The use of patents as loan collateral by early stage companies is extremely rare. But these companies can unlock the collateral value of their patents and secure cost-effective financing by using insurance to transfer business viability risks.
Turning an innovative idea into a revenue-generating company has always been a challenge. Under normal circumstances, banks are leery of lending against untested intellectual property no matter how promising it appears. Entrepreneurs who have secured patents on intellectual property they believe will be transformative often face the unpalatable choice of selling or licensing the patents, in some cases for a fraction of their long-term revenue-generating potential. Or they can resort to dilutive rounds of venture capital financing. Entrepreneurs have faced additional challenges since the COVID-19 crisis hit, as most banks have tightened their credit standards, especially for small business lending. Despite this, companies with patents that can pass certain business viability tests can now use them as collateral for loans.
This could develop into a meaningful source of financing for early stage companies. In the past, even under the best pre-COVID-19 economic circumstances, the use of untested patents as collateral was rare. Only 1% of the 6.3 million patents in the U.S. Patent and Trademark Office’s 2015 assignment database had security agreements, meaning that they were pledged as collateral, according to a USPTO report at the time. Many of the patent holders that are successful at using them as collateral are companies with positive earnings, many of them in the big pharmaceutical and technology sectors, with some in the Fortune 500. These companies are creditworthy enough to obtain loans even without using their patents as collateral. They decide to use them to reduce their borrowing costs.
The urgency of finding efficient ways to monetize intellectual property assets, especially for startups that might never get off the ground otherwise, is reflected in the burgeoning value of these assets in the economy. The value of intangible assets like patents, trademarks and other intellectual property has grown so rapidly that it now accounts for the bulk of U.S. stock market value.
The consulting firm Ocean Tomo estimates that the intangible asset market value (IAMV) of the S&P 500 index components grew from 68% to 84% between 1995 and 2015. COVID-19 appears to be accelerating the trend, with Ocean Tomo’s latest analysis from September putting the IAMV at 90%. This demonstrates the profound move in the U.S. from a manufacturing economy to a knowledge-based economy, and it highlights the need for effective ways to use intellectual property as collateral.
Large companies already know this. Last year, the CFA Journal cited research showing that lending to companies that used patents as collateral increased significantly after four legal decisions between 2002 and 2009 strengthened creditor rights. The research found that the number of patents pledged as collateral had doubled since 2000. However, all these companies were large and had positive revenues; startups and early stage companies were not included in the research sample. Even so, the results showed the growing importance of intangible assets to economic activity over the last two decades.
IP Collateral Challenges
For startups and early stage companies, there are several challenges to using a patent as loan collateral, even apart from the effect of COVID-19 on bank risk appetite. First is the lack of industry standards or benchmarks for valuing novel IP assets. The element of a new product or process that makes it most compelling — its promise to solve a problem in a unique way — usually means there are no market comparables against which to estimate its potential value. Since many of the loans sought are small — say, between $5 and $25 million — banks do not find it economical to do the due diligence necessary to estimate a patent’s business viability. Banks often decide that this sort of research is not worth the trouble for small borrowers, especially in the current banking environment where lenders are allocating capital with an eagle eye.
Banks also loathe the idea of being stuck with collateral of unknown value should a borrower default. Again, banks see the difficulty of disposing of such collateral as a costly headache, especially if the borrower who developed it was unable to profitably exploit it.
The key is to transfer the business viability risk of the patent from the lender to a third party, such as an insurer. This is different from what is typically called “patent insurance,” which generally refers to defensive coverage to protect a patent holder against legal challenges, or enforcement coverage, which funds legal challenges against other parties who infringe on a patent. Insuring a patent’s business viability is meant to facilitate the launch or early development of a company before patent defense or enforcement issues become pressing.
Entrepreneurs who want to launch a company without bringing in equity investors at the outset but whose only lendable asset is their patent would find this approach especially useful. But companies slightly further along in their development also can benefit. One example is a company that already raised first-round financing from angel or venture investors but needs a small additional amount to turn its patent into an operational business. The founders might decide that the amount required, say, $5 million, would not justify a second round of financing. They also might wish to avoid unnecessary dilution, or simply be looking for a more advantageous cost of funds than is available from other sources.
How It Works
In general, patent holders should go into the process with a clear business plan based on the intellectual property’s prospects. Along with a clear description of the technology itself, the patent holder should include anything that supports the argument for the potential business’ viability, such as offtake agreements or established supply chain relationships.
The potential borrower should have the business plan evaluated by an institution with experience in intellectual property, risk transfer, insurance and capital markets. This firm should do a risk analysis based on the patent’s business viability to determine the patent’s value. Also, to work as collateral, the patent must have a clear and clean title, meaning it must not have been used to secure other financings and it must not be subject to any litigation.
The firm will then approach insurance carriers to get prices for business viability insurance. If a carrier accepts the firm’s patent valuation, the process can go forward. If not, the firm and the startup can decide whether to pay the insurer to do its own valuation, or to take its business to another carrier. Once the insurance is negotiated, the firm can approach lenders with collateral that has neither appreciable market nor credit risk. Depending on the situation, the lenders could be banks or other types of non-bank asset-based lenders.
The process, which is currently available for loan amounts between roughly $5 million and $25 million, takes about six to eight weeks and can secure a cost of financing well below that of alternative sources. In the current environment, companies can borrow between 6% and 8% using properly insured patents as collateral.
This approach breaks the logjams that prevent entrepreneurs from using their intellectual property productively so they can cultivate and benefit from the fruit of their innovations.
Nemo Perera is the managing general partner of Edge Management, a risk finance consultancy offering risk mitigation, specialty insurance products and rated innovative bond structures.