Intellectual property, finance and economic development
By John P Ogier, Intellectual Property Economist and Lead of the Finance, Business and Economics Sector Workgroup of the Intellectual Property Awareness Network (IPAN), London, UK, of which he is also Vice Chair
Intellectual Property (IP) is now the most valuable asset class on the planet and yet establishing IP value and exploiting the economic potential of IP assets remain much of a mystery to businesses, financiers and investors.
The UK-based Intellectual Property Awareness Network (IPAN) is working to help get IP understood as a key asset class for business growth and economic development.
Only by developing and adapting market mechanisms and risk-return methodologies for IP assets and other intangibles and then applying them, will it be possible to offer IP-rich companies the financial support they need to expand their businesses and thereby improve economic growth. But progress in this area must involve financial markets, professional bodies, government policies and international trading standards.
IP value in knowledge-based economies
In knowledge-based economies, economic value is captured through the IP system, and the rights it confers which transform intangibles into tradable economic assets.
Up to the 1980’s, tangible assets accounted for 80 percent of company value; the rest was made up by intangibles, including IP. Thirty years later, the reverse is true with 80 percent of company value made up of intangibles.
The relative value of intangibles combined with digital trading is evident from the fact that Alibaba, the world’s largest retailer, owns no stores; Uber, the world’s largest “taxi business”, owns no taxis; and iTunes only supplies digital recordings of music.
Research published in 2012 by the United States Patent and Trademark Office notes that “the entire US economy relies on some form of IP, because virtually every industry either produces or uses it.” In 2010, IP-intensive industries accounted for USD5.06 trillion in value added, representing 34.6 percent of US GDP and directly supporting 27.1 million jobs.
Similar results were found in the UK where, according to a report by the UK IP Office, in 2011 the UK market sector invested some GBP137.5 billion in intangible assets and IP rights, with just GBP89.8 billion invested in tangibles. The gap in investments in tangibles and intangibles continues to widen.
The report indicates that just under half (48 percent) of knowledge-based investment - worth around GBP65.6 billion - is protected by IP rights. Copyright represents 46 percent of the total, trademarks and designs, 21 percent respectively, patents 9 per cent with registered designs making up the balance at 3 percent. The true value of UK IP-related investment, however, is likely to be higher as the study does not include the value of trade secrets nor does it fully account for “combination assets” like brands.
The gap in IP finance and funding
Despite broad recognition of the economic value of IP and its contribution to economic growth, many start-ups face difficulties accessing affordable funds to expand their businesses. Many micro, tech/creative start-ups and small and medium-sized enterprises (SMEs) are IP rich and the life blood of a growing economy. However, in the aftermath of the economic crisis, these businesses continue to face a squeeze on capital, especially when seeking to finance the development of intangible assets.
Equity investors, from early stage funding to management buyout, see intellectual assets as a critical factor when evaluating prospective deals. But businesses, especially SMEs, generally rely on bank lending or asset finance to raise capital. Such financiers remain strongly focused on traditional assets (real estate, equipment, inventories or receivables). Knowledge-intensive businesses, which have the greatest need of finance for growth, therefore often struggle to obtain funds because their intangible assets do not appear on the balance sheet and are therefore not considered by commercial banks as collateral.
With the application of reforms by the Basel Committee on Banking Supervision, banks are seeking additional security, even when government-backed schemes, such as the UK Enterprise Finance Guarantee scheme are available.
Without new solutions, it will be even harder for innovative companies, including creative digital enterprises, to obtain capital. These are precisely the types of high-growth enterprises that need to be financed to enable economic recovery.
The funding challenge
IPAN flagged the funding gap facing IP-rich SMEs in 2012. Responding to these concerns, in 2013 the UK IP Office published a report on the role of IP and intangible assets in facilitating business finance. The report reaffirmed that mainstream lending practices rarely recognize IP or intangibles as collateral. Balance sheets do not represent the value of these assets, and current regulations actively work against recognition of IP and intangibles as an asset class.
IP-backed financing offers significant benefits as follows:
- Potential for value appreciation – the IP assets of a well-run business increase in value over time, whereas the value of most tangible assets depreciates.
- A wider pool of assets – lenders often face situations where “good” customers want to borrow more than established asset lending ratios allow. The value that core intangible assets represent provides a means to lend more with additional security.
- Stronger repayment incentives – where intangibles are core to business activity, they provide a powerful incentive for borrowers to honor repayment commitments.
- Improved security –defining intellectual assets as part of a lending agreement puts a bank in a stronger position with an administrator in the event of financial difficulties.
- Alternative to personal guarantees – IP and intangibles provide an additional source of security that is directly related to a company and not an individual, thereby making it easier to recover funds if necessary.
Overcoming the limitations and difficulties associated with current practice with regard to IP-backed financing does, however, present some challenges. These include:
- Visibility of IP assets: the significant investments in internally generated IP rarely appear on company balance sheets. Company directors need to understand and explain the value of their intangible assets in a language lenders understand and thereby provide a more representative picture of company resources and value.
- Value attribution: unquoted companies have no access to a market mechanism to measure the off-balance sheet value of their business. Whereas many tangible assets have a realizable disposal value, even if at a fraction of the original cost, the market for the resale of IP and intangible assets is underdeveloped and offers less certainty about the ability to realize any resale value.
- Understanding value/managing risks: the value of some intangible assets, such as brands, can change rapidly in line with company fortunes. Training and the adoption of recognized standards for intangible asset value management will give lenders greater confidence in managing the risk profiles associated with these assets.
IP and capital allocation
Notwithstanding the importance of intangible assets and their huge economic potential, a combination of factors - commercial trading practices, lending and risk criteria, accounting standards and financial regulations - means their true and fair value are not reflected in market mechanisms for allocating capital.
Current mechanisms for allocating capital were designed for the 20th century economy which was underpinned by the production of physical goods and services. The markets, regulations and investment return mechanisms for the intangible, technology-based assets of the 21st century are yet to fully materialize.
Greater transparency, as well as valuation methodologies and market mechanisms that are more attuned to the digital economy and that accurately measure and represent the risk and returns associated with intangibles are essential. Without them, innovative companies will continue to face restricted access to capital or will continue to pay a high price for it in terms of equity, security and interest.
Harnessing the growth potential of IP-rich businesses
If the market for intangibles does not evolve, large quantities of capital will remain tied-up in low or negative yielding assets. In Europe, for example, government bonds worth between USD1.7 and USD5.3 trillion are yielding negative equity. The reallocation of just a fraction of this capital to finance IP-rich business could provide the much needed stimulus for global growth and employment. For this to happen, various steps are needed, including:
- Company IP audits to provide a clear picture of the role IP plays in their business;
- Professionally accredited standards for IP valuation and risk management;
- Common platforms to advise and support banks and other investors in IP asset evaluation;
- Greater understanding of IP licensing as a means of enabling small businesses to grow rapidly and internationally without large-scale infrastructure investment;
- Active engagement of financial services industries in financing, insuring and structuring intangibles as an asset class;
- More accessible and effective IP marketplaces;
- Better access to IP training, including for the financial services sector;
- International standards for registering IP-related information of relevance to financial transactions.
The evolving financial IP environment
The financial services sector is starting to wake up to the economic importance of IP and intangible assets but there is still some way to go. A seminar hosted by the Institute of Chartered Accountants, England and Wales (ICAEW) in February 2015 highlighted the increasing importance of IP in mergers and acquisitions in the global market. In November 2015, the Creative Industries Federation and ICAEW released their Creative industries – Routes to Finance guide. At the same time, a GBP40 million Edge Creative Enterprise Fund, backed by the British Business Investment Bank and the private sector, was launched.
Valuation methodologies for IP assets, including new regulation standards, are coming on stream but a standard methodology endorsed by accredited accounting bodies to assess the “true and fair value” of these assets is still needed. Brokerage services and marketplaces to facilitate sale and purchase of intangibles are also multiplying.
The commercial finance sector is also slowly responding to the needs of knowledge-based companies. More specialist lenders are now entering into sale and license-back agreements secured against IP assets, including trademarks and copyright-protected software. The first transactions leveraging brand assets to address pension fund deficits have been completed with large organizations including Philips, GKN, Costain, Diageo, AA and TUI adopting creative structures that leverage IP and/or the income streams derived from it. Financiers taking equity positions are also electing to take a charge over software assets, protected by escrow arrangements.
The absence of international standards to provide greater clarity and certainty regarding charges or securitization of IP assets is putting a brake on investment and business loans that could otherwise be secured against these assets. Is there a role here for WIPO to facilitate the negotiation of such an international standard? IPAN thinks there is, because such information could readily be recorded by national IP offices along with other IP registration details.
A way to stimulate global growth?
The world is experiencing a crisis in economic growth that record low interest rates and quantitative easing have yet to resolve. Coupling the power and size of the financial services industries with the IP-protected intellectual capital of knowledge-based companies could be a part of the solution. A key factor in unlocking this potential is ensuring access to capital is eased for those economic units with the greatest growth potential, namely start-ups and SMEs.
All the key players from industry, financial services, professional bodies, educational establishments, governments and international organizations like WIPO will have to apply their respective skills and resources to realize this potential for economic growth and public good. That after all is why the IP environment was created in the first place.