From Ideas to Assets

Asset-Backed IP Financing: Strategies for Capitalizing on Future

Returns (CH. 21)

Jerry BarnesIEOR 190G

The Fiscal Strategic Paradox of Intellectual Property

• The securitization of intellectual property can be both beneficial and costly to a firm's health.

• The creation of intellectual property (IP) assets, which can be a good strategic maneuver under the right circumstances, poses a threat to a firm's stock value.

• Creating IP assets can devalue a company from an accounting perspective, by consuming cash, shortening the balance sheet, and and reducing current earnings.

-According to Elliot, “Coming to grips with the fiscal-strategic paradox of intellectual property is likely to take center stage early in the new millennium.”

• The pros-cons comparison with respect to the creation of intellectual property assets is as much a time issue as it is a money issue.

• CFO’s and other executives are largely pre-occupied with matters that pertain only to the short-term—quarterly earnings reports and stock price. Given IP assets negative effect on short-term value, executives find the creation of IP assets as a long-term strategy a less than attractive investment.

• This lack of foresight may prove costly to companies in the long run. While IP assets can be harmful from an accounting perspective, the creation and development of these assets are vital to the long-term health of our economy.

“For an economy increasingly based on knowledge, intellectual property must serve up more value than ever to keep companies competitive.”

Converting IP Inventory into Cash-Generating Corporate Assets

• To mobilize the widespread conversion of IP into financial assets/derivatives, CFOs and CEOs must be convinced “that putting technology into play, financially speaking, is a win-win proposition… intellectual property derivatives will be successful only if they can make, hold, and deliver market value.”

• IP securitization on a large scale will be a challenging undertaking and will require a “new generation of IP investment banking.” Elliot argues that Wall Street is not likely to produce this new breed of banker. We should instead look to “Main Street,” particularly the licensing departments of companies and universities, “where the skills and intuitions exist to translate IP into a twenty-first century financial currency.”

• One of the key challenges in the securitization of IP results from the fact that the majority of proprietary IP rights are “submerged from view.” The hidden nature of IP rights makes it difficult to extract market value from them, a dynamic that poses a challenge as well as a great deal of opportunity to licensing professionals.

• For IP-backed asset financing to be an attractive investment, IP assets must clearly demonstrate the ability to generate future revenues. More specifically, IP asset-backed financing should address the following:

1) Pricing the IP asset portfolio2) Defining the term and payout of IP revenues 3) Maintaining continuity with existing business practices4) Satisfying the multiple market needs of IP owners, IP users, and financiers5) Creating practical entry and exit strategies

Asset Financing: An Investment Banking Perspective

• Money is the official language of the investment banking industry. Consequently, IP assets and payouts must be translated into the literature of cash flow to make sense in the IB world. In a traditional asset-backed financing investment banks raise cash for companies in exchange for…

1) Future income2) Future asset appreciation 3) Sale of pledge of company assets

General Mechanics of Asset Financing

General Mechanics of Asset Financing

• As is shown in the diagram in the previous slide, investment banks function as the intermediaries between investors and companies by channeling investor capital into these companies. In exchange for their services, investment banks demand/receive financial obligations that are collateralized by the asset of interest. These financial obligations can take a variety of forms, the most common being debt and equity instruments.

• Extending this traditional function of investment banks to intellectual property can be difficult. Specifically, IP assets are difficult to price because the majority of internally generated IP lacks book values for the assets.

Investment Banking: Mechanics for IP Assets

• A problematic characteristic of IP assets is that they only appear on profit and loss (P&L) statements and are unvalued on all other financial sheets. This lack of representation of IP assets on financial sheets prevents CFOs and CEOs from extracting the maximum financial advantage from the IP portfolio.

• Benefits of transforming IP into cash reserves: 1) Improve corporate cash flow2) Finance new R&D3) Increase short-term profits4) Fund Acquisitions 5) Increase shareholder assets 6) Support and increase share price

IP Securitization Methods• The pricing of financial instruments requires the ability to

measure both value and risk. • Unlike many other financial instruments, IP asset derivatives

have no trading market. Valuation of IP asset derivatives must therefore be based on cost and income methods.

• Cost Method: – This method attempts to reconcile the reason for IP assets’

“conspicuous absence from the financial sheets, tax policy.” – Attempts to integrate portfolio production costs with economic life.

Doing so results in a recurring investment cost, less amortization (the depreciation of a tangible asset), spread over the IP life.

– 2 assumptions of cost-based valuation: generating the IP is a result of rational business processes; a portfolio of IP properties is less risky than a single IP asset.

IP Securitization Methods• Income Valuation Method

– Unlike cost methods, income methods consider only what future economic value is added by IP in use in its valuation of IP assets.

– Income methods consider the cost to acquire IP as incidental. – This method is the most familiar to licensing executives – The income value of the IP is equal to the royalty payment stream less

costs. – IRR/NPV analysis allows for straightforward conversion of IP into

financial instruments. – The underlying IP asset value can be determined by computing a use

royalty consistent with the value of the technology using NPV and IRR techniques.

– Income based value for internal IP turns on the fraction of profits (less necessary expenses) that would not exist but for the existence of the IP itself.

Other Valuation Methods

• Technology IP Sale• Royalty Trust• IP Debt Leveraging• Synthetic License Monetization: Sale and Back-

License