A new place to find security
When considering whether to grant credit to a business, it’s always important to understand how “substantial” it is. Assessments traditionally start with an examination of cash flow and the contents of the balance sheet. However, if the question is security, it is clear that balance sheets provide an imperfect answer at best.
This is because the assets which are principally responsible for value generation (in terms of turnover or shareholder value) are now mostly intangible. They are generally not represented on the balance sheet at all, and where they do appear, it is on a cost basis – a fairly poor predictor of the contribution they make to the company in question.
A growing need for solutions
This problem has been growing for some time, but the uncertain value of many tangible assets has exacerbated the need for new forms of security, especially types that are better attuned to knowledge-based companies. From this viewpoint, the quantum of value now residing in intangible assets makes them the obvious place to look.
The EU recently observed that three-quarters of the value of quoted companies is now not underpinned by tangible balance sheet assets. This is in line with long-term analysis of the S&P500 in the US by Ocean Tomo, which shows that the average “implied intangible asset value” – in other words, book value as a proportion of market value – has grown from 17% in 1975 to 80% in 2010. Here in the UK, Government statistics on business investment show that intangibles outstrip tangibles by about one-third – totalling £143bn per annum.
Even where intangibles are shown in a company’s accounts, traditional lending practice has attributed zero value to them. When credit conditions toughen, this creates a real problem for solid, knowledge-based SMEs, and the most recent ONS survey data on lending activity (released in October 2011) seem to reflect this. These show that demand for bank lending among ICT businesses grew between 2007 and 2010, but approval rates fell from 85% to just 45%. The picture for service businesses is little better, with loan approval rates falling from 84% to 61%, and of overdrafts from 94% to just 26%.
Interestingly, over the same period, the ONS statistics also indicate that demand for leasing and factoring fell a little in the services sector (it remained fairly level among ICT companies) but that approval rates held up much better than bank lending. This may reflect the fact that when specified assets are involved, it is easier for businesses to find the money they need. It also suggests that there is a substantial opportunity going untapped.
Getting to grips with intangibles
Credit grantors face three main challenges when trying to leverage intangible assets as security. The first is determining what they are; the second is deriving an appropriate valuation for them; the third is in determining what to do with them at the end of the fixed term, or if the company which owns them gets into difficulties in the meantime. Some of the solutions being adopted are highlighted separately.
Once they can be properly harnessed, intangible assets have a number of strong potential attractions in the credit context, especially when dealing with knowledge-based businesses which typically own, and therefore require, very few tangible assets.
The first is that these assets are not replaceable commodities, but integral to the company’s offering and its existence. This provides a strong incentive for repayment – in the event of default, a business cannot simply acquire a fresh set of intangibles.
When a business prospers, its intangibles appreciate in value (rather like tangible property is supposed to do). Should the company fare less well, many of these assets still have considerable value even in a forced sale context; trade marks, designs, proprietary processes and service formats, and crucially customer and supplier contracts and intelligence, can all be sold, and their uniqueness can sometimes make them more valuable, not less.
Also, these intangibles are generally available - they are often not properly secured by any creditor, which is why they tend to re-surface after companies cease trading (often in the hands of the original proprietor). But banks, and even pension funds, are increasingly realising that they need to get involved with this valuable form of collateral, before someone else gets there first.
New times, new solutions
Tangible assets have been creatively used for finance since the industrial age, when the key determinant of business success was the ability to produce goods by multiplying manpower. But in the knowledge economy, competitive advantage is about offering something unique and distinctive, involving multiplication of brainpower, not brawn. Funding approaches need to recognise that the seat of value has shifted.
The US-based Athena Alliance has put it rather neatly: “Just as physical assets were used to finance creation of more physical assets during the industrial age, intangible assets should be used to finance creation of more intangible assets in the information age.” While dealing with intangible assets represents unfamiliar territory for many in the credit management field, it is a skill set that seems well worth acquiring, if lenders want to get close to the real seat of value in today’s growing businesses.
Inngot provides web-based tools to companies, lenders, investors and other organisations looking to leverage the value “hidden” in a company’s intangibles. These include the Sollomon indicative valuation system, created by Inngot with specialist input from Grant Thornton UK LLP. For further information, see www.inngot.com.
How do you pin down intangibles?
Most of the intangible assets companies own have been created by them, usually not with the idea of selling or licensing them. Before they can be used for any kind of transaction, the company first has to “commodify” them by means of description and documentation. Once this is done, the assets can be leveraged in a wide variety of ways: specifically, they can be brought within the scope of a fixed charge rather than a floating one (the latter is unlikely to be effective when assets are being used every day in the ordinary course of business).
Inngot views intangibles as falling into five distinct types. The two that are easiest to define are registered rights (patents, trade marks, registered designs) and copyright (not registered, but within the scope of IP law). These can all be freely transferred and assigned, but in themselves, may not constitute a complete “bundle” from which value can be realised.
Other intangibles are either i) resource/relationship assets (contractual and informal agreements, and the specialist technical know-how a business owns), ii) product/service assets (trade secrets, proprietary processes and other assets that are embedded within what a business does), or iii) approvals and endorsements (such as awards, approvals, market leadership and reputation).
Of these three groups, the first is already recognised by lenders as being critical in risk assessment. For a comprehensive approach, though, all five types need to be identified and considered.
Valuing intangibles
Traditionally, valuation of intangibles has been the province of specialist accounting practices, costing several thousand pounds at a time. This may be acceptable in the context of large equity transactions, but effectively precludes consideration of IP value as part of a credit assessment process.
Developed with the assistance of Grant Thornton UK LLP, and known as Sollomon, Inngot’s online valuation tool aims to address this cost barrier. It uses a “relief from royalty” mechanism to estimate the worth of a given set of intangibles. Grant Thornton’s partner for valuations, Mike Thornton, explains: "We were interested in working with Inngot because we know that many businesses are considering ways to derive greater financial benefit from their intangible assets. While a value indication of this nature cannot replicate individual expert analysis, it provides a consistent starting point for discussions."
One of the lenders taking an interest in this area is PNC Business Credit, which has recently been looking at intangibles in order to get a better understanding of off-balance sheet values. In the course of this activity, it has run some of its existing portfolio through Inngot’s IP valuation tool. Senior Manager for Risk & Operations, Danny Harrison, comments: “We know that there is value in many of our existing client companies that is closely linked to brands and other intangibles. As our portfolio expands, it’s helpful to develop ways of assessing this value and re-visiting it periodically.”
Ways to harness intangibles When deciding which intangibles are suitable for finance, their relationship to current revenue streams is a key consideration. If a set of intellectual property is clearly linked to ongoing incomes, then taking an interest in it can give a lender important additional protection.
One organisation which has already lent successfully against intangible assets is independent finance provider Syscap. Having been active in technology financing for many years, it has on a few occasions bought the copyright in the code belonging to software companies. This can then continue to be used by the business as usual under an exclusive license arrangement, in exchange for monthly repayments. As CEO Philip White explains, “This gives the company an opportunity to realise the value of their development investment. The cash injection it provides can be used to update software or invest in business growth.” |
Meet the team
Indycube VenturesIndycube Ventures offers funding and expert advice to entrepreneurs. Entrepreneurs and small-business owners based at coworking space network Indycube are being offered access to a half-million-pound annual funding stream and expert advice.
Mentoring"We have benefited greatly from David's experience, counsel and contacts on a wide range of issues. His past experience in the IP space is particularly useful to Inngot, but even without that, he is just the sort of investor and non-executive director a high growth business needs. He sees potential, makes connections, and keeps us focused on the things that matter."Martin Brassell, CEO, Inngot Ltd |
