The Value of Intellectual Property in Corporate Finance

Valuing and lending on trademarks and patents are evolving. Once the domain of “loan to own” shops, this practice is no longer in its infancy, but has grown to be a unique differentiator in a lender’s tool chest. Intellectual property (IP) is generally under-appreciated as a source of corporate value. IP-backed lending can give business owners access to debt capital that can be less expensive and dilutive than equity. It can offer both borrowers and lenders a new opportunity to unlock a valuable source of leverage.

The History of the Patent

Patents have rapidly evolved throughout history. On July 31, 1790, the first U.S. patent was issued to Samuel Hopkins for an improvement “in the making of Pot Ash and Pearl Ash by a new Apparatus and Process.” This patent was signed by President George Washington.

The 1836 U.S. Patent Office Fire was the first of two major fires that the United States Patent and Trademark Office (USPTO) experienced in its long history. The fire occurred in The Blodget’s Hotel Building in Washington, D.C. on Dec. 15, 1836, which was home to both the USPTO and The United States Post Office. An initial investigation considered the possibility of arson due to suspected corruption in the post office. This possibility was later ruled out.

Local fire suppression efforts were incapable of preventing the damage due to lack of fire personnel and proper equipment. All 9,957 patents and 7,000 related patent models were lost. The fire occurred shortly after the Patent Act of 1836 was passed, which required that patent applications be examined before being granted. An amendment to the Act in 1837 required submission of two copies of drawings — one for safekeeping in the USPTO, the other attached to the patent granted to the applicant.

In a report to Congress in 1843 by the USPTO Commissioner, Henry Ellsworth stated, “The advancement of the arts, from year to year, taxes our credulity and seems to presage the arrival of that period when human improvement must end.” In 1899, Charles H. Duell, commissioner of the USPTO, sent his resignation letter to President William McKinley, urging the closing of the USPTO. “Everything that could be invented has been invented,” was his reasoning. Well into the 20th century, newspaper and magazine polls continued to select Thomas Edison as America’s “greatest” and “most useful citizen,” with the greatest number (1,093) of patents ever issued to one person.

Companies’ Crown Jewels

When Jennifer Palmer, CEO of JPalmer Collective, first joined Gerber Finance (GFI) in 2006, the company had a deal on the books secured solely by its trademark. “The company previously had a revolver with GFI but refinanced with a bank, and the bank paid out GFI on 90% of its exposure in release for a termination over the company’s assets — which did not include the trademark or a right-of-use agreement.”

To support the term note, Palmer says, GFI kept the founder’s personal guaranty and a lien on the company’s trademark, which was owned by the founder. “The company later got into trouble and when the bank tried to foreclose, they were surprised to learn they couldn’t — that is, without our permission or without paying us off,” Palmer says. “They fought us, but we quickly got an injunction against using the website and selling the inventory which had the trademark we had a security interest over. In that case, the lender lost its leverage because it didn’t underwrite the intellectual property which, in turn, created real value for us.”

“Acuitive lenders like JPalmer Collective realize the significance and value of a borrower’s trademark and other intellectual property as an integral component of the borrower’s good will and value,” Paul Shur, shareholder at Becker & Poliakoff, says. “Including it in the borrowing base is a testament to the lender’s flexibility and creativity. To facilitate that, the lender must a) conduct its due diligence on all applicable licenses, domain and third-party agreements relating to the IP, and b) collateralize that property interest under the Uniform Commercial Code and register notice of its interests on the applicable federal registry. These steps encapsulate the full measure of value recognized by the lender.”

Intellectual property — particularly brands — is the crown jewel of many companies. Careful underwriting and monitoring of a brand can offer a reliable source of repayment or recovery for asset-based lenders. Understanding brand value and capitalizing on it in the right situations can be a key strategy to maximize borrowing capacity — or enhance recovery.

“In the past three decades, brands have become increasingly important in lending circles as the private equity and second lien community focused on brands as a key part of enterprise value,” David McReynolds, managing partner of Five Crowns Capital, says.

Lending Against Brands

How is a brand loan structured? Three typical structures include:

• ABL: The brand becomes part of the borrowing base, usually at some percentage (advance rate) of net forced liquidation value.
• Stretch ABL: The brand is valued and is part of first lien collateral package. The asset- based lender is willing to stretch to higher advance rates on working capital assets with the backstop of “boot” IP collateral.
• Second Lien: This type of lender comes in with a second lien on the working capital assets and a first lien on the IP.

Richelle Kalnit, chief commercial officer of Hilco Streambank, advises that lenders need to plan ahead for a forced liquidation when the loan is first underwritten. “Without careful and realistic planning for the downside scenario, selling IP — whether through an Article 9, Assignment of the Benefit of Creditors or Chapter 11 — is fraught with challenges,” Kalnit says. “This is particularly relevant with digital assets such as social media accounts, domain names and channel relationships with marketplaces such as Amazon.”

Another important consideration in structuring a deal is whether the brand has a licensing stream of revenue. If a lender can get visibility on the cash flow from a predictable royalty stream, this can be another way to substantiate brand value.

Selling Brand Products

The fickle nature of selling a brand’s products only to wholesale channels poses some interesting questions about brand value. Historically, getting shelf space at a major retailer was a long and arduous process. At grocery retailers, brand manufacturers often had to pay stocking fees, which could swamp the marketing budget of upstart brands.

The internet has dramatically tilted the playing field, enabling new products to gain traction in a highly targeted way. With e-commerce as a major channel to consumers, brand owners and manufacturers have real time information on how their brand is performing. For those companies that sell only through wholesale channels, their brands typically suffer from opaque visibility on customer behavior compared with the internet. An interesting question for historians in 10 years’ time will be how the internet has influenced the rate of decline and demise — or resurrection — of weak and orphan brands.

Technology has altered the life cycle of many brands. In some cases, the internet has shortened the life cycle of once strong brands. In other cases, underperforming brands can be tweaked to extend their life cycle instead of being abandoned.

“A brand is much more than a name,” Kalnit says. “Its value is supported by the channels in which it operates and how it reaches its customer and, particularly for e-commerce and retail, the data it leverages to further serve the customer.”

Putting Up Guardrails

A good brand appraisal will install guardrails on the important functions and expenditures that support brand value. Typically, brand appraisers are asked to provide fair market value, net orderly liquidation value and net forced liquidation value.

Kalnit explains the difference:

• Fair Market Value: The price that a willing buyer and seller would agree to for an asset in a normal marketplace.
• Orderly Liquidation Value: The amount that could be expected to be received from selling an asset within a reasonable time frame, assuming the seller is required to sell on an as-is basis.
• Net Forced Liquidation Value: The amount that could be expected to be received from selling an asset in a public sale that’s properly advertised and conducted, assuming the seller is required to sell.

If there were no budgetary limitations, companies would file for IP protection around the entire world. Since that often isn’t possible, when implementing an IP strategy, it is critical for companies to properly select jurisdictions where they might make and sell their products — or expand into new lines — to ensure that future opportunities have been adequately protected. For example, an apparel firm could logically anticipate it might expand into the fragrance business at some point; therefore, it should make sure its IP portfolio safeguards that future market.

The Value and Longevity of a Brand Name

FAO Schwartz was the main stage for the blockbuster movie “Big,” in which Tom Hanks danced on the floor piano at its Fifth Avenue flagship. For decades, FAO Schwartz’s Fifth Avenue store in Manhattan was a magnet for tourists. The company was founded in 1862 in Baltimore by German immigrant Fredrick August Otto Schwartz. By 1897, The New York Times declared FAO Schwartz “the largest dealer in toys in this city.”

In 1963, Parent’s Magazine Enterprises purchased the brick-and-mortar assets of FAO Schwarz, licensed the FAO Schwarz name, and continued using it for five years, paying the Schwartz family a substantial royalty on sales. The brand name license was renewed in 1968, as Parent’s Magazine felt the name was too significant to lose. Part of the price of keeping the name was to maintain this royalty agreement.

In January 2003, the retailer made a quick trip through bankruptcy court, emerging in April 2003. By December 2003, FAO Schwartz did a “Chapter 22,” with investment group D.E. Shaw winning the 363 sale. In 2008, D.E. Shaw sold the retailer to Toys “R” Us, which put FAO Schwartz boutiques into some of its stores.

The FAO Schwartz brand is currently the property of the descendants of the founder through the FAO Schwartz Family Foundation but is exclusively operated by ThreeSixty Group, with stores including 30 Rockefeller Center, LaGuardia Airport and, most recently, in Paris at Galleries Lafayette Haussmann.

Is a “Brand” Worth It?

Lenders also need to consider whether a brand truly has a reason to exist. This is particularly true in today’s changing retail environment. Can competitors do what your borrower is doing, only cheaper or better? And, if so, does it diminish the value of what was once a strong brand? Certain sectors, such as the teen apparel market, show that it can be challenging to avoid getting abruptly sideswiped by new competitors. Many ABL players have covenants that require pay-down or provide additional collateral if the brand value starts to fall or the recent appraisal shows weakening. Radio Shack was a prime example of a brand that lost its luster.

“While that trademark-only deal was my first experience lending against IP, it certainly wasn’t my last,” Palmer says. “Today at JPalmer, we lend against IP for CPG brands that are growing and have a valuable mark. When determining whether a mark has value and if we should extend value to a borrower’s IP, we use third party appraisers, but it is our own internal analysis that provides us the real comfort. This analysis is a combination of objectively underwriting our ability to sell the mark on its own in a liquidation scenario — coupled with a subjective analysis around the brand’s value that is arrived at through heavy deliberation and years of experience in IP lending.”

Do lenders like to lend against a service company brand name? In the current lending environment, the U.S. economy is made up more and more of service companies. The broad answer is yes — there are some strong service companies with very sticky streams of revenue that support the brand name.

Rick Hyman, a partner at Crowell & Moring, reminds us that the importance of IP is evidenced in the recent trend of “liability management exercises.”

“In one of the earliest LME transactions, it was J. Crew’s valuable intellectual property that was stripped from the senior lenders’ collateral package and down-streamed to a new, unrestricted subsidiary through a series of steps that, although controversial, were permitted by the credit agreement,” Hyman says. “The IP, sitting unencumbered in a new subsidiary, was enough to attract new debt that was structurally senior to all previously existing obligations of the company. Critically, the company was able to continue the use of the brand and other IP by way of a license back to the parent.”

Looking at IP through a different lens, Vince Belcastro draws on his experience in equipment finance. “Many sophisticated manufacturing systems are 50% hardware, 50% software. An often-overlooked aspect of intellectual property is the “secret sauce” of successfully implementing and maintaining complex manufacturing processes,” Belcastro says. “Often times, the hardware is useless without the software running it — and it is important to understand what rights are transferable, otherwise, valuations can be heavily challenged in a liquidation with the equipment being worth a fraction of its value.”

“In ABL, we can sometimes get so in the weeds evaluating the primary collateral that we lose sight of the significant value of the IP,” George Psomas, managing director at Brooks Houghton, says.

A few years back, Psomas says, a chip manufacturer that was recently bought by a tech investor was being turned around, going from negative $30 million in EBITDA to positive $30 million. Psomas’ team closed on an asset-based revolver for $50 million on a book value of assets (mostly accounts receivable, inventory and some equipment) of $100 million. “We knew the company’s dozens of patents and trademarks also had value but that was just a ‘cushion,’” Psomas says. “Several weeks after closing, they raised equity, selling 20% of the company for $120 million. This indicated total enterprise value to be $600 million. Some quick algebra strongly suggested the IP was worth about $500 million — 10 times our borrowing base! Me and my underwriter had a good chuckle, feeling quite validated.”

From a control distressed equity standpoint, Mike Healy, CEO at Gardner Standard, says, “Patents and brand names can represent a significant competitive advantage. We buy troubled companies and, in many cases, the intellectual property we acquire is critical to driving increased margins once the business is stabilized and growing again.”

Today’s Patents

Today, the USPTO deals with the mundane such as U.S. patent 6,004,596 “Sealed Crustless Sandwich” approved in 1999, which covered the design of a sandwich with crimped edges. All claims of this patent were canceled by the USPTO upon reexamination.

The USPTO also encounters game-changing innovations, such as Amazon’s “1-Click” shopping cart trademark in 1999. By the time Amazon’s patent expired on Sept. 11, 2017, Amazon’s market capitalization exceeded $500 billion. •

Hugh Larratt-Smith is a managing director of Trimingham and is a regular contributing author to ABF Journal.