The prominence of intangible
assets in economic growth and corporate valuation has never been greater. As
companies try to harness innovation and technological advances and create
product and service differentiation, these assets are playing a greater role in
corporate investment decisions. Economic performance is gained more by
out-thinking your competitor and less by out-producing him. As the United
States moves away from a manufacturing-based
economy and toward a technology- and innovation-driven one, the need for
extensive intangible asset investment is vital to economic growth and
sustainability.
Yet we are failing to tap into
the full potential of these assets, especially as a financing tool. Investment
in the creation of intangible assets in the U.S.
is more than $1 trillion annually.[1] The
total value of intangibles in the U.S.
when measured in 2005 dollars was estimated at $9.2 trillion.[2]
However, only a portion of that value shows up in company financial reports.[3]
Likewise, intangible assets rarely merit consideration in the financial system.
As a result, companies are missing valuable sources of capital that could be
used for business expansion and innovation.
Compared with traditional fixed
assets, intangible assets have been treated much differently by the capital
markets, which have historically limited their financing potential. The unique
nature of these assets—underscored by transferability difficulties and
valuation challenges—has limited borrowing capacity and driven up finance
costs. To overcome obstacles to investing in intangible assets, government
intervention will likely be needed to encourage capital markets to support and
invest in this asset class and consequently to free up its enormous potential.
Increasing investment will require tapping into the financial enhancement
possibilities inherent in any asset. Evidence is emerging that both the
government and the private sector recognize the significance of intangible
assets, but the means for leveraging their extraordinary value have been slow to
materialize.
That is not to say that
monetization of intangible assets is a completely new phenomenon. Intellectual
property (IP) has long been used as loan collateral. The first trade secrets
case in the United States
involved the debt on a bond secured in part by a secret chocolate-making
process in 1837.[4] In 1884, Ara Shipman
loaned Lewis Waterman $5,000 to start a pen-manufacturing business, secured by
Waterman’s patent.[5]
Today, the law firm of Buchalter
Nemer can begin a newsletter on the subject with the following
statement:
It
is common practice for lenders to extend credit to their customers that require
their customers to use their intellectual property (such as copyrighted
material, trademarks, or patents) as collateral.[6]
Intangibles traditionally have
played a significant yet largely unspoken role in financial activities. Market
analysts spend as much time in their reports considering intangibles, such as
managerial experience and technological know-how, as they do calculating
financial statistics. Investors have started to carefully measure company
metrics like corporate culture, stakeholder relationships, environmental
practices, and governance ratings when choosing where to place their money. In
recent years, innovative financial products like intellectual property
securitization have emerged to capture values never before realized from these
important assets.
These financial innovations are,
however, still insufficient to bring about robust capital support of
intangibles. Many intangible assets have no standardized financial tools to
capture their value. Furthermore, the value of most intangibles has never been
regularized; the lack of a universal valuation model for intangibles may serve
as a significant impediment to capital market usefulness. While progress has
been made, the promise of unlocking the hidden value of intangible assets has
yet to be fulfilled.[7]
To understand the significant impact of
intangible assets, we must know a little more about them: what constitutes an
intangible asset, what are the different types of assets, and how are
intangible assets considered in corporate financial statements.
There are numerous ways to define, categorize,
and classify assets, including intangible assets. According to Daum, assets are
everything owned economically by a company that has monetary value. Assets come
in the following four forms:
•
Current
assets, such as assets likely to be sold or consumed within one year
•
Fixed
assets, like plant equipment and properties that have a useful life of more
than one year
•
Investments,
such as a company’s stock and bond holdings
•
Intangible
assets, which includes everything that is not physical or investment but is of
value to the company … also called “intellectual capital.”
Lev notes that “[a]n intangible asset is a
claim to future benefits that does not have physical or financial (a stock or a
bond) embodiment.” He adds that intangible assets are “sources of
value generated by innovation, unique organizational designs, or human
resources practices. Intangibles often interact with tangible and financial
assets to create corporate value and economic growth.”
As Daum goes on to describe:
Intellectual capital comprises human
capital, structural capital, partnership capital and customer capital. … In
addition a company’s culture and strategic capabilities count as intellectual
capital or intangible assets.[12]
Others have differing categories.
For example, Contractor divides corporate knowledge into the following subsets:
•
Intellectual property: patents, brands,
copyrights (registered)
•
Intellectual assets: drawings, blueprints,
written trade secrets, databases, formulae, recipes (unregistered but codified)
•
Intellectual capital: collective corporate
knowledge, individual employee skills
•
Knowledge, “know-how,” organizational culture,
customer satisfaction (uncodified human and organizational capital).[13]
A slightly different version of
this comes from Zambon, et al.[14] Like
the other studies cited here, this framework defines intangible assets as
“non-physical sources of expected benefits,” with the following three
subcategories:
- Intellectual Property—Intangible assets with legal or
contractual rights, including patents, trademarks, designs, licenses,
copyrights, film rights, and mastheads.
- Separately Identifiable Intangible Assets—Information
systems, networks, administrative structures and processes, market and
technical knowledge, human capital (if embodied in a codified form),
brands, intangibles embodied in capital equipment, trade secrets,
internally generated software, and drawings.
- Goodwill (Non-separable Intangible Assets)—Prior
intangible investments embodied in organizations, management expertise,
geographical position, or monopoly market niche.
Because there are so many different kinds of
intangibles assets perhaps the best way to fully recognize all of them is to
make an extensive list (Appendix A).[15]
The Financial Accounting Standards Board (FASB) classifies 29 intangibles into
five categories: marketing-related, customer-related, artistic-related,
contract-based, and technology-based. This list details assets such as package
design, customer lists, and trade secrets. Additionally, the American Institute
of Certified Public Accountants (AICPA) lists at least 90 different
intangibles, ranging from chemical formulas to retail shelf space.[17]
Since the industrial revolution—an era dominated by the
supremacy of manufacturing economies—wealth has been measured in terms of
control of scarce resources, productivity, and market domination or market
share. However, American industry has evolved into an environment defined by
technology, innovation, creativity, and service. The metrics of the 21st
century economy must now accurately represent the wealth creation arising from
knowledge-based activities across all sectors.
Manufacturing has long been supported by
economies of scale, but size advantages do not necessarily drive success in
innovation-based economies. Large centralized organizations can end up limiting
productive operations and growth in the global economy. Today’s rapid advances
in science and technology can incubate and flourish in coordinated or
integrated—and relatively smaller and more flexible—enterprises. Flexible
operations spring up where resources such as talented labor pools exist or
where valuable technological partners reside. The intangibles of know-how or
innovation-based relationships thus drive operational decisions under this new
paradigm of competitive advantages in the market. Consequently, popular
phrases, such as “information revolution” or “knowledge-based economy,” have
sprung up to describe these modern economies.
These changes have transformed industries from
centralized behemoths to widely dispersed operations that tend to operate well
below the gaze of Wall Street. Overall economic growth and market value
creation is being driven by the little enterprises that can more easily adapt
to rapid changes in this new economy. The new economy is and will continue to
be intangible-focused to harness the advantages of technological productivity,
high-skilled labor, and cutting-edge creativity. In this new economy,
knowledge-based and intangible resources represent the true source of sustained
competitive advantage.
According to Daum:
Knowledge as a new factor of
production will help a society or [a] nation as well as its organizations to
handle new challenges and ever-changing conditions and to master innovation,
which is the success factor in the new economy—not only for companies but also
for nations.[19]
But the standard notion of “knowledge” is not
sufficient to explain the shift. As Daum goes on to remark:
Economic power will not simply flow
to those nations who educate their people, who are the most wired, or who
invest most of their GDP [gross domestic product] in R&D [research and development]. It will
flow to those who, in addition, are the most creative in bringing together
business, government, capital, information, consumers, and talent in networked
coalitions that create value.
Most companies are composed of
significant amounts of intangible assets in their net worth. But does senior
management recognize them and effectively and consequently include them in
performance measures and corporate strategy? Yes and no.
In a 2003 Accenture survey of
senior managers across industries, 49 percent of respondents said that
intangible assets are their primary focus for delivering long-term shareholder
value. Yet only 5 percent stated
that they had an organized system to track the performance of these assets. A
full one-third of the respondents said they had no system to measure
performance whatsoever. When asked to measure the importance of managing
intangible assets for long-term value, half of the respondents listed the issue
in their top-three most important considerations. A noteworthy 50 percent of
the survey respondents seemed to believe that the equity markets recognized and
eventually rewarded companies that invest in intangibles.
Numerous models have shown the
connection between intangible assets and ultimate financial outcomes. These
models allow managers to understand the key value drivers of their specific
industry and how those value drivers can be enhanced. Such models include The
Balanced Scorecard,[22] the
Danish Intellectual Capital Statement,[23] the
Skandia Intellectual Capital Navigator,[24]
Intellectual Assets Monitor,[25] the
PriceWaterhouseCoopers (PwC) ValueReporting,[26] the
KPMG Value Explorer,[27] and,
from the now defunct accounting firm of Arthur Andersen, Value Dynamics.[28]
For example, research by Low and
Kalafut found a strong correlation between the management of intangible assets
and the overall success of a firm.[29]
Using a complicated model they call the Value Creation Index (VCI),
Low and Kalafut were able to measure the performance of companies based on such
factors as the utilization rate of patents and R&D expenditures compared to
overall revenues. They also incorporated polls taken by independent researchers
that track intangible elements, such as company reputation and employee morale.
Overall, the index measured the following intangibles: leadership, strategy
execution, communication and transparency, brand equity, reputation, networks
and alliances, technology and processes, human capital, workplace organization
and culture, innovation, intellectual capital, and adaptability.
The VCI
scores ranked companies that seemed to do the best job of managing and using
their intangible assets. The model successfully correlated high VCI
scores with strong financial performance.[30] This
research supports the notion that intangible assets are vital to financial
performance in an organization and must be accounted for in strategic
decision-making and investment.
It has been said that money is
the lifeblood of business. More to the point, the ability to raise capital for
a new idea or a new enterprise is at the heart of our economic system.
Innovation requires a financing system and the U.S.
financial system and capital markets are the model of the world. Even with
challenges from other financial centers, the U.S.
capital markets remain the gold standard. Partly as a result, our innovation
system flourishes.
But having great capital markets
does not necessarily translate into a strong appetite for innovation. New
products and ventures are risky for investors. Proven performers are the belles
of the ball who garner all the attention of financiers while upstarts are left
scrambling to impress a small pool of skeptical suitors.
Financial concerns also can cause
companies to retrench to proven revenue winners at a time when long-term
financial growth may markedly depend on investments in the potential winners of
the future. Numerous reports have indicated that U.S.
investment in R&D activities—essential for discovering new innovations—has
slowed.[31]
Likewise, the recent subprime mortgage meltdown shows what happens when the
financing system breaks down and risk aversion across markets takes hold. When
credit becomes scarce, business investment, including in innovative activity,
slows down.
Keeping our innovation system
going may very well require the development of new sources of funding. Currently,
companies can raise money based on their physical and financial assets.
Physical and financial assets can be easily bought and sold, borrowed against,
and used to back other financial instruments. As such, these assets provide
companies with a source of the investment funding needed for the U.S.
economy to grow and prosper.
But, as this paper will
demonstrate, utilizing intangible assets for investment financing is much more
difficult. The more than $9 trillion in intangible assets mentioned earlier are
largely hidden away, unavailable for financing purposes. As such, there is a
huge opportunity cost imposed on the U.S.
economy when such a large source of potential financing is locked up. Since
intangibles assets are not generally available to serve as a source of
investment and risk capital, innovative companies may face a higher cost of
capital—or even a
dearth of capital—to
fund new ideas. Unable to use their intangible assets as a financial tool,
perspective borrowers face a system that does not understand their true revenue
potential and is unable to judge operational risks appropriately. Existing
ideas, in the form of patents and other intellectual property, sit unused. New
ideas never gain traction or remain unexplored or undeveloped. Economic potential
goes untapped—and therefore wasted.
The illiquidity of those assets
raises the cost of capital for all borrowers, not just those seeking to fund
innovation. Unlocking the financial potential of intangible assets will provide
a new mechanism for fueling future economic growth. Increased asset utilization
in financial markets will allow for greater investment opportunities.
The U.S.
financial system has always been adaptive to change. Lamoreaux and Sokoloff
point out that “perhaps the most striking aspect of the record of innovation
over American economic history is the flexibility that technologically creative
entrepreneurs have exhibited in adjusting their business and career plans so as
to obtain financing for, and extract the returns from, their projects.”[32]
The monetization of intangible
assets is just one more step in the evolution of financing innovative
activities. Just as physical assets were used to finance the creation of more
physical assets during the industrial age, intangible assets should be used to
finance the creation of more intangible assets in the information age.
To foster trust in the financial
sector and guarantee the accurate functioning of the capital markets, government
laws must promote clear asset recognition, corporate transparency, and the
protection of security rights. Intangible assets, like any other asset class,
are subject to banking and securities laws and regulations. Likewise,
commercial transactions involving intangible assets are subject to normal
commercial contract and tort law.
There are, however, a number of
intangible-specific rules. From accounting standards to tax codes, many market
rules have been revised and amended in recent years to maximize the use and
development of intangible assets. For example, the commercial code has expanded
the asset categories used as loan collateral to foster access to capital for
investment in intangible assets. Accounting standards have undergone a series
of revisions in an attempt to achieve transparency and to reflect the real
value of intangible assets. The following section presents the most relevant U.S.
laws and regulations governing the use and consideration of intangible assets.
Private investors and other consumers of
financial products rely heavily on transparent, accurate, and credible
financial information that can be compared across industries to facilitate
participation in the capital markets. It is therefore not surprising that
accounting standards are central to the issue of monetization of intangible
assets. Government regulators, academics, and professional leaders have
identified an accountability deficiency in current accounting practices that
leads to a potential misuse of reporting methods and distorts the equilibrium
and credibility of capital markets.
U.S. Accounting Standards
The mission of the Financial Accounting
Standards Board (FASB)—an independent organization funded entirely by the
private sector—is to set accounting and reporting standards to protect the
consumers of financial information, namely investors and creditors.[33] FASB issues U.S. accounting standards, which are
known as Generally Accepted Accounting Principles (GAAP). In July 2001, FASB
issued Statements of Financial Accounting Standards (SFAS) 141 and 142, which addressed business
combinations and intangible asset accounting issues.[34]
These measures primarily changed the accounting process for “goodwill,” a
standard catch-all category for intangibles on financial statements.
SFAS 141 eliminated “pooling-of-interests”
accounting whereupon an organization simply merged the financial statements of
an acquired firm with its own without a separate accounting of the intangible
components of the transferred goodwill. Organizations must now separate out
certain intangibles and account for goodwill through purchase accounting, which
incorporates into the financial statements the actual purchase price paid by
the acquirer. Consequently, some intangible assets missed in the past are being
captured by the implicit market value of the entire enterprise covering all
assets—tangible and intangible.
SFAS 142 dictates accounting for the true value
of intangibles in an organization. Organizations must annually attempt to
calculate the current market value of their intangibles and integrate any value
impairment or enhancement into the balance sheet. This significant regulation
demands that a firm have comprehensive understanding of its own intangible
assets and encourages internal corporate systems for accurately tracking and
valuing them.
However, SFAS 141 and 142 only
apply to assets acquired during a business combination; assets developed in
house are specifically not covered. This severely limits the inclusion of
intangibles assets on the balance sheets since Regulation G restricts the use
of non-GAAP financial measures for accounting purposes.[35]
(For more on accounting standards, see our companion working paper, Reporting Intangibles.)[36]
This quirk of the accounting standards has a
special implication for intangible assets that may be split out from the
company during a securitization process (to be discussed later). While the cost
of an internally generated intangible is not recognized—and therefore expensed,
not capitalized—once that asset is transferred it is subject to SFAS 141. As
Anderoli and Dembitz explain:
The licensed
intangible will automatically be a long-lived intangible rather than goodwill.
SFAS 141 provides that intangible assets will be recognized (and valued)
separately from goodwill only if they (1) stem from contractual or legal
rights, or (2) can be sold or transferred. Since the intangible asset is
licensed to an affiliate, it automatically has a value separate from goodwill.
If the asset has a finite useful life, it must be amortized for financial
reporting purposes.[37]
SEC Disclosure Requirements
Two areas of securities laws and regulations
also impact the disclosure of intangible assets. The first is the Securities
and Exchange Commission’s (SEC) regulations on disclosure of nonfinancial
information. As part of these rules, companies are required to disclose
information that is considered “material” to the financial situation of the
company in the management discussion and analysis (MD&A) section of the
financial statements.[38] In the past, such
disclosures were generally vague and considered boilerplate.[39]
Under current rules, the SEC has set down
guidance that:
[W]hen preparing the
MD&A, companies should consider whether disclosure of all key variables and
other factors that management uses to manage the business would be material to
investors and therefore required. These key variables and other factors may be
nonfinancial, and companies should consider whether that nonfinancial
information should be disclosed.[40]
For the most part, the specific
types of information that the SEC suggests
be disclosed are more along the lines of performance measures than intangible
assets. However, intangibles do fit under the SEC
guidance.
The second major area of
disclosure is dictated by the Sarbanes–Oxley Act of 2002 (P.L. 107–204).
Sarbanes–Oxley requires corporate management to disclose all factors relevant
to the financial condition of the enterprise in the financial statements and
company risk strategy portions of their disclosures.[41]
According to Banham, the major
sections of the Sarbanes–Oxley Act, which require certification of financial
statements and of internal financial reporting procedures, will force companies
to better identify and manage intangible assets.[42]
However, these sections apply to all assets, not just intangible assets. These
requirements may help companies focus on intangibles, but only recently has
compliance with Sarbanes–Oxley begun to influence how companies track
intangibles.[43] For example, the
Intellectual Property Management group of the risk consulting company Kroll now
conducts audits of intangible assets to ensure compliance with the
Sarbanes–Oxley requirements for adequate controls, policies, and procedures.[44]
Intangible assets are also
covered under IASB’s regulations. In 1998, IASB issued International Accounting
Statement (IAS) 38,[45] which in part continued research
cost guidelines that had been evolving since 1978 (originally called IAS 9).
But IAS 38 went well beyond the issues covered in IAS 9. The objective
of IAS 38 is to stipulate the accounting treatment for intangible assets not
dealt with specifically by another standard.
Under IAS 38 an asset is a
resource controlled by the enterprise as a result of past events (i.e., it was
created in house or acquired) and from which future economic benefit (cash flow
or other financial assets) are expected. Thus, the three critical attributes of an intangible asset are as follows: identifiably (it can be
disaggregated and sold separately); control (there is power to obtain benefits
from the asset); and future benefits (there is substantial evidence of
the intangible’s value). If an intangible item does not meet both the
definition of and the criteria for recognition as an intangible asset, IAS 38
requires the expenditure on this item to be recognized as an expense.
Some examples of possible
intangible assets include computer software, patents, copyrights, motion
picture films, customer lists, etc. These assets can be acquired through
separate purchases, as part of a business combination, or through a government
grant, an asset exchange, or an internal generation (self-creation). However,
certain intangibles—brands, mastheads, publishing titles, and customer
lists—are explicitly prohibited from being recognized as an asset if they were
internally generated. Internally generated assets that come from research
activities cannot be recognized. Likewise, limits are placed on assets
internally generated from (nonresearch) development activities.
In addition to financial
accounting standards, tax law and regulation play a major role in determining
how companies treat intangibles. The tax code comes into play in two ways: how
expenditures on the creation and maintenance of intangibles are treated
(specifically whether and how much of those expenditures are deductible); and
how the tax code treats income from intangibles.
The differences between financial
(book) accounting and tax accounting are numerous and well known.[46] The
same distinctions apply to the treatment of intangibles.[47] For
tax purposes, even the definition of intangibles as classes of business
expenses is slightly different from financial accounting rules. According to
the Internal Revenue Service (IRS):
Intangible
Property is property that has value but cannot be seen or touched. It includes
items such as:
1. Goodwill.
2. Going
concern value.
3. Workforce
in place.
4. Business
books and records, operating systems, or any other information base, including
lists or other information concerning current or prospective customers.
5. A
patent, copyright, formula, process, design, pattern, know-how, format, or
similar item.
6. A
customer-based intangible.
7. A
supplier-based intangible.
8. Any
item similar to items 3–7.
9. A
license, permit, or other right granted by a governmental unit or agency
(including issuances and renewals).
10. A
covenant not to compete entered into in connection with the acquisition of an
interest in a trade or business.
11. Any
franchise, trademark, or trade name.
12. A
contract for the use of, or a term interest in, any item in this list.[48]
Importantly, a financial interest
in a patent is not considered an intangible, nor is most computer software.[49]
Therefore, any financial instrument using an intangible as security is not
capitalized while the underlying asset is capitalized (similar to the way
financial instruments are secured by physical assets).
Which intangible assets may be
capitalized and which are deductible is the subject of numerous IRS
regulations. For example, in December 2003, the IRS
issued updated regulations on the capitalization of intangible assets.[50]
These regulations were designed to clear up uncertainty caused by the 1992 U.S.
Supreme Court decision in INDOPCO, Inc.
v. Commissioner (503 U.S. 79), which held that payments that created a
“significant future benefit” must be capitalized rather than expensed. The
heart of the case was whether transaction costs, such as investment banking
fees, can be capitalized, but the ruling created confusion about how to treat
numerous other transaction costs.
The new regulations require that
most costs to acquire or enhance an intangible asset be capitalized.[51] As
Feinschreiber and Kent explain, “this transaction cost rule recognizes that the
taxpayer is obligated to capitalize the following amounts: the cost of the
asset itself, and the ancillary expenditures for the acquiring, creating, or
enhancing the intangible asset.”
The ability to depreciate
purchased intangible assets can result in major tax savings in some
acquisitions, such as Johnson & Johnson’s purchase of Pfizer’s consumer
health care division and the brands of Benadryl, Neosporin, and Visine.[53]
However, other regulations apply
to other types of intangible assets, such as research and development costs,
which are fully deductible. As the Congressional Budget Office noted, companies
have options when dealing with the deductibility of research expenses:
The IRS
allows firms to deduct R&D expenditures in the year in which they are made;
amortize them over at least 60 months, once the work begins to benefit the
firm; or write them off over a 10-year period.[54]
Looking at it this way, the cost
of obtaining or defending a patent is capitalized while the cost of the
research that leads to the patent is deductible.
As a recent Treasury Department
report pointed out, expensing intangibles and depreciating physical assets
results in the following situation:
Income from investment in intangible assets (e.g.,
R&D and advertising) generally receives more favorable tax treatment than
does income from investment in tangible assets (e.g., plant and machinery).
Investment in intangibles might be excessively encouraged by the tax system,
relative to investment in tangible assets.[55]
However, there is no evidence that the U.S.
is systematically over-investing in intangibles and under-investing in tangible
assets. Thus, it is unclear to what extent the difference in the tax treatment
between expensing and depreciation influences the investment in intangibles
versus tangibles.
Beyond the issue of expensing and
depreciation, other tax incentives apply to the creation of certain
intangibles. A well-known example is the research and experimentation tax
credit (commonly recognized as the R&D tax credit). The standard credit is
20 percent of qualified research expenditures above a certain base. But there
are variations and options, including an alternative incremental tax credit, an
alternative simplified credit, a basic research credit for sponsored university
research, and an energy research credit.[56]
Likewise, there are numerous incentives for investing in human
capital. A recent Treasury Department report said:
These include the tax exclusion of scholarships,
fellowships, and the value of reduced tuition; education tax credits; deduction
of student loan interest; tax advantaged education saving accounts;
deductibility and exclusion of employer- provided education expenses;
deductibility of tuition; and allowing students beyond the normal age cut-off
to qualify as eligible children when computing their parents’ earned income tax
credit and their parents’ dependent deduction.[57]
Most of these incentives,
however, deal with individuals seeking more education and not with incentives
to organizations to improve the skills and knowledge of their workforce (human
capital). The overall benefit of the deductibility of employer-provided
educational expenses and the business deduction for work-related education is
limited.[58]
The tax treatment of deductions
is important. But how income from intangibles is taxed is much more important
for public policy purposes. At issue is the determination of where the
ownership of those assets resides and is therefore taxed. Fisher puts it this
way:
Intellectual
property rights are often created in relatively high-tax jurisdictions. As a
result, tax departments in multinationals (and their advisers) frequently look
at ways of structuring operations in an attempt to reduce the overall tax burden,
usually involving a number of territories and the transfer of, or the creation
of an interest in, intellectual property.[59]
Various jurisdictions are
offering low tax rates on income from intangibles, specifically on royalties
from intellectual property. For example, Ireland
has long been seen as the location of choice for intellectual property because
of its exemption of patent income from corporate taxation.[60] More
recently, the Netherlands
has entered the race to become a tax haven for intangibles.[61] The
website LowTax.Net describes the situation this way: “The Netherlands
is an extremely attractive jurisdiction in which to locate a royalty conduit
company.”[62]
The Irish would surely dispute
that they are an IP tax shelter; they see their policy as a tax incentive to
locate R&D in Ireland.
As the law firm of A&L Goodbody pointed out in its briefing paper The Irish Patent Exemption:
The basic
requirements for the patent exemption have always been that the work which went
into developing and having a patent registered must have been carried out in Ireland,
other than work which is ancillary to the main work carried out in Ireland.[63]
Ironically, this requirement was
repealed in April 2007 after the European Commission complained that it
hampered the rights of establishment and free movement of services.[64] As
of January 2008, the requirement was broadened to require work be done in any
European Union (EU) nation and the exemption be capped at €5 million in
aggregate.
In any event, as Simpson points
out, there are ways to game the system:
A common device
is to take successful, patented American ideas and then develop new generations
of them—with help from an offshore research division. The ownership of the new
version (and profits on licensing it) can then legally be shared between the U.S.
parent company and the offshore unit.[65]
The question is how those profits
(and royalties) are shared and what price the parent company receives when it
transfers the intellectual property to its offshore subsidiary. The U.S.
tax code requires that—
prices charged
by one affiliate to another, in an intercompany transaction involving the
transfer of goods, services, or intangibles, yield results that are consistent
with the results that would have been realized if uncontrolled taxpayers had
engaged in the same transaction under the same circumstances.[66]
The efficacy of the requirement
for arms-length pricing is the subject of debate, especially given the
complexity of these cost-sharing arrangements. Cole argues that “the code now
requires that a U.S.
taxpayer take into account the full value of U.S.
intangible property transferred overseas, whether in exchange for stock or
cash, taking into account the income derived from the transferred intangible
after the transfer.”[67]
However, Sullivan said that “determining fair terms for interaffiliate
transactions involving intangible assets involves a great deal of subjective
judgment, so those determinations are a constant source of conflict between
drug companies and the IRS.”[68]
The IRS
adopted new regulations on this issue effective January 1, 2007,[69] but
concerns remain. In statements to both the Senate Finance Committee and the
Senate Permanent Subcommittee on Investigations in 2006, then IRS
Commissioner Mark Everson called this “a high-risk compliance concern”:
Taxpayers,
especially in the high technology and pharmaceutical industries, are shifting
profits offshore through a variety of arrangements that result in the transfer
of valuable intangibles to related foreign entities for inadequate
consideration.[70]
On April 5, 2007, an IRS-issued
“Industry Director Directive” stated the following:
Cost Sharing has
been identified as a Tier I issue and is one of the most significant compliance
challenges facing LMSB [the Large to Mid-Size Business Division of the IRS].
Cost Sharing Arrangements (CSAs) are often used by taxpayers
inappropriately to transfer intangible assets and associated profits offshore
to related foreign affiliates for inadequate consideration. LMSB Compliance
estimates that inadequate consideration has resulted in material underreporting
of taxable income by U.S. Corporations.[71]
On the other hand, Hardgrove and
Voloshko argue that the concern is overblown and that “properly done it [a
global IP strategy] can save tax without abusive or underhanded methods.”[72]
Within the U.S.,
there is a similar concern. Many states exempt intangible property from state
and local property taxes. Most of these exemptions are for financial
intangibles (stocks, bonds, and other securities) rather than intellectual
property (patents and copyrights). But intellectual property is often covered
as well. For example, Montana defines intangible property as that which “has no
intrinsic value but is the representative or evidence of value, including, but not
limited to, certificates of stock, bonds, promissory notes, licenses,
copyrights, patents, trademarks, contracts, software, and franchises.”[73] In Kentucky,
intangible property is exempt, but “research libraries” are considered tangible
property subject to fair-market-value tax.[74]
Nevada and Delaware
are seen as tax-haven states for intangible income. Nevada
has no corporate income tax and Delaware
does not tax income on intangibles. Taxes are reduced by setting up an
“intangibles holding company”—also known as a Delaware Holding Company or a
Passive Investment Company—which owns the intangible assets. The income from
the intangible assets is considered received in Delaware
or Nevada and is therefore not
taxed.[75]
This strategy is often used by retail companies and
franchises. As Stansky explains:
First, a national retailer creates an intangible
holding company in a state that does not tax royalty income, such as Delaware.
The retailer then assigns its trademarks to the holding company, which it owns.
The holding company licenses the trademarks to the retailer, which, in turn,
pays the holding company for the use of the marks.
In states where it may do so, the retailer taxes a
deduction on its corporate income tax returns for the royalty or licensing fees
paid to the holding company. That leads to less taxable income in those states.[76]
But as the Bureau of National Affairs reported, “States
have increasingly resisted a corporate tax planning strategy involving the
deduction of royalty payments for intangible property rights held by an
out-of-state subsidiary.”[77] The
key feature is the “substance” presence rule. As one holding company management
firm warned, “an intangible holding company must be prepared to satisfy [to]
other states as to its substance in Nevada
or Delaware.”[78]
This is the same issue that arose concerning the
application of state sales tax to Internet sales. In Quill Corp. v. North
Dakota, 504 U.S. 298 (1992),
the U.S. Supreme Court ruled that states could not tax an out-of-state catalog
company that lacked a physical presence in the state. However, state courts
have recently held that Quill does
not shield intangible holding companies from corporate income taxes on their
in-state earnings, arguing that the physical presence argument works both ways.
Since these companies have no business substance or business purpose in their
supposed home state of Delaware
or Nevada, they are therefore
subject to taxation where the income was earned.[79]
Recent cases in Oklahoma,[80] New
Jersey,[81] and West
Virginia[82] have
upheld this argument and found intangible holding companies liable for state
taxes. In addition, a number of states have laws on their books that
effectively nullify this tax strategy.[83]
The federal government also has afforded certain
intellectual property royalties special treatment, admittedly in a very minor
fashion. Last year, Congress changed the tax code to allow sales of song
collections to be taxed at the capital gains rate rather than as ordinary
income (see Sec. 204 of P. L. 109–222) and to allow songwriters to amortize
their expenses over five years (see Sec. 207 of P.L. 109–222). Both of these
changes were relatively noncontroversial because royalties on songs are paid
differently than on other copyrighted materials. Songwriters are paid royalties
every time the song plays and must pay taxes immediately; writers can spread
out their royalty payment and taxes over a number of years.[84]
There seems to be little interest in expanding this form of tax relief to
income from other intangibles.
Interestingly, the combination of
expensing and income give rise to an opportunity for tax arbitrage. The new
Irish law on the patent income exemption has lead to fears in that nation that
companies will move their R&D out of Ireland
to high-tax-rate countries.[85]
Companies could expense their R&D costs in a high-tax country to lower
their taxable profit, while claim the income from the royalties in a low-tax
country.
As stated previously, one type of
intangible asset is classified as intellectual property. These assets include
patents, copyrights, and trademarks, and are specifically protected as
exclusive property by law. Article I, Section 8 of the U.S. Constitution grants
Congress the power to—
promote the progress of science and useful
arts, by securing for limited times to authors and inventors the exclusive
right to their respective writings and discoveries.[86]
Sometimes trade secrets are
included as intellectual property since they can also be protected by law. In
addition, contract law can shield other types of intangibles, such as
noncompete covenants. But these assets are not considered IP.
Patents and copyrights long
predated the Constitution. Patents—the state grant of a monopoly—were known in
the ancient and medieval world. The word patent comes from the Latin litterae
patentes, meaning an open letter. Such letters were used by medieval
monarchs to confer rights and privileges.[87] But
these were royal favors and not meant for a specific invention; that happened
much later. The antecedent of U.S.
patent and copyright law is the British Statute of Monopolies of 1624 (patents)
and the English Statute of 1710 (copyrights).[88]
Patents are issued by the U.S.
Patent and Trademark Office (U.S. PTO). A patent is a government grant of a
monopoly right to an invention. A patent is described in law as “the right to
exclude others from making, using, offering for sale, or selling” the invention
in the United States
or importing the invention into this country. It is important to note that a
patent does not confer the right to manage the invention, but the right to
exclude others from managing it.[89] As
such, a patent right must be enforced through the courts by suing the alleged
infringer. Remedies in a patent infringement case include injunctions against
the infringing product, damages, and royalties.[90]
In exchange for this grant, the
patent applicant must disclose all relevant information to the public in the
form of the application. As such, patents fulfill the Constitutional mandate of
promoting “the progress of science and useful arts” in two ways. First, by
granting a limited monopoly, they create a financial incentive for the
development and commercialization of the invention. Second, by requiring
disclosure, they spread knowledge that might have otherwise been locked up as a
trade secret. While patents are not granted for inventions that are the same as
a previously patented invention, many patents build on the knowledge disclosed
in previous patents.
Patents are generally only enforceable
within a nation’s boundaries or at the border (in the case of imports). There
is, however, an anti-circumvention clause in the patent law that deals with
supplying components in the United States
for assembly abroad.[91] In
addition, the lack of sufficient intellectual property rights is considered an
actionable trade subsidy under international trade law. Countries may impose
trade sanctions, such as higher tariffs, on the goods and services coming from
another nation found to have lax intellectual property rights.[92]
Ironically, intellectual property rights (IPR)
have recently figured in a trade dispute in the reverse fashion: a nation was
granted the right to override IPR
protections as a sanction against the U.S.
for compensation for a trade violation (although the case involved copyrights
not patents).[93]
Two international treaties govern
cooperation among nations specifically on patent law: the Patent Cooperation
Treaty and the Paris Convention for the Protection of Industrial Property,
known as the Paris Convention.[94] The
Paris Convention covers a variety of “industrial property,” including patents,
industrial designs, trademarks, and trade names. The Patent Cooperation Treaty
is more process-oriented, dealing with “cooperation in the filing, searching,
and examination of applications for the protection of inventions, and for
rendering special technical services.”[95]
It should be made clear that the
subject of patents is currently in flux. Concerns have been raised that
excessive patenting and poor patent quality are harming the innovation process.[96]
Issues include the expansion of patents to business processes, the severity of
the remedies, the process of enforcement (“patent trolls”), the question of
whether an invention is “novel,” and other concerns. Patent law has been a
regular subject of recent Supreme Court cases and patent reform legislation is
pending in Congress. As of this date, the current patent system is in danger of
creating more confusion over the enforceability of patents,[97]
which could create additional risk for the monetization of intangibles.
Like a patent, a copyright is a
legal grant of a monopoly. A copyright conveys the sole right to publish or to
perform an original work. A copyright also prohibits derivative works without
the permission of the copyright holder. Copyright covers “(1) literary works;
(2) musical works, including any accompanying words; (3) dramatic works,
including any accompanying music; (4) pantomimes and choreographic works; (5)
pictorial, graphic, and sculptural works; (6) motion pictures and other
audiovisual works; (7) sound recordings; and (8) architectural works.”[98]
Unlike patents, the copyright is
not granted by a government agency after a review process. A copyright comes
into existence with the creation of the work “in fixed form.”[99] A
copyright may be registered with the U.S. Copyright Office in the Library of
Congress and a notice of copyright (usually the symbol ©) placed on a
copyrighted work. However, neither of these actions is required. The copyright
exists automatically.
Recently, alternative forms of
copyright have emerged. Two of the most widespread are the Creative
Commons and the free and open
source software licenses. Creative Commons was established to cope with growing
problems resulting from the automatic granting of copyright. Prior to the
Copyright Act of 1976, copyrighted works had to be registered and a notice of
copyright was required. Since the elimination of this registration requirement,
it has sometimes become problematic to find and secure permission to use a
copyrighted work. While the copyright law allows for “fair use” without the
copyright holder’s permission, the definition of what is covered under that
exception is somewhat unclear.[100]
Under the Creative Commons, an author
can register differing levels of rights. The system “defines the spectrum of
possibilities between full copyright—all rights reserved—and the public
domain—no rights reserved” (emphasis in original).[101] An
author can specify what level of rights they retain; they can waive all rights
to the work or waive only some rights in specific cases. For example, an author
may allow unlimited reproduction/republication of a work for noncommercial
purposes while prohibiting the creation of derivative commercial works without
permission.
Free and open source software
licenses cover a number of types of licenses that generally allow the sharing
of software without permission or the payment of royalties.[102]
Often known as a “copyleft,” the purpose of these licenses is to require that
the software continue to be freely shared. Developers of the GNU operating
system—pioneers of open source software—explain it this way:
The simplest way
to make a program free is to put it in the public domain, uncopyrighted. This
allows people to share the program and their improvements, if they are so
minded. But it also allows uncooperative people to convert the program into
proprietary software.
[C]opyleft says
that anyone who redistributes the software, with or without changes, must pass
along the freedom to further copy and change it.[103]
Copyrights have long lives, well
beyond those of patents. Current law states that copyrights remain for the life
of the author plus 70 years. After the copyright expires, the work becomes part
of the public domain.
As with patents, enforcement of
copyrights is generally through the courts. Remedies include seizure of the
infringing goods, damages, and criminal charges. Unlike patents, however, there
are some compulsory licenses required by the Copyright Act, including royalty
fees from cable operators and satellite carriers for certain retransmission and
from importers or manufacturers for distributing digital audio recording
products. The U.S. Copyright Office manages these fees.
Copyrights, again like patents,
are a matter of national law. However, international treaties, especially the
Berne Union for the Protection of Literary and Artistic Property (Berne
Convention) and the Universal Copyright Convention (UCC), govern the protection
of foreign copyright holders.[104]
The Lanham Act (Title 15, Chapter
22 of the U.S. Code) covers trademarks and service marks. According to the U.S.
PTO, a trademark is “a word, phrase, symbol, or design, or a combination of
words, phrases, symbols, or designs, that identifies and distinguishes the
source of the goods of one party from those of others.”[105]
Trademarks apply to goods; service marks apply to services. The term trademark,
however, is usually used to cover both trademarks and service marks. There are
also certification marks, collective trademarks, and defensive trademarks.[106]
Unlike patents and copyrights,
the rights conferred under a trademark are not absolute. The standard is not
simply unauthorized use but whether such use causes confusion, deception, or
misrepresentation. In addition, a mark must be used to be enforced. Nonuse can
result in the abandonment of the mark and the removal of the mark from U.S. PTO
registration. Likewise, a mark may at some point be deemed generic (and part of
the public domain) if it becomes commonplace, such as the term Aspirin.
Trademarks need not be registered
with the U.S. PTO, but such registration helps in enforcement actions.
Registration also assists in the search for, and the resolution of, any conflicting
marks. It also prevents the trademarking of common words or phrases that are
part of the public domain.[107]
International treaties that apply
to trademarks include the Paris Convention, the Inter-American Convention for
Trademarks and Commercial Protection (the Pan-American Convention), and the
Buenos Aires Convention for the Protection of Trade Marks and Commercial Names.
Trade secrets are another form of
intellectual property, although they are sometimes not included in the IP
category. As Quinn explains, “a trade secret is any valuable business
information that is not generally known and is subject to reasonable efforts to
preserve confidentiality.”[108]
Unlike patents, copyrights, and trademarks, trade secrets are protected by both
federal and state law—the 1996 Economic Espionage Act (EEA) at the federal
level and the Uniform Trade Secrets Act at the state level.
The EEA created a federal trade
secrets act to deal primarily with foreign economic espionage, but it was
rewritten to comply with international trade treaties to treat U.S.
citizens and foreign nationals the same.[109]
Unlike state laws, which are civil with private right of action, the EEA is a
criminal statute and the government must prosecute violations. While not as
common as state trade secret cases, the U.S. Justice Department has prosecuted
35 trade secret cases since 2000.[110]
The Uniform Trade Secrets Act,
which virtually all states have adopted, prescribes the remedies in cases of
misappropriation of trade secrets, which are defined as—
information,
including a formula, pattern, compilation, program device, method, technique,
or process, that: (i) derives independent economic value, actual or potential,
from no being generally known to, and not being readily ascertainable by proper
means by, other persons who can obtain economic value from its disclosure or
use, and (ii) is the subject of efforts that are reasonable under the
circumstances to maintain its secrecy.[111]
That last part of the definition
is important. Unlike patents or copyrights, the effort of maintaining secrecy
is critical to maintaining the right.
Nor does trade secret law grant
protection in all cases. The criterion for relief is misappropriation not
infringement. One law firm explains it this way:
Trade secrets
are not afforded the exclusivity provided by patent protection, since third
parties are at liberty to independently develop the subject matter of a trade
secret or to take a product and perform reverse engineering until the trade
secret is discovered.[112]
On the other hand, a trade secret
need not be actively used in the conduct of business. It just needs to be
information of a commercial value. It may be, for example, an alternative
production process that a company chose not to use.[113]
However, a trade secret is
something that ultimately only exists through litigation. Its existence is only
proven through a court finding applying six tests from the Restatement (First)
of Torts, as Halligan and Weyand point out.[114]
Such trade secrets cases are not always open and shut. As Pooley explains,
“despite the widespread adoption of the Uniform Trade Secrets Act, trade secret
principles continue to develop primarily through the common law.”[115]
Special mention must be given to
the laws covering government-created intellectual property. Transfer of
government-funded technologies is generally covered under a number of laws and
provisions, including the Stevenson–Wydler Technology Innovation Act of 1980
(P.L. 96–418); the Patent and
Trademark Law Amendments Act of 1980, otherwise known as the Bayh–Dole
Act (P.L. 96–517); the Federal Technology Transfer Act of 1986 (P.L. 99–502);
and the Technology Transfer Commercialization Act of 2000 (P.L. 106–404).[116]
This set of laws governs how the federal government funds research with
industry (either through a government laboratory or through a grant to a
university) and how the rights to that and other federally funded research are
controlled. Specific to the monetization of intangibles, these laws establish the
ownership of federally funded intellectual property and the sale and licensing
of that IP by the federal laboratory or university.
Two important international
organizations need to be mentioned with respect to the protection of
intellectual property. The first is the World Trade Organization (WTO).[117] As
mentioned above, intellectual property rights are included in international
trade agreements, including those administered by WTO. The Trade-Related
Aspects of Intellectual Property Rights (TRIPS) agreement established the
framework for international enforcement of intellectual property rights through
trade law and for dispute resolution procedures. Under TRIPS, one nation may
impose trade sanctions (such as higher tariffs) on another nation that fails to
adequately protect intellectual property. As of January 2008, 23 TRIPS cases
have been filed with the WTO.[118] The
U.S. law that
triggers a TRIPS dispute is known as “Special 301.” A subsection of the Trade
Act of 1974, Special 301 allows the U.S. Trade Representative (USTR)
to proceed with enforcement actions against other nations that may be using
intellectual property laws to harm American companies in violation of TRIPS.
The USTR also compiles an annual Special 301
report on compliance by other nations.
The World Intellectual Property
Organization (WIPO), a specialized agency of the United Nations created in
1967, has the mission of “promoting the progressive development and
harmonization of IP legislation, standards, and procedures among its Member
States.”[119] As such, WIPO is the
primary administrative organization of the Paris
and Berne Conventions, and 22 other IP treaties.
The intersection of intellectual
property protection and antitrust is a special area of interest. Since IP
protection is a grant of a monopoly right, it is important to determine how
that right affects and is affected by antitrust policies designed to prevent
monopolies. Two recent reports by the Department of Justice and the Federal
Trade Commission have looked into the issue. The first was a review of patent
law.[120] The
second looked at antitrust enforcement. [121]
Licensing is an issue of specific concern.[122]
Guidelines issued in 1995 state that IP protection is not presumed to create
“market power” (i.e., a monopoly or oligopoly) in the antitrust context and
that existing antitrust analysis is applicable and appropriate for cases where
IP is involved.
Noncompete agreements, which have
their own particular quirks and nuances, are another element of contract law
that should be mentioned as part of intellectual property. Noncompete
agreements or covenants are essentially an attempt to control the use of
intellectual capital that remains within an individual (as opposed to that
intellectual capital that is codified outside a person in the form of a patent
or copyright). Because they are part of contract law, the enforcement of these
agreements varies from state to state. In California,
noncompete agreements are considered illegal under Business and Professions
Code Section 16600. Agreements made in other states are also generally found to
be unenforceable in California. Nevada,
Arkansas, Washington,
Montana, North Dakota,
Minnesota, Wisconsin,
Connecticut, West
Virginia, and Oklahoma
are also seen as jurisdictions that do not enforce these agreements.[123]
In other states, noncompete
agreements are generally subject to a reasonableness test. As Klingshirn puts
it:
Courts have
traditionally frowned upon restrictions placed by employers on their employees’
right to find and make a living. However, courts will enforce noncompete
agreements if—
•
the employer proves that it has a legitimate
business interest to protect by restricting its employee’s right to compete
against it
•
the restriction on the employee’s right to
compete is no greater than that necessary to protect the employer’s business
interest
•
the covenant not to compete is supported by
consideration, meaning that the employee received something in exchange for it.[124]
Research has found that
noncompete agreements can be an effective way for a company to decrease the
mobility of its star employees.[125]
However, such restrictions may have a detrimental impact on the ability of a
geographical area to foster economic development.
Two sets of commercial laws are
especially important to the use of assets as collateral, either directly in a
loan or in an asset-backed securitization: the Uniform Commercial Code (UCC)
and federal bankruptcy laws.
The UCC serves as the basic
business law in the United States,
covering business and commercial transactions from sales to borrowing. Since it
covers commercial transactions within a state (not necessarily interstate commerce),
the UCC is a state law. The “uniform” part comes from the adoption of a
standardized set of laws in each of the state and the District
of Columbia.
Article 9 of the UCC covers
secured transactions and the perfection of secured interests.[126]
Perfection simply means the priority of creditors to a secured loan. In other
words, Article 9 of the UCC determines who gets what in cases of default. As
the Texas Secretary of State’s office puts it:
In plain
language, the Uniform Commercial Code allows a creditor to notify other
creditors about a debtor’s assets used as collateral for a secured transaction
by filing a public notice (financing statement) with a particular filing
office.[127]
Since these are state laws,
filings take place with the designated state office.
For most of us, the only time we
are a party to a recorded financing statement is when we record our home
mortgage. But the UCC covers a variety of assets types. In the late 1990s, an
effort was undertaken to substantially revise Article 9 to both simplify and
expand its scope. These
revisions, which became effective in 2001, broadened the definition of
intangibles to include, for instance, software and embedded software as a part of other goods and the
definition of proceeds to include IP royalties.[128]
The revisions to Article 9 also
helped clarify the filing location as well as the scope of assets. As Schwarcz
explains:
The problem with intangible assets
is that it is often unclear where the collateral is located or where it
originated from. Article 9 UCC improved this situation by making the location
of the debtor—as opposed to the location of the collateral—determine the
jurisdiction whose law governs perfection; and by clarifying where a debtor is
deemed to be located. The former point is more relevant to tangible assets;
but, the latter one is quite significant to intangible asset-based
securitization.[129]
Yet the revision did not
completely solve the problem, especially for patents. In addition to filing a
financing statement (often called a UCC–1 filing) at the appropriate
jurisdiction, a patent, trademark, or copyright holder may also file a security
agreement or conditional assignment with the U.S. PTO or the Copyright Office,
as appropriate.
This dual filing system creates a
less-than-perfect situation. In a report to the U.S. PTO, Murphy noted that
“secured financings involving intellectual property are currently caught
between the statutory schemes governing intellectual property rights,
essentially a federal title system, and the UCC Article [9] state encumbrance
system.”[130]
As a result, it is common for
lawyers to recommend that security interests be filed with both the U.S. PTO or
the Copyright Office and the UCC–1 jurisdiction.[131]
While this remedy gives some level of protection to the creditor, it does not
solve the problem. For one thing, dual registration increases the transaction
costs. It also does not eliminate the uncertainty surrounding who else may have
a security interest (and who may not have filed in all correct places). Murphy
notes that:
The result of
this legal complexity is that creditors making a good faith effort to comply
with statutory perfection requirements risk complying with the inappropriate
statutory scheme and losing their interest in the collateral—the very risk which
secured financing is supposed to eliminate.
Some proposals that have surfaced
to remedy the problem are discussed later.
Federal bankruptcy laws add
another dimension, especially concerning the executory contract portion of any
licensing deal. For example, Section 365(n) of the Bankruptcy Code protects the
right of a licensee of IP in the case of the IP owner’s bankruptcy. But as
Borod and Cassidy note:
Section 365(n)
protects only the licensee’s rights in the patent or copyright, not ancillary
contractual obligations of the licensor to provide technological support or
other services. Accordingly, a bankrupt licensor could reject provisions in the
licensing contract that require the licensor to perform functions in support of
the licensed intellectual property.[133]
Therefore, the licensor could be
freed from any obligation to provide technical support or to defend the IP from
infringement.
It should be noted that the law with respect to ownership
of and security interests in intangibles continues to evolve. For example, the
U.S. Bankruptcy Court for the District of New Jersey ruled in 2004 that UCC–9
overrides the New Jersey Alcoholic Beverage Control Act and allows a liquor
license to be used as collateral.[134] On
the other side, in 2005, the Bankruptcy Appellate Panel of the Sixth Circuit
ruled that a former employee of a debtor company could be released from his
noncompete covenant as part of a settlement between the two, even though the
intangible assets (including the covenant) had been bought by another company
in an earlier settlement. Most recently, the
United States Court of Appeals for the Federal Circuit ruled that patent law
took precedent over bankruptcy law in a case where one bankruptcy trustee held
title to a patent but the bankruptcy settlement gave the right to sue for
infringement to a separate trustee.[136] In
a 2-to-1 decision, the Court ruled that only the title holder had the right to
sue under patent law.
The impact of securities and
banking laws and regulations goes beyond the SEC
disclosure requirements mentioned earlier. As we discuss in the next section,
intangibles also constitute a class of assets that can be collateralized and
securitized. Any securitization of intangible assets is subject to the same
regulations as any other asset class. However, exactly how the securities laws
and regulations apply to, and affect, intangibles is sometimes unclear.
Many securitizations are
purchased and sold in private placements to institutional investors like pension
funds and insurance companies. Consequently, these securitizations do not
require the same disclosure guidelines as mutual funds, for instance, that
trade on open markets. This does not mean, however, that asset-backed
securities are trading unregulated. SEC
regulations cover asset-backed securitization. These rules have expanded the
disclosure and information-sharing requirements of securitizations, especially
in response to the Sarbanes–Oxley Act, to assuage investor concerns while at
the same time expanding securitization asset definitions. Their intent is to
“increase market efficiency and transparency and provide more certainty for the
overall ABS [asset-backed securities] market
and its investors and other participants.”[137]
The new rules, including a new
Regulation AB, codify past rules and expand the reporting requirements. The
requirements have generally been viewed positively, although there is some
concern over the new requirement for an annual servicing assertion and
accountant’s attestation.[138]
However, it is unclear how these rules apply specifically to securitization of
intangible assets compared with any other form of asset-backed securities. The
extent to which intangible asset-backed securities are seen as especially risky
or esoteric could determine whether they are subject to special provisions.
In addition to the specifics of
asset-backed securities, the entire range of securities laws and regulations
may have an effect on the monetization of intangibles. As discussed earlier, SEC
regulations cover the disclosure of financial and nonfinancial information,
which may affect how intangibles are viewed by the financial community. Other
rules may also apply—rules that have an unforeseen impact on intangibles until
they are applied to a specific case.
Banking regulations also may
specifically impact the use of intangibles as collateral. For example, new
banking standards on lending risk are coming into force under the Basel II
Capital Accords.[139]
These and other banking regulations have an indirect impact on the formation of
intangibles.
Likewise, rules and regulations
governing federal lending programs, such as those of the U.S. Small Business
Administration (SBA), also indirectly impact intangibles. The 7(a) program
provides SBA guaranties for a portion of a loan from a commercial lender.[140]
CDC/504 loans are provided with partial guarantees through certified
development corporations (CDCs) for projects involving tangible assets, such as
renovations, facilities construction, and equipment purchases.[141] The
loans are collateralized by the project’s assets. However, as we will discuss
later, these regulations treat intangibles inconsistently.
Intangible assets do not contain
the same characteristics as tangible assets. They don’t sit on factory floors,
product showrooms, or, for the most part, balance sheets. As we will discuss in
greater detail in the next section, their fluid nature often makes them hard to
segregate and measure, challenging the ability to discern these assets from
other assets, tangible and intangible alike. How does a company, for instance,
determine the explicit value of industry experience in its operations? When
does the attractiveness of a brand supersede its functions and features? Furthermore,
an organization could be completely cognizant of its uniquely competitive
intangible assets—company culture, for instance—but be unable to replicate it
across regions or to sustain it through market change.
Intangible assets have unique
attributes and behaviors that demand different treatment by financial markets.
One cannot think of intangibles as a single asset class. There are too many
species of intangibles, each with their own characteristics and with specific
characteristics of their markets. Some assets, such as cash-flow-generating
patents and copyrights, are well suited for existing capital models and value
theories. Their values are verifiable by the tangible revenues they have
already generated. Consistent returns beget, in the minds of financiers, an
expectation of future returns at similar levels. If a patent on a specialized
engine part has garnered predictable revenues for the past few years, for
instance, it is reasonable to assume that the patent can deliver similar
returns in the near future.
But even within the generally
well-understood areas of copyrights and patents there are unique market
characteristics. For example, in the copyright sectors, there are relatively
well-developed markets in certain areas, such as songs and plays, with a
standard system of rates and royalty payments. In other areas of copyrighted
materials (and even in the supposedly regularized areas), there is more chaos
and even an orphan copyright problem.[142] In
some areas, such as with much of existing copyrighted material, the revenue
stream is episodic. In other areas, there are regular and predictable long-term
licensing agreements; for example, in patent and trademarks/brands.
Then there are other intangible
assets, like knowledge and culture, where it is very difficult to apply
mainstream capital-leveraging techniques. No prevalently accepted valuation
model exists to accurately recognize these assets. The market has difficulty
effectively defining their value. Lacking market consensus, less universally convincing
relative valuation assessments must be used. Consequently, these intangibles
may have substantial lower market worth and higher market risk perception.
To understand how intangibles
operate in financial markets, it is important to define intangibles in a format
that aligns with the practical applications of their financial use. It is then
possible to look at methods of incorporating these assets into financial market
vehicles and to analyze creative ways to better understand and exploit their
true value.
For clarity purposes, intangible
assets can be segregated into these three broad categories: cash-flow
predictable, market value comparable, and enterprise specific. These
categories capture the various potential capabilities, qualities, and uses of
this asset class. While monetization of intangibles will undoubtedly depend on
careful analysis of the idiosyncratic features and limitations of each, this
classification should help determine the broad boundaries under which these
assets can be defined.
Cash-flow predictable assets
encompass all intangible assets that can be valued using a traditional
discounted cash-flow analysis. These assets generate relatively consistent
streams of periodic payments to the owner of the asset and serve as a basis for
determining expected future revenues, which can then be discounted back to
determine a present value for the asset. This asset category includes
intangible assets such as royalties, contractual agreements, copyrights, patent
licenses, and proprietary right leases.
Market value comparable assets
are intangible asset classes that do not generate periodic cash flows but can
be relatively comparable to like assets in the market. Some of these could very
well generate cash flows in the future, but in their present state offer no
historical revenue streams from which to gauge their value by cash-flow models.
For instance, many companies sit on large caches of unused patents that have
not yet been commercialized. Still, these patents tend to have distinct
similarities to active patents that do, thus making a market value comparable
asset valuation practical.
These assets can be valued either
by comparable valuation (determining value by comparing similar assets, much
like a real estate appraiser determines house values) or by cost-to-attain
methods (simply adding up all the costs required to create or own the asset).
These assets could be transferred from one enterprise to another without losing
relative value and, due to their transferability, could serve as potential
assets for collateralized securitizations and loans. This asset category
includes intangible assets such as brands, unutilized patents, information
systems, customer networks, formulas, trade secrets, and proprietary rights.
Enterprise
specific assets encompass all other intangible asset classes. These assets
do not directly generate streams of revenue nor are they easily transferred in
their current states. In effect, they are only valuable to the enterprise that
contains them; outside of the enterprise, they are virtually valueless. These
assets do not generally support independent collateralized financing and are by
and large only useful for whole-enterprise securitizations.
Valuation of these assets can also
be very problematic using prevalently recognized asset valuation techniques.
Nonetheless, these assets often account for the preponderance of many firms’
overall value. Their value is often recognized wholly in firm valuations and
rarely differentiated and segregated out by their specific contribution to the
market value of the firm.
These assets pose a significant
challenge to the creative financier looking to leverage intangible asset value
in the capital markets, but could offer extraordinary financial benefits for
those able to do so. Often they serve as some of the basis for projected
synergies and high acquisition price justifications in merger-and-acquisition
transactions. This category includes intangible assets such as know-how,
competencies, culture, training, reputation, employee competency, company
commitment, industry experience, customer relationships, and decision-making
capabilities.
To monetize intangible assets,
companies need to understand capital market options. There are licensing
mechanisms for turning certain intangible assets, such as patents, copyrights,
and trademarks into revenues. But these are limited to the cash flow generated,
rather than being the source of large blocks of investment capital. Capital for
intangible assets can be garnered from a number of sources, such as banks,
equity markets, debt and securities markets, private equity firms and venture
capitalists. These resources have varying degrees of understanding of and
support for intangible assets, and the opportunities and limitations of each
source will dictate their usefulness in monetization.
There are three types of buyers:
owners, long-term investors, and speculators. Using the real estate example,
the owner buys the house to live in. The investor buys the house to rent out.
The speculator buys the house to fix it up and sell it for a profit. All three
buyers have their place in the market. In terms of intangible assets, those
seeking assets to use them in their own operations (owners) have been almost
the only buyers in the market. Long-term investors and speculators are only
recently emerging as major market players.
Much of the focus on intangibles
by business leaders and writers is correctly focused on how to identify and use
intangible assets, including IP, within the organization for greater revenue
generation. The internal use of intangible assets for higher profitability is
the easiest form of monetization. The task of capturing that valuation is the
job of the equities markets.
The degree to which the equity
markets do or do not capture the value of intangible assets is hotly debated.
Some have argued that a large portion of companies’ stock market value is
intangible.[143] It has been estimated that
book value is less than 35 percent of market capitalization, and that the total
value of intangibles is 79.7 percent of market capitalization (15.5 percent
captured within book value and 62.4 percent not reported on the books).[144]
Others point to that fact that national statistics show overall market
capitalization to be generally below the market value of corporations’ tangible
assets (mainly real estate).[145]
What is clear is that equity
markets have historically valued companies above and beyond their tangible
assets. Unlike the loan market, which values assets by their explicit
properties, the equity market seems to incorporate the implicit nature of
intangibles in overall firm valuation. Stock prices capture more than just the
present value of existing cash flows and the book value of assets. The overall
ability of the company to utilize all of its assets, tangible and intangible,
to deliver future profits and thus enhance shareholder equity accounts for the
market price of company stock.
Research has shown that stock
share values reflect the contribution of intangible assets to company profits
and growth. For example, the UK Design Council found that British companies
with a strong design component (an intangible capability) outperformed other
companies in the stock market.[146] In an intensive analysis,
Communications Consulting Worldwide concluded that 27 percent of the stock
market value of one major U.S.
industrial corporation could be attributed to intangibles like reputation.[147] Choi et al. found that
“results indicate that the financial market positively values reported
intangible assets,” and note “a positive relation between the book value of
intangible assets and the market value of common equity.”[148]
Stock prices may mimic investors’ long-term expectations of profits, valuing certain
intangibles that, as Hall argues, could be expected to become future
cash-generating resources for the firm.[149]
However, equity markets also have
a painful history of mispricing these assets. Choi et al. also note that “the
market’s valuation of a dollar of intangible assets is lower than its valuation
of other reported assets.”[150] The dot.com boom was one
example of overpricing, where the perceived future value of many Internet
enterprises seems now to have been illusory. On the flipside, equity markets
also have a proclivity to undervalue intangible assets, as evidenced by the
fact that a stock value drops nearly every time company announces a new
research program. This inconsistent treatment of intangibles is contrary to the
rational market model. Zhang argues that “the predictive power of inferred
intangibles is consistent with market inefficiency.”[151]
The degree and expectation of
firm value associated with intangible assets differs across industries.
Technology and pharmaceutical companies are heavily invested in intangibles and
much of their valuation seems to reflect that fact. Nonetheless, accounting
standards do not require all of a firm’s intangibles to be valued, and have
little means to oversee the numbers that firms report on their financial
statements. Investors, one could argue, are more exposed to risk in
intangible-heavy industries since they have relatively less information from
which to determine accurate firm valuations.
It would seem then that a firm
can use some of the embedded assumptions of equity market investors to monetize
intangible assets. The stock market expects the intangible assets of companies
in intangible-laden industries, like biotechnology or software firms, to be
more valuable than those in other industries, like manufacturing. If investors
can imagine the value of the intangibles within a firm, their market valuation
of the firm could rise as a result. A firm’s reputation and standing in the
market, for instance, tends to support higher equity market valuation.
According to a recent survey of 200
Wall Street financial professionals, 62 percent of
respondents agreed or strongly agreed that Wall Street takes patent portfolios
into account when assessing company values, but only 22 percent thought patent
values were reflected in cash-flow projections or in comparable
company/multiple analyses. More than 50 percent thought patent values were
uncertain and that they didn’t have enough information or knowledge to assess
patents.[152]
An inextricable link to market
valuation of companies is merger-and-acquisition (M&A) activity, including
buyouts (private equity). While not all M&A activities are driven by
perceived low stock value, bargain hunting is a major driver. The difference
between the market’s valuation of a company and what an investor sees as the
total value of tangible and intangible assets can trigger the process. It is
unclear the extent to which perceptions of intangibles drive M&A activity.
It is clear that intangibles are gaining an important role, especially in
strategic mergers in technology fields. Often the value of the intangibles is
not factored in until late in the process. But Sterne and Laurie argue that IP
should be explicitly considered during the target stage in M&A, not just at
the end stage of due diligence.[153] They believe that early
attention to IP will insure optimal integration of assets and may provide
warning signals of future IP problems. The role of intellectual property as
part of M&A deals seems to be increasing as legal due diligence on the IP
portion of the deals is increasing.[154]
In addition, as will be discussed later, securitization of intangible assets is
beginning to show up in leveraged buyout processes.
Thus, a common form of
monetization of assets (tangible and intangible) is one of the most
traditional: sell the company, either in whole or in part, through issuing
stock.
A variation of this, somewhat
akin to the venture capital route, is to spin off a new company from an
existing entity. In this case, the basis for the new company already exists and
is simply separated from the parent under different ownership (public or
private). Recently, OceanTomo and Blueprint Ventures came together to set up a
program to foster technology-based corporate spin-offs.[155]
One of the easiest and fastest
ways for monetizing individual intangible assets outside of the capital markets
is by creating revenue streams through licensing. As Lamoreaux and Sokoloff
point out, trade in patent rights, both through sale and licensing, was well
established in the United States
by the mid 19th Century.[156]
Companies sit on stockpiles of underutilized or wholly dormant intangible
assets, generally in the form of intellectual property such as patents,
trademarks, and trade secrets (proprietary processes or technology). Often a
little creative exploration can unearth useful solutions and potential
applications for intangible assets, many times even outside of the industry
that created them. For instance, a patented design feature used to streamline
an aircraft may work to enhance fuel-efficient design in automobiles. Or, a
copyrighted rock-and-roll song may contain lyrics and rhythms that work well
for the television ad of a motorcycle company. By assessing the real value of
these assets and exploring the revenue opportunities they possess, a company
can find within itself a treasure trove of unrealized value.
Many firms have found a lucrative
market licensing their patents, copyrights, trademarks, and trade secrets to
other companies. The most common form of licensing involves trademarks and
copyrights. In fact, the entire publishing, film, and music industries are
gigantic copyright licensing machines. Licensing of patents is also a standard
company operating procedure. While it is true that a company may obtain a significant
competitive advantage by having the exclusive rights to a particular
technology, it is also true that licensing patents to firms in noncompeting
industries does not hurt its competitive standing and can generate significant
income for the company. In fact, licensing income often helps to finance
additional innovative R&D activities. It has been estimated that IBM
receives 5 percent of its total income from licensing revenues; DuPont, 8
percent; and Amgen, 17 percent.[157]
Trade secret licensing is less
common than licensing of other forms of intellectual property. The requirement
of maintaining secrecy can make sharing of the information difficult. Such a
requirement is not necessarily an impediment to licensing, however. For
example, in 1881 the formula for Listerine was licensed by its inventor, Dr.
Joseph Lawrence, to Jordan Wheat Lambert, founder of Lambert Pharmaceutical
Company. Importantly, that licensing agreement was the subject of a major court
case that decided that, as Halligan
notes, “[e]ven if a trade secret subsequently enters the public domain, royalty
payments under trade secret licensing agreements can continue indefinitely.”[158]
For all its normality in the history
of business, licensing is still not as commonplace as it could be. The
potential for licensing, especially in technology, is still developing.
Licensing of technology—also known as technology transfer—is not necessarily a
straightforward process. Malackowski notes that “even today, IP licensing
remains a hand-to-hand combat business where it often takes six to eighteen
months to complete a deal, and this comes at significant costs.”[159]
Both ends of the transaction can
be oblique. Often the holder of the patent does not know the value or the
possible uses of the technology, does not assess its value to all possible uses
within the organization, and does not have means to determine its potential
applications across markets outside the one in which the organization operates.
Potential users may not even know of the existence of the technology. In
addition, technology transfer issues go far beyond simply the identification of
the buyer and the seller and the structure of the deal. The use of the
technology requires additional transfers of know-how and tacit knowledge as
well. As we will discuss later, these difficulties can greatly hinder the
process of IP licensing (and sale).
There are two other methods of
obtaining cash for intangible assets—generally patents— that are linked to sale
and licensing: donations and litigation.[160]
Under IRS regulations, intellectual property
can be donated to a nonprofit, oftentimes a university. New rules, however,
limit the value of the tax deduction of the future royalties.[161] Litigation
(discussed later) is also an alternative means of raising cash either through
mandatory royalties or through damage awards.
Sale of
IP
Along with licensing, the
outright sale of intangibles, especially ones that have the ability to draw
varied interest due to their pliability and adaptability, is a common option
for raising capital. Take the case of patents, which can be readily applied to
other forms of intellectual property. As Abril and Plant have described,
individuals, small companies, and even large firms have a limited number of
options when it comes to utilizing their patents.[162]
They may use the patented technology themselves, building a business around it.
However, individual patents are often not enough for a complete product,
especially in information technology. Even if the patent is sufficient, for a
new drug, for instance, individuals and small companies often do not have the
resources necessary to exploit the patent. In the case of a large company, the
patent may not be related to their core business. Or it may be part of a larger
portfolio of patents needed for a product, some of which are held by other
companies. In all of these cases, licensing, cross licensing, and sales of the
patent become the strategies of choice.
An example of monetization using
the sale and leasing of patents is the $50 million patent deal between Motorola
and GE Commercial Finance. Motorola sold a portfolio of noncore company patents
to GE Commercial Finance for cash and a share of future royalties. GE will provide
patent licensing, enforcement, and maintenance.[163]
The difficulty in the sale of
patents, as in the case of licensing, is one of technology transfer—discussed
above. Even if the issues of direct technology transfer are solved, there is
the lack of a secondary market for these products. Numerous companies exist to
act as brokers and managers for the licensing and sale of patents, but these do
not necessarily add up to a secondary market.[164]
Other forms of intellectual
property, especially copyrights, have a long history of being bought and sold.
For example, singer Michael Jackson and Sony own the rights to some of the
Beatles’ songs, whereas ex-Beatle Paul McCartney’s MPL Music Publishing owns
the rights to many old standbys. Again, there are numerous brokers, especially
on the music-licensing side of the business.
New mechanisms for buying and
selling of patents are emerging. The Danish Patent and Trademark Office runs an
online IP Marketplace.[165]
There are also Web-based patent exchanges, such as ipAuctions.com and
FreePatentAuction.com.[166] The
investment firm OceanTomo has pioneered patent auctions.[167]
The first auction was held in April 2006, with a number of subsequent auctions.
The next auction is scheduled for April 2008. During the first auction, only about
half of the items were sold because bidders did not reach the sellers’ reserve
prices. However, all items were later sold in off-auction floor negotiations.
Another relatively new phenomenon is the emergence of the patent holding
company. Such companies buy the patent rights to obtain the royalty rights—and
in some case to be able to more aggressively license the technology. One such
company, Royalty Pharma, holds the rights to a number of drugs.[168] For example, in 2005, Emory
University sold its royalty rights
in a HIV drug to Gilead Sciences and Royalty Pharma for $525 million.[169] Royalty Pharma purchased
the rights to the drug HUMIRA® from AstraZeneca in 2006 for $700 million.[170]
A variation on this model is
Symphony Capital, which provides funding for drug clinic development.[171] Symphony sets up a
separate joint venture with the originator of the drug for the clinic
development phase. In one deal, Symphony Evolution and the biotech company
Exelixis gain access to $80 million in exchange for the rights to three cancer
drugs. The twist to this model is that Exelixis also entered into a repurchase
agreement that allows it to buy back the rights at a 25 percent premium.[172]
The dark side of the patent
holding company is the so-called patent troll. Such companies are building on
the business model of infringement lawsuits to collect royalties and damages
rather than licensing. Sullivan explains that—
the term applied
to companies that, while having no technological operations of their own,
acquire and aggressively assert dubious patents against entire industries,
hoping to obtain settlements based upon alleged infringers’ desire to avoid the
high costs and uncertainty of litigation (especially in jurisdictions, such as
the U.S., that afford significant advantages to plaintiffs in litigation or
that allow for the imposition of substantial, unrecoupable litigation costs on
defendants).[173]
Debate rages over who is and is
not a troll and over whether such patent trolls, with their vigorous hunt for
infringers, are good for the patent system. Regardless of whether the business
model is based on aggressive licensing or on infringement litigation, patent
holding companies are becoming an important mechanism for the monetization of
intellectual property.
The process of IP sale and
licensing may get a boost from the OceanTomo’s work to create an Intellectual
Property Enterprise Zone to “facilitate technology transfer through a physical
collocation of technology buyers, sellers, licensors, and licensees as well as
an electronic intellectual property exchange.”[174] The
electronic IP exchange will “enable investor and company participation in a
broad spectrum of IP-related financial products such as qualified equity
listing/co-listing; IP-related indexes, futures, and options; IP-backed debt
instruments; patent-rich company IPOs [initial public offerings]; and new
IP-based exchange-traded products.”[175] M-CAM
is also expanding its financial activities.[176]
Additionally, the National Knowledge and Intellectual Property Management Task
Force is working on ways of facilitating IP transactions.[177]
The most direct way of tapping
capital markets is through direct lending. Lending on intangibles is not a
completely new phenomenon—even if it is not explicit. As Hall points out:
It’s often
assumed that banks aren’t concerned with measuring and evaluating intangibles
beyond characteristics of a business such as goodwill and patents which
currently feature in established accounting standards. Intangible and latent
competencies such as competitiveness or quality of management have in fact been
incorporated in credit risk analysis for some time, albeit intuitively and
subjectively, and with neither a common language nor explicit measurement.[178]
The IP consulting firm Consor
Intellectual Asset Management claims that IP lending has moved even beyond that
stage, noting:
In the past,
many banks and other lenders required that the IP be included in any financing
arrangement along with the other assets used to secure the loan. Now, however,
IP owners are beginning to realize that these assets can generate significant
financing options on their own. Rather than have the IP act as insurance above
and beyond the required collateral, trademarks, patents, and copyrights have
been pledged as the primary source of collateral in a wide range of situations.[179]
A recent survey of small and
medium-sized high-tech companies in New England revealed
that 18 percent of the companies surveyed said they had used patents as
collateral to secure financing.[180]
Intangibles can come into play in
the lending process in two ways: as collateral and as a factor in determining
the credit rating. The latter seeks to determine the ability of the borrower to
repay the loan and therefore the probability of default while the former helps
determine the extent of a possible loss in case of default. The credit rating
is the first screen, with collateral then used to adjust the rating depending
on the value of the collateral. Traditionally, the credit rating has been
determined by cash flow—i.e., the borrower can sustain the debt service
requirements. Total debt payments, cash flow, total income, and related factors
are used to make this determination.
In fact, it has been argued that
collateral (tangible or intangible) is almost irrelevant to the lending
decision, which is driven by cash-flow considerations. The Brookings
Institution Task Force on Intangibles put it this way:
To be sure,
lenders, including banks and insurance companies, and their regulators,
consistently reported that their rules and standards for evaluating
creditworthiness do not discriminate against borrowers whose assets are
primarily intangible rather than tangible. They noted that credit risk does not
depend on the nature of the assets; neither intangible assets nor bricks-and-mortar
have intrinsic value if they are not used for something. Thus, they insisted,
it is the characteristics of an entity’s cash-flow generation that determines
the amount of credit it should receive.[181]
Others, such as the pathbreaking
microloan organization Grameen Bank in Bangladesh,
rely on peer pressure and joint liability, rather than on collateral, to insure
repayment.[182]
That said, there is still a role
for intangibles. First, intangibles can help determine the cash-flow-generation
possibilities. Both existing and potential royalty streams directly derived
from the intangibles, such as a licensing agreement, can be used to determine
discounted cash flow. Second, collateral is still important in determining the
final structure of the credit. For example, a person with the same exact cash
flow will get a much better rate on a collateral-backed home mortgage than on
an unsecured line of credit.
In the case of intangible assets,
large banking institutions like JP Morgan Chase, Credit Suisse First Boston,
and Bank of America, to name just a few, offer loans secured by intellectual
property assets. These intangibles, generally in the form of patents,
trademarks, and copyrights, find some credence from lenders since they are
reasonably transferable and can act to support credit institutions against
default risk. For example, pop star Michael Jackson used his portfolio of songs
by the Beatles and other songwriters to collateralize a $270 million loan,
which was refinanced in 2006.[183]
IP assets have also been used as
collateral for second-lien loans and mezzanine debt. Acting as a hedge on loans
issued as subordinate financing to tangible, real property assets, these assets
can provide the lender with an unencumbered collateral asset in case of default.
Generally, these products are only available to large and mid-cap companies
with more than $100 million in assets and strong credit histories. The element
that makes these loans so attractive to lenders may be their high rates of
return, often 600 to 800 basis points above the London Interbank Offered Rate
(LIBOR).[184]
Banks with ties to specific
industries can build up an expertise in intangible-based lending. According to
Billboard magazine, “In Nashville, SunTrust has been extending loans to artists
for about 26 years in which their intellectual property—in this case, their
songs—serves as the collateral. [Brian] Williams [SunTrust’s director of music
private banking] says that’s a ‘garden variety’ product for his bank as well as
for others in town.”[185]
Such lending can be prospective
as well. For example, Royalty Advance Funding in Los
Angeles offers both cash advances to musicians and
songwriters and buys music royalties.[186]
Likewise, Content Partners LLC buys the rights to future payments for films, television programming, and music from writers,
producers, actors, and others who need immediate liquidity.[187]
Presidential candidate Sen. John
McCain (Ariz.) even used his
fund-raising list as collateral for a campaign line of credit.[188] In
this case, the bank required that the campaign take out an insurance policy to
backstop the loan in case the candidate would not be able to continue fund
raising activities.
Lending institutions have not
traditionally favored loans solely collateralized by intangible assets. Historically,
IP has only been used to enhance loans made to real asset or receivables loans.[189] According to Bergelt and
Meintzer, IP is used with a loan-to-value ratio of 10 percent to 40 percent
compared with 50 percent for physical plant and equipment.[190]
Bankers view IP collateralized
assets as loss hedges on loan funds. They evaluate the historical returns
correlated to the IP collateral and heavily discount the projected future
earnings attributable to the assets. Often they also compare like assets across
a company or industry to determine an appropriate valuation. Most IP assets
merely act to improve the risk character of the loans they back. While every
effort is made to lend only to credit-worthy corporations, commercial bankers
will often seek collateral as a credit enhancement for the loan. In a
worst-case scenario—absolute payment default of the borrower—the bank can claim
the collateral and resell it to cover the loan.
Intangible asset
collateralization for lending faces several potential problems. Can the asset
ownership be transferred without encumbrance to the lender in case of loan
default? Can the banker discern an appropriate, fixed value for the asset over
the term of the loan?
Because of these concerns,
lenders find the risk of supporting loans with assets limited to only
subjective valuations and nebulous risk profiles as too great without either
additional tangible collateral or a third-party credit enhancement. Recently,
many intellectual asset consultants have sprung up to help satisfy lenders’
concerns. Organizations like Brody Berman Associates provide valuation and due
diligence services on IP. To reduce risk to the lender, insurance companies
like MBIA Insurance Company and Swiss RE New Markets offer a number of forms of
credit enhancements.
The combination of valuation due
diligence and credit enhancements may make the deal secure enough to be
supported by the intangibles. Edwards explains how this works:
GIK Worldwide is
a small company based outside San Francisco.
They are the patent holders of a groundbreaking technology that delivers
high-speed broadcast quality video conferencing over twisted copper wire. Like
many such technology rich companies, they were running out of cash and either
did not want to or could not tap the venture capital markets. Taibbi Ltd, a
Boston based boutique investment bank and IP management consultancy put
together a financing package that raised $17MM [million] in debt provided by
Pitney Bowes Capital based on an appraised value of $57MM. Pl-x provided the
valuation, Intellectual Property Insurance Services of Louisville, KT provided
IP value insurance to protect the lender against loss in value of the patent,
and XL Capital of Bermuda provided the financial guarantee. The entire process
took less than 90 days to complete.[191]
Two other examples of credit
enhancements by IP Innovations (IPI) provide further illustrations. In late
2004, GMAC Commercial Finance provided a $43 million loan to Palladium Equity
Partners, a New York
private-equity firm, backed by the trademark of its Wise Foods snack-food
lines. The five-year deal was credit-enhanced by IPI, which guaranteed $7
million of the deal in exchange for a priority-secured position on all the IP
of Wise. This deal used the brand and trademark value of the snack-food company
to collateralize the term loan. The intangible assets were the sole collateral
for the deal.[192] In September 2004, IPI
also backed a $15 million credit facility issued by London’s
Lloyds TSB to Cambridge Display Technology (CDT),
a maker of polymer organic light-emitting diodes for flat-panel displays. The
three-year revolver loan was supported by CDT’s
patent and trademark assets.[193]
Another interesting twist is the
use of intangibles in the bankruptcy process. As Aston explains:
Intellectual
assets—including IP and intangibles—have taken on a new level of importance,
respectability, and legitimacy for those institutions involved in bankruptcies.
For example, providers of IP financing or loans to insolvent companies, or exit
financings for those emerging from Chapter 11, often consider using the
company’s intellectual assets or IP as collateral.[194]
Nonetheless, overt market
prevalence of IP collateralized loans has yet to emerge. Many lenders still do
not feel comfortable with the assets. They question how the assets should be
accurately valued and financially projected. Patent infringement or brand-name
erosion, for instance, could greatly diminish an IP asset whose value had been
supported by a strong history of financial returns and renowned standing.
Eustace noted this in his 2000 paper Intellectual Property and the Capital
Markets: “With respect to the use of intangible assets as debt security, in the
mainstream corporate lending market, bankers generally do not take explicit
account of intangibles as collateral for loans.”[195]
He acknowledged that in Europe there are “a range of
issues for the city banks and investment institutions, whose lending policies
and credit risk models face deep-rooted conceptual and practical difficulties
in keeping pace with the changing corporate value schema.”[196]
A 2006 report by the Organization for Economic Co-operation and Development
(OECD) showed some progress, stating that “[g]reater attention is being paid in
OECD countries to the use of IP as collateral for bank loans,” but that use “of
IP as collateral for bank loans remains limited, largely because of limitations
in valuation.”[197]
As banks start to better
understand IP assets, they will undoubtedly begin to greatly enhance their use
of them to leverage loans and to make confident in-house credit-analysis
decisions.
Many intangible assets, though,
are enterprise-specific, making it difficult if not impossible to transfer
ownership rights. They do not serve as useful loan collateral. While
enterprise-specific intangible assets such as firm competency, reputation, and
managerial expertise support the credit decision of the banker, they are not
likely to serve as defined credit enhancements on their own. However,
short-term lines of credit are often extended collateral-free and undoubtedly
reflect the banker’s recognition of these factors as critical value components
in the underwriting of the loan. Certainly the relationship between company and
banker, fostered from previous dealings, provides a valued form of asset that
acts like tangible collateral.
Another route to the capital
markets is through the debt market using the mechanism of an asset-backed
security. The SEC defines an asset-backed
security as—
securities that
are backed by a discrete pool of self-liquidating financial assets.
Asset-backed securitization is a financing technique in which financial assets,
in many cases themselves less liquid, are pooled and converted into instruments
that may be offered and sold in the capital markets.
[P]ayment on the
asset-backed securities depends primarily on the cash flows generated by the
assets in the underlying pool and other rights designed to assure timely
payment, such as liquidity facilities, guarantees, or other features generally
known as credit enhancements.[198]
Most securitized assets are
largely homogenous, highly liquid assets that can be easily traded and
purchased in open markets, such as mortgages, credit card receivables, auto
loans, and other financial instruments. Asset-backed securitization (ABS)
has been growing rapidly, from $500 billion in 2000 to $3 trillion in 2006 and
is well established in global markets.[199]
Arguably, securitization could
seemingly grab any firm asset, including assets beyond the bounds of the
balance sheet, and make a market for them. If an asset can generate cash
streams, its value can be ascertained and leveraged to draw potential interest
from the capital markets. Note that intellectual property is but one of numerous
types of assets that are subject to securitization, including both traditional
and esoteric asset classes.[200]
These include assets such as equipment leases, sports franchise fees, and
property tax liens. While the idea of intangibles as an asset class may seem
revolutionary, the understanding of their respective securities need not be.
Securitization of intangibles is simply an extension of these existing
practices that started with mortgage-backed securities and are being refined
with these other esoteric asset classes.
The promise of future revenues
has long been used to raise funds for intangible activities. For example,
Broadway shows are funded through the sale of shares. Seed money invested in an
artist—or more acutely, the artistic talent of an individual—for instance,
could eventually lead to a stream of royalties on the art that the person
creates. Artist Sharon Louden and her commodities-trader husband have taken
just that route. They solicited investors to buy shares in a sculpture in
process for an exhibition at the Kemper Museum of Contemporary Art in Kansas
City, Mo. The piece was later
sold for enough of a profit to provide the investors with a satisfactory
return.[201] While Louden was already
recognized as an artist, an unknown artist whose work is endorsed by an
established artist is arguably an untapped reserve of future revenues. Thus,
talent, an elusive intangible, becomes a marketable asset for capital
generation.
One of the first intangible asset
securitization deals occurred in 1997 when the Pullman Group’s Jones/Tintoretto
(a.k.a. “Bowie Bonds”) deal securitized offerings based on the record master
and music-publishing royalties of rock star David Bowie.[202]
One of the first deals using patents was in 2000 when Royalty Pharma
securitized the Yale University
patent to the drug Zerit.[203]
In 2005, IP Innovations estimated
that there are about $1 billion in IP-backed deals each year.[204] Intangible-based
securities aren’t even a blip in the overall ABS
market, with almost $3.6 trillion outstanding.[205]
However, interest in the securitization of intangible assets appears to be
growing. According to Jay Eisbruck:
In recent years
the securitization of various types of intellectual property has evolved from a
small niche market utilized by individual artists or thinly capitalized
companies to a broader corporate financing tool used to facilitate mergers and
acquisitions, stock buy-backs, and risk transference to investors.[206]
Music catalogs provided the early
movement, with a flurry of deals following the Bowie Bonds model.[207] However, the music
industry activity has slowed.[208] More recently, the
expected securitization of music publisher EMI’s music catalog has apparently
fallen victim to the current credit crunch.[209]
While securitization of music has
not grown rapidly, the technique has been adopted by the movie industry.[210] It is expected that
securitization of film rights will continue to grow.[211]
More recently, Morgan Stanley set up a new private fund to sell bonds backed by
the revenues generated by films released by Paramount Vantage.[212] In 2005, Merrill Lynch
recently created a $465 million revolving credit facility for Marvel
Entertainment, insured by Ambac Assurance using the film rights to the comic
characters and the movie revenues as collateral.[213]
However, such deals are also requiring stricter covenants given previous
problems.[214]
The area of franchise fees and
trademarks/brand names has also expanded, including brands such as Arby’s,
Athlete’s Foot, and Guess.[215] In these deals, rights to
the trademark and franchise fees are transferred to a special purpose entity
(SPE), which sells bonds backed by the royalty stream (see Appendix B).
Royalties flow directly to the SPE with the parent company receiving a
management fee for administration and marketing. Such deals are sometimes
referred to as Whole Company Securitization because they essentially take a
firm’s entire cash-flow stream and securitize it.
More recent deals have increased
in size. The 2006 Dunkin’ Brands securitization of its franchise and trademark
royalties raised $1.7 billion.[216] That same year, KCD IP
(which owns the Kenmore, Craftsman, and DieHard
intellectual property for Sears) structured a $1.8 billion securitization deal
with a twist on the model where there was no outside royalty stream and no outside
capital.[217] In March 2007, Moody’s
issued a rating for a bond offering of almost $1.8 billion by Domino’s, backed
primarily by the pizza maker’s intellectual property and franchise agreements.[218]
Patents have long been seen as a
promising area for securitization but one that has yet to live up to that
promise.[219] The most cited examples
have involved pharmaceuticals and the early attempts have been mixed. In 2000,
BioPharma Royalty Trust securitized the patent for the HIV drug Zerit,
developed at Yale University.
Standard & Poor’s rated the bond issue of $115 million single A. But
lower-than-projected sales resulted in violations of the deal’s financial
covenants for three consecutive reporting periods and, in November 2002, the
deal entered into the phase of what in financial-speak is called “early
amortization.”[220]
That experience led Royalty
Pharma to become more of a whole enterprise securitization form of transaction
in July 2003.[221] The $225 million deal
was backed by a portfolio of 13 patents, structured by Credit Suisse First
Boston and insured by MBIA Insurance Group. Moody’s and Standard & Poor’s
gave the deal an AAA rating. Royalty Pharma has since expanded this original
debt facility through additional securitization and refinancing, using those funds
to acquire rights to additional pharmaceuticals.[222]
Using intellectual property as an
alternative to existing funding mechanisms in pharmaceuticals has drawn a good
detail of attention.[223] But
pharmaceuticals may be a special case. Because of the need for Food and Drug
Administration (FDA) approval, these products may have a more secure position
once they make it through all the regulatory hurdles. As Eisbruck notes:
Compared to
other technology patents, pharmaceutical royalties are better suited to securitization
due to the high barriers to entry in pharmaceuticals—largely due to the long
development and regulatory approval processes for drugs. This generally makes
the risk of obsolescence lower than for other types of technology patent,
reducing the potential variability of future royalty payments.[224]
However, Dorris and Wilkes note
that pharmaceuticals face a special set of challenges. The need for FDA
approval can be a two-edged sword, raising the risk of failure before the
product even hits the market place. Other challenges include National
Institutes of Health (NIH) patent reach-in provisions and special patent-waiver
provisions in cases of HIV/AIDS drugs for use in third-world countries.[225] The
difficulties—especially in the concentration of risk involved and the need for
a large pool of patents—are such that Eisbruck expects only modest growth in
this area.[226]
Another
version is the Patent Investment Entity (PIEÒ) structure used by
TEQ Innovations. A combination of a real estate investment trust and equipment-leasing
model, it raises funds from investors and lenders to acquire patents, which it
then licenses back to the original owner. This allows companies to monetize
current core patents as well as create a vehicle for holding and leasing
non-core patents.[227]
In all the above cases, the
predictable revenue streams from the licenses supported the securities. This
cash-flow securitization uses the expected returns generated by the asset to
determine the return of its associated security. Historical returns from the
asset provide a discounted cash-flow method of valuation that can quite easily
formulate expected returns on assets such as patents, copyrights, and
royalties. Contractual agreements on intangible assets, like franchise
agreements or trademark licenses, also make return calculations relatively
simple. A firm could also estimate the expected returns from comparable asset
categories to project expected returns on assets without having access to
useful historical data due to the newness of the asset or after significant
structural changes to it.
This method of securitization
promises to offer attractive options for companies sitting on other forms of
intangible assets as well. Contractual agreements may also provide the creative
means to securitize intangible assets for an enterprise. Since many
service-based industries, such as high tech or health care, find the
preponderance of their value in intangible assets resting in contractual
relationships and know-how, these industries could find the greatest benefit
from securitization. For instance, let’s say a computer-consulting firm
contracts its services to a manufacturing firm for a fixed monthly payment for
the next 12 months. The contract provides a fixed income stream as well as a
good approximation on risk for the returns. In effect, the firm has captured an
intangible asset, its technological know-how, and created a fixed income stream
that could be bundled with all its other consulting contracts to support a
cash-flow securitization.
Furthermore, other forms of
intangibles that are based on market valuations might also be used in
securitization. Here assets whose value can be independently appraised by a
universally acceptable method, such as mining rights, are used as collateral to
support the security. Asset value is found by either determining a value based
on a known value of a comparable asset or through historical expectations of
assets with like characteristics or it is determined by estimating the
replacement value of the asset or cost to obtain it. With a little creative
thought, this securitization category can encompass a significant array of
intangible assets. Mining rights, leasehold interests, noncompete covenants, or
developmental rights all serve as assets with comparable counterparts.
Such activities may increase now
that hedge funds and private equity funds are beginning to see the value of IP
portfolios and securitization.[228] The
Dunkin’ Brands securitization was used to raise funds to support the leveraged
buyout.[229] Once EMI started
discussing the potential for securitizing its music catalog, it became the
target of rumors of a private equity takeover.[230]
The eventual buyer, Terra Firma Capital Partners Ltd., has a history of using
asset-backed securitization for acquisitions and had apparently planned to
securitize the catalog. However, recent problems in the credit markets have
reportedly put that plan on hold.[231]
The problems of EMI and Terra
Firma are emblematic of how the recent troubles in the subprime mortgage market
may cause investors to shy away from the entire sector of asset-backed
securitization. Guha and Callan note that investors “have lost confidence in
their ability to value complex structured credit products that include some
exposure to subprime [that is] bundled up with exposure to other underlying
assets.”[232] Intangible asset-backed
securitization may be too esoteric for the market to swallow in its present
state. In addition, the tightening of credit standards in the mortgage area
also may make intangible deals too expensive for borrowers by either giving
such deals a lower bond rating and thereby increasing the interest rate
demanded by the market or by requiring greater levels of insurance.
As it becomes clearer just how
much these instruments have disrupted the credit markets, investors are left
wondering why the risks of these securities were so misunderstood. Quite
clearly, the assets that made up these securities—loans to risky borrowers—were
not as strong an asset as investors, financiers, and the ratings agencies
originally surmised. In the process of markets pulling back from the enormous
amount of loan defaults and the consequential diminishment of securities value,
the near-term promise of intangible asset securities will likely be greatly
hampered. Since these assets have a tendency to be difficult to value and
risk-assess, they will be held to even greater scrutiny by potential investors.
Nonetheless, it is still too
early to accurately predict the long-term ramifications of recent events.
Markets have traditionally been both resilient and elastic as they continually
seek out innovative means to move capital and deliver returns. From calamity
may spring opportunity. Intangible-backed deals tend to be overcollaterized
with extensive credit enhancement (insurance and performance covenants)
structures. Such enhancements may make these deals attractive to investors
still smarting from the covenant-‘lite’ deals backed by no-document loans.
Performance problems of the kind we have seen in the subprime market have not,
to date, been repeated with respect the intangible asset-backed deals.
Intangible assets could prove to be palatable to investors looking for
instruments built on varying asset classes to better balance their respective
systematic risk tolerances.
The ratings aspect of the
securitization process requires special mention. Like for any other security,
an independent analysis is performed by a ratings agency to assure the issuer’s
capacity to fulfill its debt obligations. This analysis takes an intimate,
confidential look at the financial condition of the issuer to determine the
credit risk assumed by the investor who purchases the debt issued by the
entity. Institutional investors often require a rating, usually performed by
one of the three major ratings agencies—Standard and Poor’s, Moody’s, and
Fitch—to comply with legal or self-imposed guidelines on investment quality.
The role of intangible assets in
the ratings process may be hard to quantify. Rating agencies have to take into
account a number of qualitative factors, such as the ability of the artist to
continue to promote his or her music.[233]
The ratings agencies seem to recognize value, but in a nonspecific way, as
Adele Del Bello notes:[234]
Despite the
frequent reference to specific intangibles in their ratings manuals—it appears
that there is no algorithm or procedure to track down in a systematic and
formalized way the role of intangibles in the evaluation process. Nevertheless,
the presence of these assets—and in particular human capital—seems often to be
related with the granting of high levels. The credibility of management—that
is, its ability to realize its ambitions and plans—is crucial to the ratings
process. It also emerged that intangible assets can have a weight on the final
credit rating of up to 20-35% according to different industries.
As is the case with
collateralization mentioned earlier, securitization packages are often
structured to provide a credit enhancement to reduce the unknown risk. Even in
the Bowie Bonds deal, there was a form of credit enhancement because EMI (Bowie’s
distributor) provided “guaranteed payments and other structural enhancements.”[235]
The structure of the enhancement
can take many different forms. A common structure is bond insurance from a
so-called monoline insurer.[236] The
bonds issued in the Domino’s securitization were insured by MBIA Insurance
Corporation and Ambac Assurance Company, two of the most well-known monoline
insurers.[237]
But, as the S&P framework for
evaluating a securitization deal highlights, there are multiple means of
creating a structural enhancement, such as liquidity reserves and triggering
events.[238] The Dunkin’ Brands’ deal
contained a set of performance measures, a “cash trap” (a reserve account
mechanism), and an insurance policy.[239]
This credit enhancement can be
the make-or-break factor in an issuance because it determines the final cost of
capital. The bond house PIMCO explains it this way:
Typically, the
originator aims to obtain a credit rating on the ABS
that is higher than its own rating and will work with the rating agencies and
investment banks to provide enough credit enhancements to achieve that goal. A
higher credit rating can lower the yield on an ABS
and thus lower the originator’s cost of issuing the bonds.[240]
Arguably, no market entity has
played a more vital role in financially supporting business innovation than
venture capitalists (VCs). These investors have served to bridge the capital
gap between financial markets often hungry only for large proven winners or
established enterprises and entrepreneurs who are restrained by their own
limited capital resources and unproven track record. Venture capital was always
about intangibles. The venture capitalist generally infuses both financial
support and managerial expertise into businesses that have more potential than
physical assets. In other words, they invest in intangible assets such as ideas
or innovations to capture future profits from an enterprise value enhancement.
But, like the cliché states, VCs usually invest in people not ideas. Smart,
entrepreneurial people will make things happen, even if the original ideas
don’t pan out. Invention, human talent, technological advancement, and
proprietary advantage combine to describe the promise that venture capitalists
perceive when they place their money into these enterprises.
Venture capitalists rely on their
own unique valuation assessments to determine the worth and risk of an
investment. They are not as limited as loan, equity, and security markets that
must often define a market-prevalent perception of asset value to maintain
investment liquidity. The valuation schema employed by VCs often varies
depending on the background and preferences of the financier. Most will use cash-flow
models and projections to ascertain valuations, but the flexibility of the
capital resource allows venture capitalists to use internal metrics to also
capture perceived values within the enterprise as a whole. If they feel
comfortable with the viability of the enterprise in its entirety, they will
often subscribe higher valuation assessments on intangibles without
identifiable cash flows or market comparables. For instance, if a VC feels
strongly that innovative genetic research on prostrate cancer cells looks
promising for long-term profits, he/she may be willing to invest in a
relatively new start-up enterprise in that field that heretofore may not have
delivered profits or displayed distinct proprietary assets. The VC may feel
strongly enough about the management team and the talent of the research team
to invest in the intangible assets contained within the enterprise.
Venture capitalists take
advantage of the long-term benefits of leveraging the often-intangible
attributes of an operation to deliver impressive future returns on their
investment. They often incubate an enterprise’s potential until it delivers the
consistent cash flows necessary for recognition by other capital markets.
Consequently, venture capitalists provide a vital resource for monetizing
enterprise-specific intangible assets by incorporating their value into an
assessment of the overall potential of the enterprise.
The financial means of raising
capital must be aligned with investors willing to buy it. Thus, numerous
complimentary mechanisms must exist. The various options outlined above,
therefore, should not be viewed as either/or alternatives. Nor are they
completely separate activities; they are highly interrelated. For example,
securitization benefits greatly from a primary market in the asset. In fact,
one credit enhancement technique is a sales trigger, which requires the trustee
(holder of the asset) to sell the asset if the revenue stream drops below a
certain point. As Eisbruck explains:
If structured
properly, such a trigger can be hit before the value of the assets—which is
closely related to the revenue they generate—falls below the remaining bond
balance. At that point, the assets would be sold, and bondholders can be paid
off, albeit earlier than expected, without suffering a loss.[241]
Such a mechanism only works if
there is a market in the underlying asset. In the case of music portfolios,
there is an active market—which helped make the Bowie Bonds a viable financial
product.
