Startups

IP valuation in IP-based financing

December 15, 2021 · 4 min read
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Financial institutions use different approaches to IP valuation as part of their financing process. One of the threshold considerations for lenders in evaluating whether and how much to loan a borrower using its IP as collateral is determining the scope and value of the company’s IP portfolio. Unlike inventory and equipment, where established procedures can predict the value of such assets today and in the future, the value of a company’s intellectual property assets is considered to be far more speculative. 

Maximizing Intellectual Property and Intangible Assets” report (PDF) by the Athena Alliance, issued in 2009, provides context for financial institutions’ approaches to IP and intangible asset-based financing. By highlighting effectively structured and completed Intangible Asset (IA) debt-and-equity arrangements, the Report addressed the fundamental difficulties in IA finance that face financial firms and corporations alike. The survey found that the most major barrier to increased interest and involvement in IA finance is the uncertainty around intangible asset valuation. 

Valuation plays a different role in IP financing, based on two considerations: (1) Present and future cash flow for the purpose of servicing the loan repayment plan; and (2) Value to cover the investment in the event of default. 

Some financial quarters view the use of certain forms of IP as collateral to be problematic because the financial firm is ultimately concerned with the revenue-generating potential of the asset on which the firm is basing its investment in the company. If it is to be valued in the event of default, which is of paramount importance to the potential creditor, this revenue generation must be able to be achieved independently, even partially, from the company. 

It has been argued that for banks to lend positively and directly against the value of IP and intangibles in isolation (setting aside regulatory considerations), it is necessary for the bank to be confident that it can dispose of the IP separately from the business if the need should arise, in much the same way as it can expect to do with an item of tangible property.

Barriers to IP-based financing for startups

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Despite its potential for innovation financing, IP-based finance is widely believed to be underexploited, by young startups that would need it most. Intangible assets account for more than half of the enterprise value in most startups. Startups typically seek external funding in the form of equity financing, but this can also be challenging. There are additional levels of uncertainty in the valuation of early-stage technologies.

In some cases, the extent of complementary assets necessary to generate earnings may be unknown. The degree of uncertainty in the development trajectory influences the valuation approach chosen, but it does not invalidate the valuation process entirely. These considerations are generally incorporated into licensing negotiations and can be accounted for in a valuation. However, the asset’s risk profile and the range of probable outcomes should be reflected in the valuation report.

For investors, particularly business angels and venture capitalists, the presence of IP acts as signals on the quality of the company. The key distinction between debt and equity financing is that equity investors invest in the entire company rather than just the IP. As a result, they typically assess the company’s expected profitability without assigning a specific financial valuation to the IP. Because the enterprise’s technology is new and unproven, and the enterprise lacks an established market, IP valuation may not work for startups. A VC may be more interested in IP value at exit, particularly if the purchaser is a corporation.

In a research commissioned by the European Commission Expert Group on Valuation, in identifying significant differences in the approach to lending to SMEs and start-ups compared with larger corporates that have a strong trading history, it was observed that IP is mostly evaluated and not formally valued in the regular banking, VC, or Private Equity sectors. Liens, warrants, and debentures on IP assets, as well as numbers relating to IP capitalized on the balance sheet, may be examined – but only as risk factors, not as part of a formal IP valuation. This reluctance in the IP valuation market may be attributed to information asymmetry, regulatory lapses and market immaturity. 

Venture debt as an alternative 

Photo by Iwaria via Iwaria.com

With the growing recognition of the value of IP assets, there are a few segments of the regulated credit market that have devoted themselves exclusively to serving startups and high-growth companies in the tech industry. These segments are described as “outlier banks”.  Outlier banks, in particular, lend to early-stage and late-growth stage enterprises that have already obtained venture capital investment.

The lending decisions made by the outlier banks are based on the probability that the VC-backed companies will secure subsequent rounds of equity money from investors. This type of financing, known as venture debt, is a hybrid equity-and-debt financing structure that allows businesses to borrow money in the form of a loan while also offering warrants for equity in the company in addition to the loan interest. This arrangement offers the loan issuer with a considerable upside as an incentive to lend to an otherwise risky enterprise.

Conclusion

Although established valuation methods for IP exists in Nigeria, it has, however, not gained mainstream acceptance, and valuation is still mostly seen within the context of tangible property. Nigerian banks must understand that there is a significant difference in the approach to lending to SMEs and start-ups when compared to larger corporates with a strong trading history. A solution is required to fund the commercialization of innovative ideas using the value of the intellectual property asset as collateral. There is a clear need to increase market actors’ confidence and certainty in IP valuation methods in order to stimulate IP transactions, support IP-based financing, and provide companies with tools to provide information about their intellectual property. 

There is a need to develop new financial market segments dedicated to the valuation, exchange, and financing of IPRs and other intangibles, by establishing the necessary pre-conditions and infrastructures for such markets to operate efficiently and effectively on a global scale. 

Contributor
Mosun Oke
Mosun Oke

A Managing Partner with Tope Adebayo LLP, Mosun is a consummate Attorney with wide experience in Corporate/Commercial, Intellectual Property and Competition/Anti-trust law practice.

📧: m.oke@topeadebayollp.com
📱: +234 706 365 4055

 

Tope Adebayo LLP

Tope Adebayo LLP

Author

Tope Adebayo LLP is a Nigerian Law Firm with its head office in Lagos State, registered as a Limited Liability Partnership under the Partnership Law to carry on the business of legal practice within Nigeria.

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