Intellectual property venture banking is becoming an attractive financing vehicle to leverage SME’s intellectual property. To help us better understand this vehicle and its potential, I exchanged with Professor Xuan-Thao Nguyen and PhD candidate Eric Hill. Xuan and Eric will be publishing a series of papers on Intellectual Property Venture Banking with different journals, including University of California Irvine Law Review…. stay tuned!
Professor Xuan-Thao Nguyen is the Gerald L. Bepko Chair in Law & Director of the Center for Intellectual Property & Innovation at the Indiana University Robert H. McKinney School of Law and Erik Hill, PhD candidate in Economics at Southern Methodist University.
KH – What is IP Venture Banking?
XTN/EH: IP venture banking targets start-up companies that have already received venture financing (Series A venture funding). These companies are looking for funding to boost their growth. IP is their most important asset.
Lenders (or commercial banks) enters this portrait after the first venture capital (VC) financing round and are open to lending on the basis of the company’s intellectual capital and on the likelihood that the company will receive Series B venture funding. The bank is counting on the company’s success. To leverage the SME’s intellectual property as the key driver of the enterprise value, the banks require warrants as part of the loan pricing. The loan is typically made for a three-year period with interest, fees and a security interest in the IP.
KH - Can this method of financing help SMEs propel their innovation?
XTN/EH: Yes. Growth companies have a high cash burn rate. Whenever they get venture capital (VC), they give up equity. They see banks as a less expensive way of receiving capital to extend their ability to grow while they are burning cash. They are developing new products and new ideas – so cash is a must. A bank loan can certainly help with that development.
The bank would come in after the VC’s injection and extend the time the company has to develop its product before the next round of VC injection. This way, the company is more likely to fulfill its benchmarks and, if it has extra time, it can develop further benchmarks. This will allow it to arrive to the next round of financing and give up less equity in the company or receive more funding from the next round of VC. Bottom line: the financing is both good for the company and for the bank which supports the company.
As noted earlier, the bank typically gets less than 0.5% in the enterprise value through equity warrants and holds on to it until the company announces an IPO. The warrants can turn into an attractive source of future revenue for the bank.
KH – Given your experience, can you describe some of the IP-debt financing programs available in Asian countries? Can these be replicated in the North-American context?
XTN/EH: There are many ongoing projects in China. In 2008, the government launched initiatives embracing IP financing, both at the national and provincial levels. The Regulations for Patent Pledge Registration were promulgated in 2010. China believes that innovation and IP assets will be very valuable for the country. The Chinese government encourages innovation.
The IP growth is exponential: China leads the world in both patent grants and trademark registrations. In the first half of 2017, the State Intellectual Property Office of the People's Republic of China (SIPO) reported 31.8 billion Yuan (approx. 5 billion USD) loans with patents used as collateral.
One of the largest loans ever based in IP was granted by China Development Bank in 2014. The Bank lent 1.3 billion USD to Tralin Paper, manufacturer and supplier of unbleached paper products. The pledge recorded at SIPO included 110 patents and 34 registered trademarks. Tralin is an established company with large annual sales from its paper products and its IP technology (approx. 82 billion Yuan, ie. over 12 billion USD).
In China, banks in the IP venture space are growing in parallel with banks or lenders which provide substantial loans to established companies with large IP portfolios.
We are currently working on an article which will focus on IP financing in China. Very exciting!
KH: - What can assist financiers and lenders in leveraging the value of their clients’ intellectual property?
XTN/EH: We can see two streams to leverage IP value. In the first one, IP generates cash flow and the focus lies on the cash receivables to value how much to lend against. This a conventional stream. In the second one ie. venture lending, there is no cash flow or receivables and there is cash burn. The lending strategy will depend on whether the company can make it to the next round of VC funding. In this scenario, while the enterprise is riding on the IP because it is the most valuable asset of the company (as opposed to cash flow), the bank does not conduct an IP valuation. An IP valuation at this stage is both impractical, given the absence of a licensing stream from IP and comparable data, and costly. However, the bank relies on the VC’s valuation of a successful enterprise. IP without the enterprise is much less valuable than the realization of IP through a successful enterprise.
When the VC conducts an enterprise valuation and we note that such valuation increases between a series A and a series B round, as well as between a series B and series C round, the bank gets comfort that it can extract value from the enterprise’s IP.