Smarts Money

Date:  Sat, 2000-01-01

By: Phaedra Hise Inc. Magazine January 1, 2000

Most banks give the cold shoulder to companies that have little more than a patent or a trademark to their names. A new company that assigns dollar figures to intellectual property could change that.

David New wasn’t asking for much: just a little bump to keep his root-beer company breathing until he could tweak the packaging and solidify regional distribution. He figured $50,000 would do the trick.

That was in 1997, three years after New had launched Roadside Beverage with $5,000 borrowed from family and friends and another $20,000 kicked in by a partner. He had tinkered with the soda’s formula in his kitchen until he perfected it and had signed contracts with outside bottlers. Now he needed the cash to take his start-up to the next level. But the venture capitalists dismissed his request as small potatoes. Just as well, figured New. (“You can never get rid of those guys.”) That left debt as the entrepreneur’s best option. Unfortunately, the dozen or so banks he approached didn’t bite. “They kept saying, ‘Nice business plan, but you don’t have any assets,'” New recalls.

But the banks were wrong. New did have an asset — albeit one he himself didn’t recognize. His golden ticket was the trademark “Root 66” on each bottle of his soft drink.

The potential value of “Root 66” was explained to New by David Martin, whose brother New had become acquainted with after a chance meeting in a coffee shop. Martin came by his expertise as CEO and founder of $3.2-million Mosaic Technologies, which like Roadside Beverage is based in Charlottesville, Va. Mosaic manages R&D projects for corporate and university labs and then commercializes the results, taking its share in equity or royalties. Pricing is relatively straightforward, since the customers for Mosaic’s “products” — patents, formulas, software code, even trademarks — are generally large corporations well versed in the value of their industries’ advancements. A biomedical company licensing the patent for a new medical device, for example, can make a pretty good guess at how much that particular piece of intellectual property will pay off over time.

But listening to New’s tale of rejection, Martin realized that such intangible assets don’t mean much to the lending community. Banks almost never weigh intellectual capital when considering loan applications, because lacking an intimate understanding of all the markets for such properties, they can’t assess their value. Yet start-ups, particularly high-tech start-ups, often have little to their name but a few thousand lines of ingenious code. Martin figured that if he could slap the same kind of dollar figures on patents, trademarks, and formulas that are routinely placed on real estate, revenues, and machinery, the banks would eat it up. Moreover, small businesses would have a better shot at getting the money they needed to grow.

What Martin envisioned was software that would place a dollar figure on a piece of intellectual property and then continue to recalculate that figure throughout the property’s lifetime. He spent the next four months developing such a program, drawing on expertise gained during his brief stint as an insurance-company actuary and from his graduate work in statistics. The product, First Dollar, was finished in January 1998. That same month Martin spun off a new company, which he called M·CAM, to market its services, and signed several small banks in Virginia as beta test sites.

Bankers and investors who have seen the product and understand Martin’s vision call it nothing sort of revolutionary. “This will potentially have a profound effect on the economy, banking, balance sheets, and how assets can be valued,” says Carlyle Eckstein, director of Next Generation Capital, a venture-capital fund in Fairfax, Va. “You’re creating value where the accounting profession has tried to insist there’s no value for years. Say the asset value of all of corporate America is $15 trillion. What would it be if you factored in intellectual property? Add 50%?”

A mechanism for quantifying intellectual capital could set off economic shock waves if whole niches of businesses that banks have ignored were suddenly to get financing, according to Dennis Ackerman, director of the Bank of America Entrepreneurial Center at Old Dominion University, in Norfolk, Va. “This changes the whole paradigm of how you look at corporate wealth, at national wealth,” says Ackerman. “I’ve never heard of any financial idea as big as this.”

M·CAM’s founder accepts the praise but insists that he was surprised by how swift and enthusiastic the reaction to the start-up was. “It’s a great idea, but I didn’t realize there was this much pent-up demand,” he says.

On a sunny day in August, David Martin is sitting in the conference room of a century-old brick building overlooking Charlottesville’s pedestrian mall, a cobblestone avenue framed by antiques shops and trendy restaurants. The building also houses Mosaic, but M·CAM, now a separate company, is quickly outgrowing its parent. That growth will likely continue, judging by the dozens of phone calls Martin has fielded from large U.S. and Asian banks.

With his natty suspenders and silver-rimmed glasses, Martin looks like the professor he once was. The 32-year-old earned his Ph.D. in sports medicine in 1995 from the University of Virginia, where he also taught radiology and orthopedic surgery. But the entrepreneurial urge was strong in him: while still studying for his master’s Martin began doing consulting work for large international companies interested in commercializing medical technology. In 1995 he incorporated as Mosaic, and within two years his consulting income had surged to five times his academic earnings, a state of affairs that scandalized his tweedy peers. So in 1997 he fled the ivory tower for a riskier business: specifically, the business of risk. “Risk is a funny thing,” says Martin. “It’s a business opportunity if you can model it, and a liability if you can’t. The insurance industry is proof that risk management is one of the most lucrative businesses anyone can be in.”

M·CAM itself is a strange hybrid of insurer, investor, and technology marketer, with the third role kicking in only if a borrower tanks. Here’s how it works: Each time a bank considers an intellectual-property-based loan, it pays M·CAM to run information on that asset through its proprietary software. M·CAM’s approach resembles the methods insurance companies use to predict how many of the houses they cover will burn down in the coming year. It compares 234 pieces of data about the borrower and its asset with aggregate data on market changes and comparable companies. M·CAM then uses those results to produce depreciation schedules that show, for example, how the value of a software program declines based on projected competition and obsolescence. “A long time ago people thought mortgages were discrete things — that you couldn’t model the risk on the aggregate,” Martin explains. “But now you can get mortgage insurance. That’s what we’ve done here.”

Once M·CAM has assigned a dollar value to the asset, the bank decides whether or not to grant the loan, and what percentage of the value’s asset to lend. In the case of a thumbs-up, M·CAM then guarantees that if the borrower defaults, it will purchase the property from the bank. Under those circumstances, M·CAM assumes control of the intellectual property, which it tries to sell into secondary markets untapped by the company that developed it. The property is all that remains in play. M·CAM slices the borrower’s management team — the wildest card in the pack — right out of the equation. “Our premise is to look at intellectual property not as a basis for a business but simply as an asset,” Martin says.

Since M·CAM may eventually try to succeed where the borrower has failed, the borrower never sees the evaluation process. “Then they’d be asking us how we plan to liquidate their assets, and they might try to do it themselves first if they got into trouble,” Martin says. “The chance of them screwing that up is high.”

What prevents M·CAM from screwing it up is the extraordinary tabs the company keeps on each asset during the life of the loan. Fluctuations in value are judged by constantly studying new applications and potential new markets. In the past a few lenders that worked with software companies have tried holding borrowers’ source code in escrow as collateral, but those efforts generally failed because the lender lacked the knowledge and imagination to exploit the code. “Venture capital has not been successful at technology licensing,” says John Jarve, a general partner and managing director at Menlo Ventures, in Menlo Park, Calif. “We make our money through big winners, so if a company does poorly, we generally spend our time on another deal that will have more return to investors, instead of getting back half a million on licensing.”

But as Martin points out, intellectual property “can be licensed, sold, commercialized, any number of things,” possibly all at the same time. Every quarter M·CAM runs new calculations to determine how all the assets it is backing will perform in every conceivable market, and shares the updated value information with the banks. To ensure that all possible stones are turned, a four-member team evaluates each asset, bringing to bear a wealth of experience in commercial lending, corporate funding, technology litigation, and sales and marketing. Martin also consults with Mosaic employees who are adept at envisioning new tricks for old dogs.

Although Martin claims he can make money on bank fees alone, the big profits will come from successful fire sales. M·CAM expects to generate 80% of its revenues from seized assets; margins, the founder says, will be as high as 60%. And if Martin’s experience selling and licensing intellectual property for Mosaic is anything to judge by, marketing those assets should earn M·CAM 170% more than it pays out to banks in foreclosures. Early last fall the company was finding new homes for more than 75 pieces of intellectual capital, and Martin expects that number to grow to about 150 by the end of this month.

Clearly, M·CAM flies only if it can guarantee hundreds of millions of dollars in loans. The company, financially backed by Martin and Mosaic, must set up the same kind of contingency fund that insurers have: essentially a pile of money that just sits there waiting to buy out loans while earning little for investors. Martin is currently talking with large insurance companies about strategic partnerships in which M·CAM would use their funds to guarantee its loans in return for a piece of the resale action, and his banking contacts are introducing him to other potential partners.

The lack of a contingency fund is the only thing standing between M·CAM and several substantial customers. After presenting a talk at a Small Business Administration conference last spring, Martin began fielding calls from leading high-technology lenders, including Silicon Valley Bank, Imperial Bank, and Japan’s Sakura Bank. “The most proactive banks want to become as familiar as they can with the product and do a little with the few guarantees they can get,” says Bank of America’s Ackerman. “But until there’s a large guarantee pool, banks can’t go out and make loans based on the product to a lot of customers.” Ackerman says Bank of America, for one, is “very interested” in working with M·CAM once the fund is in place, something Martin expects to happen this summer. Meanwhile, he’s doing deals ranging from $250,000 to $1.5 million with small regional and community banks such as Citizens & Farmers Bank in Williamsburg, Va.

Unfortunately, M·CAM wasn’t around to help Roadside Beverage, the company that gave Martin the idea in the first place. But Martin went to bat for New anyway. Flashing his intellectual-capital credentials, M·CAM’s founder assured a local bank that the “Root 66” trademark was worth more than the $50,000 New had requested. Martin’s guarantee that he would pay off the bank in return for that trademark won Roadside Beverage’s founder a loan of $300,000.

Thanks to Martin’s faith in the power of trademarks, New is now able to use his loan for operating capital and sit on his equity until he needs it for strategic moves or expansion. Just as important, he can devote his time to managing the company instead of dancing for investors. “We’re in a nice position because if it takes a while to find the right investment relationship, we don’t have to stop,” he says. “We have enough capital to keep moving.”

Phaedra Hise is a freelance journalist and author living in Richmond, Va.

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The Formula: How M·CAM Gets Its Numbers

M·CAM’s methodology for affixing hard numbers to soft ideas is a complex amalgam of human-envisioned possibility and technologically calculated risk. Let’s say that a start-up called BioPlant has developed a gel that preserves donated organs for transplants. The company applies to its bank for a loan, and the bank turns to M·CAM, which embarks on a three-stage evaluation process.

Stage 1: The bank pays M·CAM $5,000 to evaluate BioPlant’s plans for the gel. First, M·CAM considers whether the asset (the gel formula) is owned or merely licensed. Second, it evaluates the product’s life cycle, using actuarial tables that it has built for each industry. Third, it rates the litigiousness of the industry, drawing on corporate lawsuits and settlements. Fourth, it uses a database to produce a “Transplant Survival Index” that determines how reliant the gel’s success is on the company’s management team and key suppliers. M·CAM then issues a report recommending for or against the loan.

Stage 2: The bank pays M·CAM points (similar to those on a mortgage) to calculate how much the gel is worth in the organ-donation market. At this point M·CAM’s staffers gather data about BioPlant’s direct and indirect competitors that include sales, profits, and market shares. The assembled information is then keyed in to M·CAM’s software, which spits out a suggested dollar amount for the asset, a figure that gets a reality check by Martin and his management team. The bank decides what percentage of that amount to offer. (M·CAM also creates what it calls a collateral-liquidation plan focusing on alternative applications and markets for the gel.)

Stage 3: The bank pays M·CAM from 1.5% to 3% of the loan’s principal to perform quarterly evaluations of the state of the asset. M·CAM ensures that the asset is being maintained (for example, that BioPlant is documenting any changes to the gel’s formula) and updates the asset’s value based on market changes, which it monitors through press releases, news stories, and new patents and copyrights. For example, the gel’s value might receive a boost from legislation that requires that organs go to the sickest patients regardless of their geographical proximity to the donor. “That becomes a really critical piece,” Martin says. “It tells us what to watch for as the asset sits there.”

Intellectual Assets: Know What You’ve Got

Companies that take an out-of-sight-out-of-mind approach to intellectual property are, well, out of their minds, business analysts agree. That’s because intellectual property — in the form of patents, trademarks, product designs, and even customer lists — has a profound effect on every aspect of business. It is the motivation behind a growing number of mergers and acquisitions. It is among the gaudiest feathers in the hats of investor-courting CEOs. It is the stuff of controversy, as high-wired contenders like Priceline.com and Microsoft, or Amazon.com and Barnesandnoble.com, duke it out over code-driven business models. And it is a boon to the bottom line: patent-licensing revenues exceeded $100 billion in 1998 and could top $500 billion by the middle of this decade, according to the recently published Rembrandts in the Attic: Unlocking the Hidden Value of Patents (Harvard Business School Press).

In this idea-stoked environment, organizations that have systems for identifying and exploiting their intellectual property and other intangible assets stand to enhance their revenues and competitive advantage, concludes a recent white paper from consulting, tax, and accounting firm KPMG LLP. Roger Carlile, KPMG’s national partner in charge of intellectual-property services, talked with Inc. senior editor Leigh Buchanan about the historically woeful management of intangibles and how it must change.

Inc.: Why is intellectual property underexploited?

Carlile: Intellectual property has historically been managed defensively. You had legal counsel protecting it from infringement and making sure that the patent-maintenance fees were paid. But there has not been this proactive approach where you have a strategy for identifying ways to get the most out of the intellectual property that you own. Most companies don’t even have a good understanding of how intellectual property generates value in their organizations, let alone methodologies for managing and measuring it.

One of the chief problems is that the financial systems in this country are based on historical cost accounting. As a result, the majority of intellectual property — unless it’s purchased from another company — doesn’t even show up on a balance sheet. Organizations tend to manage assets that are measured. Although there have been a number of attempts to uniformly quantify intellectual assets, there isn’t a generally accepted framework for placing their value on a company’s balance sheet.

Inc.: What has persuaded companies that this is important?

Carlile: There was a period when the most successful organizations were those that excelled at combining tangible resources. Getting raw materials at the best price. Producing a finished good with the greatest efficiency. But companies got better and better at those things, and consequently those skills have become less of a differentiator. Today it’s technology, brands, the trade name, and so forth that differentiate products and companies. At the same time consumers are much more attuned to changes in the marketplace and in products. You hear about somebody who has a great idea and creates a whole new industry or a great deal of value. As a result, people are becoming tuned in to the notion that ideas are worth a lot. And they’re starting to ask their boards of directors, “What are we doing with our intellectual property? What great ideas do we have for generating value that are going to show up in the stock price?”

Inc.: What’s the single toughest challenge to putting in place an intellectual-property strategy?

Carlile: One of the toughest challenges is that most companies, with the exception of a few industries, don’t know what intellectual property they have. There are several reasons for that. One is related to the great number of mergers and acquisitions that are taking place. When you’re buying a company, do you really know everything that it owns? Maybe it had one great idea that you wanted but you didn’t know that behind that, in the R&D labs, it had a hundred other ideas with potential. I was working with a company that told me, “We have 44,000 technologies, and we need to know what we have.” I asked, “How do you know you have 44,000 technologies?” And the response was, “Well, because we just think we do.”

Inc.: Are there some industries where the opportunities are greater?

Carlile: There are opportunities in every industry. IBM went from virtually no licensing revenues some years ago to approximately a billion dollars in licensing and royalty revenues today. And it’s expecting to double that in the year 2002. Defense contractors license plane designs to toy manufacturers. Companies like Coca-Cola are putting their trademarks on clothing, so they’re getting licensing revenues from that while at the same time extending their brand.

Inc.: Who should be in charge of a company’s intellectual-property strategy?

Carlile: You need somebody who has a good understanding of the intellectual property itself and is also a business-type person who can think more broadly in terms of applications and markets. In the case of small companies and start-ups, that’s going to be the very top management, because generally the company was formed around a single idea that drives the organization’s value in the marketplace. But as companies get larger and look for ways to extend their value, they’ll need someone with an understanding of licensing, marketing, and product issues. What companies need is someone who comes in every day and says, “What can I do to make this property more valuable?”