Sale and Leaseback – a model for increasing trust in IP assets?

WTR

We are pleased to reprint a copy of an article in the August 2016 edition of World Trademark Review authored by Stephen Robertson – Sale and leaseback – Stephen Robertson – Online Version – WTR 62.docx.pdf.

Placing a tangible financial value on a brand and then leveraging that value remains a frustratingly opaque process. However, the creation of secondary markets to sell IP assets has encouraged lenders to look more closely at this asset class. 

The power and value of a brand are rarely contested; in fact, brands are often considered to be a business’ most valuable IP asset. However, a brand’s financial value is often hard to quantify – the process of providing a brand with a tangible financial value and then leveraging that value remains frustratingly opaque. Under internationally recognised accounting rules, a company cannot value its own internally generated brand and capitalise it on its own balance sheet. The only way to Sale and leaseback – Stephen Robertson – Online Version – WTR 62.docxput a brand on a balance sheet and have its value recognised is through a transaction; in other words, through selling the brand from the trading business that owns and uses it (TradeCo) to a separate company, such as a holding company or special purpose vehicle (SPV).TradeCo can then license back use of the IP assets it has just sold from the SPV, as in a traditional sale and leaseback arrangement.

“Brands are often considered to be a business’ most valuable IP asset.”

Brands as secured assets

“Absence of IP assets on the balance sheet means that they have been overlooked by lenders.”

Balance-sheet assets are typically secured by lenders in relation to borrowings. It is therefore no surprise that the absence of IP assets (including brands) on the balance sheet has meant that these have been overlooked by lenders. Further contributing to the disregard of IP assets as bank security are the perceived difficulties in taking security or control over IP assets and then realising value from them in the event of default.

However, the creation of secondary markets to sell IP assets – as well as evidence of a more active market for the sale of IP assets in insolvency situations – has encouraged lenders to look more closely at this asset class. In the current market, lenders are seeking ways to improve their security in transactions where they feel they need additional asset cover – either for the level of lending on offer or where they want additional security in order to competitively price the proposed lending facilities at a lower margin.

While this article does not cover the legal points of taking security over IP assets, it should be pointed out that it is more straightforward for a lender to take security over registered IP assets – such as patents, trademarks and registered designs – than unregistered IP assets, such as software or trade secrets.

Valuation of brands

One of the key issues to consider is the value of the IP assets in question, in particular brands. Much has been written about the different methods of valuing IP assets, which can take into account:

  • the current value of the brand (based on current trading or income);
  • the future value of the brand (based on financial forecasts); or
  • the value to another party (e.g., a special purchaser which might have a large global footprint and distribution chain through which it can sell the branded products or services).

All three of these valuation methods will provide different results, which highlights why agreeing on a value for a brand is such a challenge.

Valaution

Control of brands by secured creditors

In addition to uncertainty over the proper valuation methodology, another main issue in relation to leveraging brand value is how to exercise control or security over the brand. A bank might take security over the registered trademarks and include a number of conditions in a facility letter, including conditions:

  • requiring TradeCo to keep trademark renewals up to date;
  • requiring any new trademark filings to be automatically added to the security;
  • preventing TradeCo from disposing of the trademarks in certain territories without the bank’s permission; and
  • preventing TradeCo from further encumbering the trademarks (ie, by licensing use of the marks to third parties).

The challenge for the bank is to ensure that these conditions are being met and fulfilled on an ongoing basis.

Further, if the bank wants to enforce its security, the available remedies are not straightforward. Lenders will need to seek specialist assistance to help them understand the extent of the IP assets that were secured and changed during the term of the loan, including whether goodwill was bundled in with the brand.

Sale and leaseback arrangements

Sale and leaseback arrangements are one way to get around some of these issues. They provide clarity, transparency and accountability, and clearly demonstrate the link between the secured assets and the ability of those assets to contribute to revenue generation. This is particularly important when a relief from royalty-based valuation method is being considered.

It is important to recognise that different royalty rates can be applied to the same brand (in different markets), in recognition of the price premiums (and contribution to margin) that a brand name offers to different products in different markets. This is why a sale and leaseback arrangement is often more appropriate when there are multiple revenue streams in different markets or products. This concept is not new – for years, larger global corporates have been creating central IP holding company structures which then license the intellectual property to group companies through internal licensing arrangements. Often this company is incorporated in an offshore jurisdiction. There are well-known examples of brand holding companies being used by Shell, HMV and Nestlé, to name but a few. The efficiencies of centralising internal licensing structures for global companies are well documented – they focus on controlling the use, development and protection of the brand.

“Sale and leaseback arrangements provide clarity, transparency and accountability.”

“IP assets which are owned by TradeCo must be valued in order to support their sale or transfer to the SPV.”

In simple terms, a sale and leaseback works as follows: the IP assets which are owned by TradeCo must be valued in order to support their sale or transfer to the SPV. Following valuation, the transaction takes place. This provides the bank with a clean company – the SPV – over which it can take security and get comfort from proper enforceable controls. This means that the sale and leaseback gives both the SPV and the bank (as it has security and an interest in the brand being licensed back) comfort and control, such as reporting of sales, payment of royalties, minimum royalty payments and ongoing use of the brand and goodwill relating to the brand.

One key matter to be considered is a buyback clause, which may be needed for TradeCo in the event that a buyer emerges and wants to secure the IP rights as part of the acquisition. Normally a pre-agreed structure or valuation mechanism is in place to facilitate such a buy-back arrangement. This often forms part of the licence agreement.

This type of sale and leaseback structure also overcomes another challenge for banks and lenders – their lack of visibility over what constitutes IP assets. Currently, any bank which takes security over IP assets through a floating charge probably does not know on a month-to-month basis whether those assets still exist or have lapsed, been sold or been transferred to another company. It is impossible to know without having specific security over those assets and getting regular updates from TradeCo.

SPVs and controls

Having the IP assets valued and sold to an SPV will give the bank a clearer idea about which assets it now has security over (particularly if it is seeking the security of additional assets beyond any relevant trademarks). The bank has more control because these assets are held in an SPV, whose sole purpose is to act as an IP holding company and generate licence revenues or income from these IP assets. It also means that the SPV has control over certain factors which will underpin the ongoing value of the security, such as the maintenance and protection of the IP assets. When IP assets are retained by TradeCo and it gets into financial difficulties, any associated maintenance or IP asset protection measures are often seen as non-essential costs, which the company might be unable or unwilling to afford. This means that these often go unpaid, undermining the value of the assets as a consequence. A TradeCo in financial difficulty might not be keen to spend money defending itself against infringers or renewing registered trademarks. However, this would be less likely to happen if the assets resided in a separate SPV which was funded through royalty payments.

The SPV structure also means that the bank will have a better understanding of trading challenges which might affect the brand’s value. If TradeCo gets into financial difficulties and certain products or services experience a slowdown in revenues – which translates into a reduction in associated royalty payments – then the bank will have a better understanding of the situation through quarterly licence reporting and be able to monitor it more closely. This is particularly important if the business is, for example, a conglomerate with different business interests and the brand is a lifestyle brand used in multiple sectors (eg, food and drink, financial services and travel), each of which might be experiencing different trading performances. It is important that the link be maintained between the IP assets and the revenues that they help to generate and any material and sustained changes in those revenues.

Role of licence agreements

The licence agreement should make clear which trademarks are used in which sectors (via registration in appropriate trademark classes), as well as the corresponding and often differing royalty rates which provide the bank or lender with more information on the business’s trading performance and the result of the licensee’s royalty payment and reporting obligations under the licence agreement. The bank will have more influence through this structure, as failure by TradeCo’s management to comply with disclosures under the licence agreement could result in the licence being suspended or terminated. This is a real and powerful sanction which the bank or lender can get behind. Imagine an SPV telling TradeCo that it can no longer use its brand in a particular market (eg, food and drink), or even all of its relevant markets, until it has complied with the terms of the licence.

A licence agreement provides a lender with more flexibility with regard to the terms of the licence, including royalty rates, accrual of goodwill, buyback provisions and IP enforcement rights. It is critical to ensure that such agreements are properly drafted and cover not only the trademark itself, but also any goodwill which accrues through use of the mark. Any accumulated goodwill will increase the value of the trademark and provide greater collateral should the lender to the SPV be forced to sell the mark in the event of default.

Via a sale and leaseback, the borrower (TradeCo) will be paying a regular or monthly royalty rate for the right to use its corporate or product trademarks. This licence agreement will provide the lender to the SPV with a steady income stream linked to sales revenues rather than on a fixed repayment basis (minimum royalties). Loan payment default is less likely if the loan is linked directly to the regular or monthly royalty payments from TradeCo, which are subject to penalties under the licence if not paid.

Lender’s position is improved

The SPV structure offers more options for recovery in the event of default under the licence agreement by a TradeCo which might be experiencing financial difficulties. If the bank is a lender to the TradeCo, then in theory it would have to realise its security through some form of insolvency event before it could begin to protect its interest in the value of the brand or IP assets being secured. However, an SPV structure strengthens the bank’s recovery position, ring-fencing it from the trading business. The value in the secured asset in the SPV stays intact and separate from the impact of any decline in the trading business. While this does not mean that the value will remain unchanged, any damage resulting from the TradeCo’s decline in revenues or insolvency will have less impact on the brand’s value in the SPV.

Most importantly, an SPV structure provides the lender to the SPV with many more options which are under its control and not driven by the insolvency process. The lender has control over the intellectual property and can appoint someone to look for new licensees or sell the brand outright.

Loan repayment

The SPV structure gives the bank or lender to the SPV more opportunity for early repayment, on the basis that if sales or revenues in TradeCo increase, there will be a corresponding increase in the royalty payments to the SPV, allowing it to pay down the debt quicker.

This may also prove more feasible for the borrower itself, as the royalty rates will be linked to sales of the relevant product, thereby linking repayment to the company’s success. Giving the borrower more flexibility with regard to repaying the loan according to its means or cash flow may lead to lower rates of default.

Case study: musical instrument business

As an example, take a company which manufactures musical instruments. The business and its brand are well known, having operated in the sector for 25 years. However, in the last few years it has had to change its business model to compete with cheaper imports from overseas. Increasing manufacturing costs in the United Kingdom compounded this problem, so the business moved its manufacturing operations offshore to Asia. As a result, its business model and turnover changed, dropping to around £4 million.

Music business

The business ended up in financial difficulties and eventually went into administration. Management bought it out of administration, but could not afford the asking price and so took on £1 million of debt, which it owed to Bank A.

A few years later, it was in trouble again as a result of further financial difficulties due to a continued downturn in the market. Bank A was still owed £1 million plus working capital of between £300,000 and £400,000, and was not prepared to offer any more support. The company had unfulfilled orders, as it could not afford to pay the suppliers which had stock ready to ship.

Its most valuable asset was its brand, which was well known globally in the niche market. However, the company (TradeCo) had failed to pay some trademark renewal fees because of its cash-flow problems. The brand was valued at approximately £250,000 (an impaired value) and sold to an IP company (SPV).

Bank A then transferred the £1 million debt to the SPV from TradeCo – on the basis that it could then get its money back over five years from royalty income received by the SPV from TradeCo. Doing this also improved TradeCo’s balance sheet (by removing the £1 million debt).

A new bank, Bank B, refinanced the TradeCo offering the company additional working capital, allowing it to pay its suppliers and unlock the order book – Bank B took security over the usual assets, such as stock and debtors. As a result, the original lender, Bank A, had its working capital facility repaid and now had a clear line of sight towards having the £1 million debt repaid directly by the SPV, as a result of royalties being paid by the TradeCo.

As it happened, around six months later a private investor entered the scenario and bought out Bank A’s debt in the SPV, as he knew the brand and business and saw this as an interesting investment opportunity, based on the cash flow of the royalty stream being paid by TradeCo.

SHARE THIS PAGE VIA: Share on LinkedInTweet about this on TwitterShare on FacebookShare on Google+Pin on PinterestEmail this to someoneDigg thisBuffer this pageShare on RedditShare on Tumblr