«Research commissioned by the Intellectual Property Office, and carried out by: Martin Brassell, Kelvin King This is an independent report ...»
The most recent data used by the report comes from the SME Finance Monitor47, produced by BRDC Continental, which uses SME interviews to understand their experiences and perceptions.
Its 2012 report, based on a total of 20,000 surveys, found that 44% of respondents overall were using some external finance. Of those not borrowing, the study identified 34% of them as being ‘permanent non-borrowers’ who habitually do not use or seek such finance.
Of the total respondents, 23% had made some sort of application, renewed or renegotiated a facility during the previous 12 months, with another 10% stating that they would have liked to have done so but that something prevented them (interestingly, when separately asked whether any personal funds had been injected into the business over the same period, 17% of respondents said they had chosen to do so whilst 25% had felt compelled to do so).
45 Ibid 46 Ibid 47 SME Finance Monitor 2012 Annual Report, BRDC Continental, April 2013 56 The role of intellectual property and intangible assets in facilitating business finance
Where businesses want to apply for funding but do not, the SME Finance Monitor seeks to measure those dissuaded by the principle of lending; by the practicalities of the process; by the feeling that it was the wrong time due to overall economic conditions; and by being ‘discouraged’
- either by the bank after informal enquiries, or by a preconception that they would be turned
down. The breakdown of responses for the most recent period examined was as follows48:
The first annual report on the appeals process activities50, covering the 2011-12 financial year, showed that of the taskforce banks, 827,000 applications had been received for all credit products that fell within the scope of the appeals process, of which 114,000 had been declined (14%). Of those which were declined, 2% were taken to appeal (2,177 in total, equivalent to 0.3% of all applications) and 39.5% of these have been overturned – which in this context “does not mean that the business has received exactly what they asked for initially, but that they have reached a lending agreement with which both parties are satisfied51.”
The review contains an analysis of the changes to lending appetite and practices since 2008, which include requesting larger cash stakes from business owners to spread risk, taking longer to make decisions, focusing on affordability as the main driver (followed by “the ability of the management of the business to deliver what they say they are going to”), and the need to make proper provisions for default based on the credit risk and customer.
The key aspects where IP may have some influence therefore appear to be:
• Addressing information asymmetry by helping a lender to understand a business’s underlying substance
• Providing additional information to assess risk
• Mitigating risk by providing an additional form of business collateral (whether or not regarded as ‘security’ in the full conventional meaning of the world – as explored further in Chapter 8)
• Helping businesses to grow using assets they possess Within this framework, from interviews conducted to date, the taking of security or collateral emerges as having three distinct purposes, the emphasis of which varies according to the type
of instrument being used:
• Examining the quality of the assets (particularly the debtor book, or receivables) helps the lender make their initial decision on whether to lend
• Taking control over valuable assets provides the lender with the influence it needs over the business’s behaviour
• Having a charge over the assets means that the lender can take ownership in the event of default and sell them to settle a debt – which might happen independently of the business (more commonly found in conventional asset finance), or could be related to sale of the business as a going concern Currently, as the qualitative interviews for this report have confirmed, IP and intangibles (other than invoices) seldom feature in term lending and overdrafts or in asset finance. There are some cases where they have been taken into consideration in asset-backed finance. By contrast, they are viewed as fundamentally important in venture debt, because of their value to the business.
Manos Schizas of ACCA, quoted in Chapter 2, comments on the landscape as follows:
The starting point is that we are increasingly moving towards an economy that generally runs on intangibles. SMEs are more reliant on these assets than most, and lack the mechanisms larger companies can use to recognise intangible values. In a larger business you will see assets present in the balance sheet that have some relationship to reputation. If you were to create a comprehensive balance sheet for an SME you would find lots of the value would be down to intangibles.
58 The role of intellectual property and intangible assets in facilitating business finance
‘Traditional’ bank finance: term lending and informal lending As already highlighted, where SMEs are seeking finance, the vast majority turn to their primary banking relationship in order to obtain it. Traditionally, funding comes in one of two forms: bank loans (i.e. term lending agreements that are structured facilities repaid over time on an agreed basis) or overdraft facilities (informal arrangements which are applied to accounts for variable time periods).
Traditionally, the main distinction between informal arrangements and term lending is that the former is normally used to facilitate working capital needs, whereas the latter is normally for development capital. It represents a longer term commitment for both parties.
This category of finance has two distinct elements: providing finance to companies who want to purchase new (or sometimes ‘pre-owned’) assets for their business, generally referred to as asset finance, and providing finance to business that is secured against assets that they already own, commonly known as asset-backed lending.
The asset finance space includes mainstream hire purchase and leasing activities, while the asset-backed lending aspect works using a combination of a business’s receivables (which are intangible assets, but of an unusual nature, being on the balance sheet) and other assets the business owns. Some organisations specialise in one area while others do both; some are independent (and therefore raise funds from a number of sources) while others are ‘captive’ (i.e.
subsidiaries of larger funding organisations, generally banks). Of the two types, it is asset-based lending which has greater relevance for IP.
Invoice discounting and factoring are often the core products in asset-based lending, because invoices are closest of all to cash. Under these two arrangements, the bank will provide an advance that represents a percentage of the amount invoiced, which depending on the business, the sector and the payment profile will generally range from 70-90% (hence the term ‘discounting’.
The balance is then paid to the client when their customer pays, and the cost of the service is the cost of the charges for the advances made.
Venture debt and mezzanine-style finance Venture debt started in the US as venture leasing, an interesting but comparatively short-lived phenomenon. The principle behind it was that fast growth companies needed to be able to acquire assets, typically involving information technology (IT), but that owing to their lack of track record, the risk associated with their businesses was impossible to price using conventional debt. The answer was to take warrants for an additional equity stake in the business in order to achieve an acceptable rate of return.
This was a difficult thing for a lending institution to do well, and the number of examples from the UK is limited. Sam Geneen, Managing Director of Five Arrows Leasing Group, is a very
experienced asset finance professional. He explains:
We did one deal which was fantastic. Two very impressive guys came in with a concept for establishing a disaster recovery business. To run it, they wanted to finance two large IBM computers. At the time our main business was computer leasing, which is why they came to us, and we were doing a lot of business with IBM at the time. We decided to take a punt, and took a stake equivalent to about 25%. The company did amazingly well and achieved a fantastic exit. Had it gone wrong, we would have been able to do something with the computers. However, there were very few of those sort of opportunities around – you would have to kiss a lot of frogs!
The providers of venture leasing were forced to rethink by the falling costs of IT and the increased amount of outsourcing in the market, both of which led to a fall in the value of fixed assets. None of the finance companies seeking to specialise in this area were ultimately successful.
Venture debt retains the idea of combining lending with a modest equity upside (usually by taking warrants), but looks at all the existing assets of the business rather than focusing on financing specific new ones. It works by being applied alongside venture capital investment to address risk.
Peer-to-peer lending Peer-to-peer lending is a fairly recent phenomenon in the UK. Rather than debt finance coming from banks, it takes the form of loans from individuals, who compete to provide a good interest rate depending on how much they like the opportunity.
Whilst the best-known, Zopa, operates in the personal lending space, there are a number of business-to-business peer-to-peer lenders now in operation, including Funding Circle and Thin Cats in business lending, and MarketInvoice and Platform Black in invoice discounting.
Whilst they have slightly different operating models, they all create a marketplace in which individuals can participate to lend money to ‘screened’ companies.
60 The role of intellectual property and intangible assets in facilitating business finance
The increasing use of IP and intangibles in the pensions area is a particularly interesting development, especially given the high degree of scrutiny given by trustees, the Pension Regulator and HM Revenue & Customs to the value of assets on which a pension fund will rely in large corporate situations. The IP securitisation techniques used to address deficits in corporate pension funds are examined in Chapter 9, as they are particularly pertinent to the question of valuation scrutiny. However, IP is also being successfully used to help SMEs secure more modest amounts of funding, as explained in this chapter.
For general business funding, the specific scheme types which are used are either a Small SelfAdministered Scheme (SSAS) or a Self Invested Personal Pension (SIPP), the main difference between the two being that a SSAS has to attach to a limited company but has greater flexibility in terms of what it can do, including lending to a business. The opportunity to use intangible assets in the context of both SSAS and SIPP schemes arose from the Finance Act 2004;
broadly, this permitted any asset to be used for pensions, but introduced tax charges for certain classes of property, such as tangible moveable property.
To a lesser or greater extent, all decision-making processes will be assisted by automated tools and scoring mechanisms or methodologies, though the ‘computer says no’ view of credit procedures is unduly harsh – this report did not encounter any circumstances where business lending was solely determined by a computer.
The sensitivities associated with the public perceptions of bank decision-making made it difficult to attract many comments on the record but the following quotes are representative of a number
of conversations and exchanges held in terms of sequencing:
The balance sheet becomes important thereafter, though it is useful to help us get an initial view of where the business is at - if there are no net assets, the bank will have a problem with the application anyway!
Affordability is all about earnings and cash flow, and there will be particular percentages and ratios that need to be achieved. Affordability is not linked to security, but the level of belief or confidence in the forecast will affect the level of security required.
Peter Starmer, Director of the Mid-Market credit team at Barclays Bank, provides a more detailed
Serviceability is key, measured on both a profit and cash basis – cash generation is our primary source of repayment. We ensure that this is achievable with a reasonable margin of safety. Appropriate downside sensitivities are especially important for larger exposures, to ensure sustainability of the business and its capacity to service debt in a changing trading environment.
Trended Debt Service ratios are automatically calculated on our systems and available to assess smaller transactions: we apply a more sophisticated/tailored approach for larger transactions and more complex client structures.
Our analytical approach is framed around the pneumonic “COLD” – Capital structure, Operating performance, Liquidity and Debt service. In broad terms, the credit officer assessment would cover the business’s track record, industry risk, business risks, trended financial analysis, debt structure/security, monitoring and return.
Our key ratios analysis looks at a number of areas: gearing, current ratio (plus acid test), leverage, debt service ratios (i.e. interest cover/ debt service cover by both EBITDA/cash) and LTV. Balance sheet robustness is key – our focus being on a sustainable working capital position (including cash reserves/headroom in credit lines) and clear evidence there is no inappropriate creditor stretch or other arrears.