«Research commissioned by the Intellectual Property Office, and carried out by: Martin Brassell, Kelvin King This is an independent report ...»
In terms of the information that gets fed into the process, Richard Holden, Head of Manufacturing at Lloyds Banking Group, sets out the position as it currently stands within the SME market generally. When a business owner presents their financial request to the bank, they are always asked for a breakdown of assets and liabilities. At present, these seldom if ever include intangibles and IP; they don’t get offered or asked for – they are just not on the agenda. As a result, it is unlikely, in most cases, that for the credit decisioning process considers IP to any
Paying much attention to IP at the moment would be a big leap in any event, but at least when it comes to understanding a company’s overall position, it may provide comfort between doing something or not. It doesn’t necessarily follow even at that point that lending will increase or be directly assigned to the IP, but it might make the difference between lending and not lending.
62 The role of intellectual property and intangible assets in facilitating business finance Logistically, Holden thinks this would probably involve a non-standard form or process with bespoke documentation, at least initially. This would have a cost attached to it which the bank would have to pass on in some way, unless standardised approaches were available.
Holden thinks that understanding the value of the IP and intangibles will also be a factor, and that there will be some scepticism to overcome over how IP is valued. However, he also sees benefits in having more understanding and control over the IP in a recovery situation and
believes that clients would potentially view more use of IP in a positive light:
Stephen Pegge of Lloyds Banking Group reports that, across the bank’s lending book in total, around 70% by value is secured, although when viewed by quantity, the majority overall are unsecured. Unsecured lending requires a high degree of confidence that the necessary capital resources are available within the business.
Banks also take personal guarantees, which are particularly relevant when dealing with smaller
companies. Pegge explains:
This provides comfort of a charge, usually over residential property. It is rare for this ever to be realised, as it is usually avoided by arranging refinancing or putting up alternative collateral, but it does concentrate the mind!
He identifies five areas of concern when considering the suitability of IP as collateral:
• Difficulty in independently realising the value • Being comfortable you can get title to it and market it successfully • There is scope for dispute over it • There might be a limited market for it • Even if you can separate the IP, the business’s decline might be due to overall market problems which will affect its realisable value However, he added that Lloyds does feel more comfortable with unsecured lending where there is recognised goodwill in some sectors like professional practices.
Starmer put the need for security into context as follows:
Smaller SMEs at an earlier life stage have less financial sophistication. In addition, narrow balance sheets generally mean borrowing requests need to be tangibly secured. The vast majority of SME Lending will have tangible security backing to mitigate the lack of business size and generally their modest financial profile. The security taken is viewed very much as a “back stop” – a secondary source of repayment.
Certain industry sectors lack available tangible security, for example retail clients, media and technology where our approach will be focused on liquidity and cash generation. Where businesses have good opportunity, but lack the required asset backing, we can use the Government supported EFG loan product.
For SME customers, without available corporate assets, we can look to support proposals through wider recourse to the principals. This takes the form of personal guarantees – supported and unsupported.
When there is a need for security to be realised because the primary exit route (cash) has failed to materialise, the majority of lenders will refer the business to a specialist recovery unit (which have a variety of different titles). Lenders were keen to stress that they are not in a hurry to break up companies in order to realise security values, as the following (unattributed) comment
It is absolutely not in the interests of a bank for a business to fail, and we do turn around the majority of cases. There will need to be a reassessment of the security position, as the company will probably have tried to clear stock. Value realisation is not the first objective – the question will be: how do we turn it around?
64 The role of intellectual property and intangible assets in facilitating business finance Jason Oakley is Managing Director of Commercial Banking at Metro Bank, and sits on the bank’s credit commitee. He confirms that Metro Bank uses debentures when obtaining security, and is one of a number of interviewees to reference the need for care in structuring overdrafts
following the Brumark case, explained in Chapter 8:
also vary by the amount of the loan, with larger amounts attracting lower rates, and the term length may also affect the price. We will consider an element of the lending on an unsecured basis if a business is strong enough, but the price may reflect any potential increased risk.
One of the main lines of enquiry for this report has been to determine the extent to which IP and intangibles can help to satisfy lender requirements for security – whether formally recognised as such for capital adequacy purposes, or simply providing ‘comfort’. The following unattributed comment helps to explain the position from a bank perspective and reinforces the ACCA view
expressed in Chapter 2:
The Prudential Regulation Authority (PRA) rules drive the cost of unsecured lending because they allow a bank to use collateral to mitigate risk. In fact, they require us to use it to set price, though that aspect is not a credit risk team responsibility.
To use IP as collateral in this way would require a ratio to be derived which would take into account the net losses encountered following a default. If a bank did this independently as an internal rating, it would take quite a number of years to determine (though if it was a PRA decision, it could be applied by everyone). The PRA rules also say that we have to use our internal ratings when considering the extension of credit, including account conduct.
Discussions held with the PRA are summarised in Chapter 8 of this report.
Peter Starmer of Barclays confirms the standard procedures and highlights that IP’s relevance in terms of collateral, at least from a mid-market perspective, is more about sustainability of
cashflow than about an expectation that value will be independently realised in recovery:
We look at the quality of assets forming the net worth, availability of security (property/ debtors) and understanding of intangibles (including Intellectual Property - what it is, where it is located, value to the business and is it included in our security net).
The common corporate security taken for committed lines would be debenture, crossguarantee and debenture, 1st legal charge over property and personal guarantee.
These are registered at Companies House where appropriate, and recorded on our own security system.
IP is discussed as part of our due diligence - understanding its significance to the business in driving cash flows. We are keen to ensure we understand how it is protected, where it is held and that it is captured effectively in our security. However, we don’t consider IP as a tangible security with an attributed security value. Identifying and ensuring IP is captured in our security is more about achieving rights over the technology that drives the cash flow and making sure that it is available in the event of business distress.
IP can be critical to business sustainability/sale, so we endeavour to achieve inclusion in our security net where it is clearly identifiable/chargeable. However, one of the reasons why we don’t attach a tangible security value is that often IP can be vague or 66 The role of intellectual property and intangible assets in facilitating business finance
As observed elsewhere in this report, conflating technology with IP is not always helpful, as it understates the importance of IP within many businesses that are not technology-based.
However, in the case of banking, there have been various initiatives over the years where different lenders have adopted a particular focus on technology businesses for other reasons. Those who have been involved in these business units emerged as having a clear understanding of the challenges of banking on IP.
Looking back on his time as Head of Technology and Innovation for HSBC, David Gill observes:
Stuart Ager explains the thinking of the Technology Sector Group team from his time within it:
We were looking at what you could do with tech companies from pre-start up to substantial businesses. Tech was defined broadly – there was lots of ICT, quite a lot of biotech and advanced manufacturing. The principles were pretty familiar: they’re all businesses, they just don’t have assets in the same way.
Lack of familiarity with the business models of IP-rich companies is a major obstacle:
Our credit team was inclined to turn down anything they didn’t understand and which didn’t have the sort of assets that were familiar. However, we did manage to turn round a lot of decisions that were initially declined.
One of the problems is that tech companies don’t have the traditional model of adding value to raw materials and producing a product. Instead, for instance, they have a software program being developed by highly skilled (and slightly strange!) individuals, selling under licence – which means deferred revenues, and so on. There’s a lot of money been spent on developing a software suite but it is not evident from the balance sheet. If it is shown at all, it is there as an intangible asset which the bank is used to valuing at nil!
The key is understanding how the technology relates to revenue. The model is often that there is a comparatively high level of fixed cost, which is generally in people - and once the revenues hit a certain level, then it all drops to the bottom line and they can quickly become very profitable.
Also, traditional lenders don’t understand that tech companies have to continually innovate. They can’t just have version 1 and expect it to sell like hot cakes in two years’ time. They need to get feedback from clients and keep incorporating changes – I used to ask for their product development roadmap.
In Ager’s view, there is also a lot more that could be done in terms of preparation by companies
seeking funding, particularly when it comes to their business plans:
The standard is generally poor. Technologists tend to present very large technical business plans that don’t clearly answer the basic questions, like what does it do, what market does it address, how is it accessed, do the numbers add up... Forecasts are often optimistic and seem to rely on Excel spreadsheet formulae rather than reality.
I have seen substantial accounting firms put together business plan forecasts that have been daft - generally because the company hasn’t wanted to spend the money to do it properly!
The better managed the business, the better the proposal and more realistic the plans and forecasts. Still, information about IP is often scant or, sometimes, too much – especially if the management team are highly technically based and lacking in commercial acumen.
68 The role of intellectual property and intangible assets in facilitating business finance
Aside from technology, there are other sectors where IP is a visible element in the credit decision.
One of these is franchising, where businesses can be tangible asset-light. Jason Oakley of Metro Bank draws on his previous experience as director of business banking for RBS and
NatWest when commenting on both technology companies and franchises:
Asset finance and asset-based lending How credit decisions get made As would be expected, the nature of the asset requirement is central to the decision on whether to lend against it. One of Lloyds’ divisions covers both asset finance and asset-backed finance.
Finance Director of Lloyds Bank’s Commercial Finance division, Martin Cooper, explains how
the latter is approached:
The bank looks at current and past performance and considers whether there is a sustainable future for the business. This is also reputationally very important for us in terms of responsible lending.
With a smaller business, the main emphasis will be on the quality of the receivables, followed by the quality of other assets which are available, depending on how much money is required. We need to understand whether being better funded will help them and whether they are currently paying all the things they should be, in terms of PAYE, VAT and so on.
Christopher Hawes is now Director of Corporate at RBS Invoice Finance but has previous experience from a number of organisations involved with asset-based lending, including US and
European-based banks. He advises:
We look at the debt, the debtors and the financials. In terms of the nature of the debt, everyone’s favourite is temporary manpower agencies, because the potential for dispute or dilutions is minimal, so you can advance more. This is particularly the case compared with, say, contractual and quasi-contractual operations, such as companies supplying food to multiples, where there is a performance risk issue. We ask: what is the order to invoice cycle? Where’s the proof?