Overlooked Assets: Using Patents for Financing New Businesses

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 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.

IP Collateral Challenges

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.

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.

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 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.

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.