Corporate Clips

SECURITY - WHAT ARE YOUR INTANGIBLES REALLY WORTH?

August 2003

With equity markets remaining tight, companies have increasingly been turning to debt for finance. As ever, before making a loan, a finance provider will undertake due diligence on a company’s asset base to determine if there exists suitable collateral for secured lending purposes. For companies across all industry sectors the collateral available will include their intangible assets [1] .

Intangibles are a significant part of any company’s asset base. Any supply side enterprise will have goodwill and trademarks in relation to its brand, copyright in its marketing materials, database rights in its customer lists and rights of confidence in relation to its know how [2] . An intangible can be a company’s most valuable asset: in BusinessWeek recently, Interbrand included the Coca-Cola ® brand in its table of “The World’s 10 Most Valuable Brands” at a value of US$69.6 billion.

If intangible assets are a substantial part of the collateral to be offered, two of the key challenges for a company will be: (i) their valuation [3] ; and (ii) satisfying the finance provider that effective security can be taken over such assets.

Valuation itself is an art more than a science and will involve a number of disciplines including law, accounting and finance and a consideration of industry/sector norms. The difficulties in undertaking a valuation have, traditionally, been compounded by scepticism as to whether intangible assets can be reliably valued. In essence, the value of an intangible asset will bring together the legal concept of rights and the economic concept of value.

Set out below is a ‘route map’ for any company thinking about undertaking this exercise.

STAGE 1: IDENTIFICATION

The first step will be to identify the intangible assets owned and used by the business (and the nature of the ownership interest or right). Legally, this process is complicated by the fact each asset has its own peculiarities. Certain intellectual property rights need to be registered (e.g. patents), others are creatures of law, not statute (e.g. rights of confidence) and their lifetimes vary [4] .

Given these peculiarities, in identifying the intangible assets, it is helpful to split them into two groups, registered rights (e.g. patents) and unregistered rights (e.g. copyright). A further group will be the rights used under a licence from a third party.

As positive steps are required to acquire registered rights, accurate information should be available on them including as to their ownership, geographical spread, term and the existence of any third party interest. This exercise can be supplemented by third party searches.

Identifying unregistered rights is likely to be more problematic as no positive steps are required to create them. Parsing out the ownership interests in a copyright work can be complex: copyright is itself a bundle of rights, including the rights to copy, adapt, distribute, etc and each of these rights can in many instances be dealt with – by licensing or outright assignment – separately. In the case of a song for example, separate copyrights will subsist in the music (composer), lyrics (author), music as published (publisher) and the recording (record company) of the song. In the case of computer software, the software itself attracts copyright as a literary work, and there will be separate copyrights in the technical and user documentation; using the software to create further works gives rise to yet further copyrights. The movie, broadcasting, publishing and interactive industries all have their own increasingly complex sector specific patterns and practices about copyright ownership.

STAGE 2: ANALYSIS

Once the rights owned and used by the business have been identified, they will need to be evaluated against a series of questions including the term, nature and scope of the rights (e.g. do they provide a monopoly (e.g. a patent), is the registration sufficiently wide), whether there exist aspects which might affect the validity of the rights (e.g. a failure to pay registration fees), the extent to which there are third party interests and if there have been any challenges or infringements of the rights and, if so, an analysis of how these have been prosecuted by the company.

If an intangible asset is used under licence, sensitivities include the ability to assign (transfer outright) it, the scope of the licence and (in the current market) the solvency risk in respect of the counterparty (e.g. insolvency is likely to lead to failure to provide required support and the risk of the licence being disclaimed by a liquidator).

STAGE 3: VALUATION AND NATURE OF THE SECURITY INTEREST

Once stage 2 and an economic valuation have completed, a value will be given to the intangible assets. As a practical matter, the valuation given by a finance provider is likely to be significantly lower than the company’s valuation as it will build into its valuation model an assumption there will be a default in repayment of the loan.

Linked to the valuation will be an analysis of whether the intangible assets are capable of forming the subject matter of an effective security interest and, if so, the nature of this interest. Legally, with the exception of know how (which is not the type of right which gives a good basis for security on its own), a stand alone

security interest can be taken over most intangibles. The effectiveness of the security will depend on the legal form of security offered and whether the intangible asset in question can be independently exploited or sold post default.

By way of example, if security is to be taken over a patent or trademark the ‘safest’ form of security interest that may be taken is a legal mortgage (which will involve a transfer of ownership to the finance provider with an exclusive licence back to the company). The upside of a legal mortgage for the finance provider is the fact that title is obtained from the outset and that it will be able to police enforcement; the downside being its potential exposure to an infringement action and ensuring registration fees are paid.

Similarly, the finance provider will need to satisfy itself that, post default, the asset can be independently exploited (e.g. by licensing it to a third party) or sold. This can be particularly problematic if the subject matter of the security interest is a trademark of the company’s name as it may prove difficult to resell or licence it to a third party.

Intangible assets now play an important role in providing collateral and can affect a borrower’s financial profile for lending purposes. Any company offering its intangible asset base as a substantial part of the collateral should be sensitive to the requirements of the finance provider and the due diligence that will be undertaken to determine its value and suitability for secured lending purposes. Careful management of such assets can increase the attractiveness of a company to a finance provider and reduce the cost of the due diligence process.

Charles Claisse

[1] A company’s intangible assets will comprise intellectual property rights such as copyright, patents, trademarks, designs, database rights and trade secrets and related rights such as goodwill. This Short Lines focuses on intellectual property rights.

[2] There are also sector specific rights e.g. a technology or pharmaceutical company may have patent protection in respect of their products.

[3] The valuation may have a knock on effect for the company on the price of its equity, balance sheet recognition of its intangible assets and risk management.

[4] A UK patent has a lifetime of 20 years whereas copyright, typically, has a lifetime of 70 years from the death of the author.