case, with adverse effects on economic performance in the short and longer term.

1 SME Access to External Finance, BIS Economics Paper no. 16, January 2012 2 The Vital 6 Per Cent, Nesta, October 2009 3 Ibid. ‘Information asymmetry’ is a term used to describe a situation in which a business seeking funding knows substantially more about its situation and prospects than the funder, making screening and monitoring difficult.

4 Ibid 5 Boosting Finance Options for Business: BIS report of industry-led working group on alternative debt markets, March 2012 20 The role of intellectual property and intangible assets in facilitating business finance

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One of the ways in which banks mitigate risk is to take collateral. The relationship between information on collateral and financing success appears clear; according to survey data gathered by the Office of National Statistics (ONS), the largest single reason identified for the lack of success with bank financing is a lack of available collateral or guarantee8. Furthermore, sectors with fewer tangible assets (i.e. less collateral) have been particularly badly affected by difficult credit conditions. Service businesses (constituting the majority of the ONS sample) saw bank loan approval rates fall from 84% in 2007 to 61% in 2010: for ICT companies these figures were 85% and 45%9. Software companies, along with other creative business categories, also emerge from recent BIS/DCMS research as having poorer access to finance because they lack business assets to offer as collateral10.

IP and related intangibles are a vitally important asset class in terms of business value and economic growth potential11, and transactions across a range of contexts (many of them documented in this report) demonstrate that they can be leveraged to help overcome the absence of tangible security. However, they are often the most poorly understood – by the businesses which own them, as well as the financiers that could be benefiting from them.

This project is believed to be the first of its kind to investigate the imperfections and asymmetry in the information flow between the parties as it relates to IP and intangibles. By understanding current attitudes to these assets across the debt and equity finance landscape, and exploring the contexts in which such assets are being leveraged successfully, it sets out to establish how IP and intangibles might be able to facilitate the supply of finance to businesses which are rich in this asset class, with a particular emphasis on those with high growth potential.

The project’s focus on SMEs

Micro-businesses and SMEs numerically account for 99%12 of the 4.8 million businesses in the UK, and all have a contribution to make towards economic growth and employment. Of these, the greatest medium to long term potential for growth in the economy and in employment opportunities is generally understood to be amongst the group of businesses which are ‘innovators’, ranging from start-ups, university spin-out companies, technology transfers and creative businesses through to high growth businesses and SMEs.

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In a recent EU survey13 SMEs were identified as the main drivers for economic growth between 2004 and 2006. Fast-growing new firms drive employment growth, with 4 per cent of surviving start-ups responsible for 50% of the jobs created by all new firms ten years later14. Research by Nesta published in 2009 drew a similar conclusion, showing that high-growth companies represented only 6% of all UK firms employing 10 or more people, but had created the majority of jobs - 54%15.

This group of businesses do not, unless at the upper end, have access to the capital markets and have been amongst the most affected by the financial crisis and consequent reduction in economic growth opportunities. Many are asset rich and cash poor, but crucially their ‘assets’ are typically in intangibles rather than physical tangible assets, as new research conducted for this report into IP ownership helps to illustrate. Access to finance for this key sector has been further constrained by the financial crisis as the risk appetite amongst investors and lenders has diminished, despite a number of government policy initiatives directed towards promoting growth in these sectors and the Bank of England’s policy of quantitative easing of the general money supply.

This project adopts the EU standard definitions for SMEs: medium-sized (employees up to 250, turnover up to €50m or balance sheet total up to €43m), small (less than 50 employees, turnover €10m or balance sheet total up to €10m) and micro (less than 10 employees, turnover up to €2m or balance sheet €2m). However, and crucially (as will be demonstrated), these balance sheet definitions do not take into account the often considerable amount of business value residing in internally generated intangible assets, meaning that IPR and intangible asset-rich SMEs are significantly more ‘substantial’ than these standard definitions suggest.

13 Eurostat 71/2009, Manfred Schmiemann 14 Understanding the Small Business Sector, Storey, D.J. (1994) Thomson Learning 15 The vital 6 per cent, Nesta, October 2009 22 The role of intellectual property and intangible assets in facilitating business finance

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The authors also note the ongoing programme of reform to IP law following Digital Opportunity, the Hargreaves Review of Intellectual Property and Growth published in May 2011, and the subsequent announcements in respect of SME engagement made in two papers entitled From Ideas to Growth: Helping SMEs get value from their intellectual property, published by IPO in April and November 2012.

The Hargreaves review was commissioned in 2010 following concerns expressed by Prime Minister David Cameron about the ‘fitness of purpose’ of the IP system to deliver economic growth. The previous review of IP law, by Lord Gower16, had been published less than five years earlier in 2006, reflecting the fast-moving nature of the debate, especially in respect of digitisation.

However, what has been lacking from recent initiatives relating to IP is an examination of its role in relation to business funding, and vice versa. There have been few papers and research documents specifically focused on where IP and intangibles sit within the funding mix, for both information and security purposes, or considering ways in which funders might be enabled and

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emboldened to be more proactive and less risk adverse in respect of this most significant asset class. Such is the information gap this report sets out to address, as a first stage in the development of resources that will test practical approaches to address this problem.

The focus of the report is on two broad types of finance, namely equity and debt. Each of these is available (or unavailable) to SMEs in a number of different forms depending principally on the business’s stage of development, a point considered in more detail in Chapters 5 and 6, which look at the dynamics of the demand side.

There is a third type of finance available, which is grant funding. This is a very important part of the landscape for innovative SMEs, especially those in the early stages of development, and large corporations and universities are also very active in grant funded collaborative working initiatives. The primary outputs of grant funding are generally new IP and intangible assets, so their relevance to the subject area is clear. Furthermore, a strong case can be made that understanding the nature and value (economic and cultural) of the assets that are created from grant funding would provide a far more effective way of measuring impact than some other techniques used in the past. The authors are aware of some important work already going on in this area17.

Beyond the acknowledgement of its importance as a source of finance, grant funding does not

fall within the scope of this report, for the following reasons:

• Whilst the IP and intangibles owned by applicants are an important part of evidencing their capabilities, the decision-making process for grant applications is primarily determined by a proposal’s fit with the aims of the specific scheme under which funding is being made available, and grants are generally provided in connection with specific outputs which are essentially project-based

• Owing in large part to State Aid regulations, many grants require an element of match funding to be evidenced before a project can be commenced, which for a business not already generating sufficient cash flows will need to be raised via equity or debt (though the authors acknowledge that having approval for a grant can make equity funding, and in some cases debt finance, more straightforward to obtain because it introduces more leverage)

• Grant funding is often paid in arrears and can therefore create new working capital issues for SMEs rather than alleviating them 17 One such initiative is the Cultural Value Project led by Professor Geoffrey Crossick, funded by the Arts & Humanities Research Council.

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

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In order to make observations which are capable of being used in support of future implementation, it is important to understand whether and how the different types of IP and intangibles that exist excite interest and appetite amongst financiers of different types. This means it is necessary to clarify which asset types are ‘in scope’.

In some contexts, for example when considering expenditure on intangibles in general, it can be appropriate to consider elements that are related to, or invested in, human capital. However, during the interview stage of this research, it quickly became apparent that it would not be

helpful to include this category, for three main reasons:

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