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Need to rely on non-traditional collateral growing

With the advent of the service economy and the growth of many computer-and technology-related companies, the demand for capital has been dramatic. In offering financing to these types of companies lenders and investors frequently are faced with the need to rely on non-traditional forms of collateral as security. Conversely, these types of businesses need to understand the perspective of the lender or investor.
These often are small start-up operations with few “hard” assets to offer as collateral. In fact, often their only valuable assets may be in the form of patents, copyrights, trademarks, trade secrets, semiconductor maskworks and other general intangibles. Their assets also may take the form of registered copyrights or licensing agreements related to software programs.
These types of intangible assets are referred to as “intellectual property” because they frequently represent an idea or representation, not a physical asset. The value associated with intellectual property most often is dependent upon the owner’s ability to restrict the use of such property or provide access to it under controlled conditions for appropriate compensation.
In order to structure a loan to or investment in a company the primary assets of which are intellectual property, care must be exercised in evaluating the collateral pool that will be available in the event of default and what value may be extracted from the security interest in the intellectual property rights. To this end, the lender or investor must satisfy itself that the company is the owner of the intellectual property or has been properly assigned the necessary ownership rights.
The lender or investor also must ascertain whether the intellectual property infringes on the rights of other third parties who may have superior rights in the intellectual property, and will want to know if the intellectual property meets the necessary statutory criteria to be valid and enforceable, and if rights to the intellectual property have been assigned or encumbered to third parties.
In addition, the financing source also must consider the stage of development of the technology, and its viability or marketability, particularly if the founder and/or key employees cease to continue to work on the given product or project. It will want to know if the technology is considerably more valuable than that provided by competitors or if the technology is in danger of becoming obsolete. And if the collateral is in the form of a patent, it will want to know the expiration date of the patent rights and not only the validity of the patent but the quality of the patent rights.
While intellectual property rights may include exclusionary rights that prevent others from using certain aspects of the technology, the intellectual property may be more valuable in the form of licensing rights which, instead of excluding use of the asset, permit others to use the technology for a licensing fee to use or produce products with the technology licensed.
Licensing fees frequently are the most significant economic rights associated with intellectual property assets. In evaluating licensing fees, the financing source also must take into account the impact of bankruptcy of the company’s licensees. If the company itself is a licensee, the lender or investor will want to evaluate the effect of bankruptcy of the licenser.
The financing source also needs to determine whether licensed intellectual property is assignable should the financing source wish to assign the rights in the event of the company’s default. Recently, particularly in the case of computer technology, lenders have insisted on the use of source-code escrows to hold all programming and related information to ensure the continued availability and access to intellectual property in the event of the bankruptcy of or default by the licenser.
Once a financing source has performed an evaluation of a prospective borrower’s intellectual property assets a host of other issues are presented. Those include identifying the manner in which a security interest in intellectual property assets may be perfected and, once perfected, identifying what substantive rights such perfection will confer in the event of default. Due to the inconsistent federal and state law overlap in certain forms of intellectual property, a secured lender or investor frequently runs the risk of having significantly less rights than initially imagined. For example, in a case involving the purchase of videotapes at a foreclosure sale, the purchaser acquired the tapes themselves but failed to acquire the rights in the copyrights for the videotapes and was therefore prohibited from broadcasting them.
Generally speaking, security interests in patents, copyrights and semiconductor maskworks are governed exclusively by federal law and therefore require appropriate filings to be made with the Patent and Trademark Office. However, security interests in trademarks are governed by both state and federal law requiring filing under the applicable state Uniform Commercial Code as well as with the PTO. Finally, trade secrets are governed exclusively by state law and the UCC.
The landscape is littered with court cases in which lenders or investors either failed to file with the PTO, or in the alternative, filed solely in accordance with the state UCC provisions only to find out that such filings were inadequate or inappropriate for the type of collateral involved. Consequently, it is essential in the case of any intellectual property financing transaction that the financing source ensure that the collateral is properly identified and the applicable filing procedure is followed.
With respect to a loan or investment secured by intellectual property, once the financing is closed and the appropriate perfection steps have been taken, the lender or investor must continue to update filings in the event additional intellectual property is developed subject to its lien. In addition, particularly with respect to trade secrets, the lender or investor will want to assure itself that the company adopt appropriate policies and procedures with respect to non-disclosure of trade-secret information by employees.
Where necessary, the lender or investor may need to pursue infringement actions with respect to intellectual property assigned to it to protect both its security interest in the intellectual property and that of the company. Ongoing monitoring and representations and warranties also are critical to ensure that the company is meeting its obligations under any licensing and/or servicing agreements to prevent the disruption of licensing income.
The use of intellectual property as collateral will undoubtedly increase as growth industries are increasingly technology-oriented. As a result, lenders and investors must become familiar with the novel issues that intellectual property collateral poses so as to properly value the intellectual property rights and, once valued, take the appropriate measures to protect these rights vis-a-vis third-party claims.
(Justin P. Doyle is a partner with Nixon, Hargrave, Devans & Doyle LLP. His colleague, Bob Roth, assisted with this article.)

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