SMEF0086

Written evidence submitted by Inngot Ltd

 

Background to Inngot and its qualifications for commenting on this issue

More background on Inngot can be found at www.inngot.com.

 

What are the key challenges Small Medium-sized Enterprises (SMEs) face when seeking finance (summary response)?

 

 

Detailed comments on selected questions raised by the Treasury Committee Call for Evidence

Key challenges for SMEs seeking finance

 

While there are multiple challenges facing SMEs, including macroeconomic issues such as COVID, the War in Ukraine and the impact of global warming, a fundamental part of the problem is the difficulty in demonstrating the real value they get out of their IP, and then convincing investors and lenders of that value.

All companies, large and small, have IP – it is what makes a company unique (its DNA, if you like) and what gives it a competitive edge. In fact, in the modern business world, IP drives growth and profits; most companies no longer rely on tangible assets to fuel their business, but instead on intangibles.

Yet IP is largely ‘invisible’ because of international accounting standards and related regulatory issues.

For example, the Intangible Asset Market Value Study, conducted regularly by Ocean Tomo and The Ponemon Institute and last published in 2021, showed that in 2020, 90% of the market valuation of the S&P 500 (the largest companies in America) was made up of intangibles. For the S&P Europe 350 index, covering the biggest companies in Europe, the figure was 74%.

The following chart from a recent OECD report, Secured lending for SMEs: Making effective use of registries and intangibles - a case study approach (co-authored by Inngot CEO Martin Brassell) also shows the shift from tangibles to intangibles over time:

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The impact of international accounting rules

International accounting rules restrict the appearance of IP in company reports and accounts. Instead, the focus is on tangible assets – buildings, equipment, finished product, raw materials etc.

Back to the issue over accounting rules. Currently, internally-developed IP can only be included on the balance sheet under exceptional circumstances, and as a sunk cost.

IP which is bought-in, on the other hand, must be valued on the balance sheet, but it is almost always subject to amortisation.

This results in IP’s apparent value only going down over time, regardless of whether the underlying IP asset has maintained or even increased in value – which is what would be expected, if the IP is any good.

Neither approach really recognises the true value of IP, and many SMEs are faced with a Catch-22 situation – the only way to realise the value locked up in their IP is to sell it, yet if they sell it, the company no longer really exists.

So while IP may be a core contributor to company value in an exit situation, if a company is looking for funding to drive growth (which will almost always involve innovation and the creation of new IP), selling its ‘crown jewels’ is not an option.

At the same time, many SMEs and scale-ups are reluctant to seek large amounts of equity funding from investors, as this almost always comes with a dilution in existing shareholders’ stake in the company.

In passing, both the International Accounting Standards Board (IASB) and the International Valuation Standards Council (IVSC) are aware of the ‘invisibility’ of intangibles and both are exploring changes to their rules to correct this; but changing their rules is, completely understandably, not swift.

 

The challenge to IP-rich SMEs and scaleups

Many modern companies simply do not have many tangible assets. Instead, they have invested heavily in their IP – patents, trade marks, copyright materials, trade secrets, databases, ‘know how’, and even relationships and reputation.

There are ways companies can use their IP as collateral; but these tend to involve very expensive bespoke valuations (which can range in costs from £5000 upwards – in some cases, tens of thousands of pounds) and are arguably only cost-effective for the world’s biggest companies.

These traditional IP valuation methods, which can help companies show the value of what they own, are too expensive for most SMEs when compared against the size of funding they want. They also tend to take too long. Small companies need swifter solutions which allow them to leverage the value of their IP.

There are rating agencies which specialise in SMEs; but rating agencies tend to charge large fees, take a long time and also arguably do not understand SMEs or the role that IP plays in driving results.

But there is solid research that shows that IP-rich companies have higher turnover and employ more people.

For example, a report from the European Intellectual Property Office (EUIPO) and the European Patent Office (EPO), Intellectual property rights and firm performance in the European Union (EUIPO/EPO, February 2021), shows that the ownership of different types of IP assets has a multiplier effect on company earnings. This report compared ownership of Intellectual Property Rights (IPR) with firm performance.

It found that “firms that own IPRs generate 20% higher revenues per employee than their counterparts without an IP portfolio. The highest revenue-per-employee gains are linked to bundles of trademarks, with performance premiums of 63% for trade mark and design owners, and 60% for combined patent, trade mark and design owners. Firms that own IPRs also pay on average 19% higher wages than firms that do not.”

IP-rich companies are also better lending risks, as a report from the UK Intellectual Property Office and the British Business Bank, Using Intellectual Property to Access Growth Funding (2018), makes clear.

The chart below from that report is based on BBB research into companies supported through the Enterprise Finance Guarantee (EFG), which specifically targeted IP-rich companies. It demonstrates that IP-rich companies appeared significantly less likely to default on loans, and that, where a company did default, the loss rate was lower for IP-rich ones than the average.

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In passing, there is an argument for the BBB to create a new scheme along similar lines to the EFG, which supported loans to IP-rich companies by providing lenders with a guarantee against potential losses.

This would allow for a much more in-depth and rigorous examination of the impact of IP and intangible assets on both default rates and recoverability of the lending funds and would provide significant additional data points, if the results were appropriately recorded and made available.

 

Through which channels do SMEs find the most success when seeking funding and why? 

Our focus is mainly on helping SMEs and scaleups leverage their IP for lending purposes, but we have had many contacts with investors and venture capital groups.

At the moment, the only realistic options for SMEs and scaleups looking for funding for growth are equity and venture capital/venture debt.

In our opinion, facilitating IP-based lending solutions targeted at SMEs would provide them with a valid alternative to dilutive equity and venture funding.

 

What role can financial innovation play in SME finance? Is there more the government and the regulators can do to improve access to finance through innovative firms? 

This question appears to revolve around developments in fintech and open banking. The massive growth in the use of electronic banking and digital cash in the UK, Europe and Asia has shown the public appetite for a new way to access and spend their money, and modern businesses expect to see similar flexible banking available for the companies they run.

However, widening the availability of IP-based finance to support SMEs is not revolutionary in the same way that consumer fintech and ‘new banks’ have been; instead, it would involve adapting existing systems.

Banks already offer asset-based lending products, although usually against tangible assets. Some, however, such as Lombard have begun to treat IP assets in the same way (Lombard offer sales-and-leaseback lending products secured against software developed by client SMEs). But IP-based lending as a mainstream product type would significantly increase SME use of bank lending.

 

How accessible is finance for SMEs of different sizes? 

As we have said above, modern IP-rich SMEs and scaleups simply do not have the tangible assets that their counterparts might have had 100 or even 50 years ago. Arguably, current accounting rules and the traditional banking attitude that IP is valueless means clever companies with good ideas (some of which would undoubtedly be tomorrow’s unicorns) are penalised.

In passing, it is worth noting that banks recognise that they are increasingly competing for a dwindling pool of tangible assets. This is why many of them are exploring products which would lend against IP and intangibles.

 

Is finance available to allow SMEs to scale up from venture capital funding? 

We have already discussed venture capital and venture debt previously. Our concern is not with the availability of venture funding, but its cost to smaller companies, both financially and in terms of loss of control. We believe IP-based lending, involving the use of IP as collateral for bank financing packages, would be a viable and cost-effective alternative to debt or equity.

 

What role do credit reference agencies play in supporting SME finance?  

It is unlikely that credit reference agencies would have much understanding of the role of IP in a particular SME, or how it contributes value to a company. We have had discussion with some of the large ratings agencies about how IP might be incorporated into their processes, but so far nothing concreate has come of them.

 

Is securing access to SME finance particularly challenging for women, people from ethnic minorities, people from certain social classes, or any other group? Is so, what should be done about it? 

In our opinion, IP-based finance products, which identify value delivered by intellectual property and intangible assets via the application of sophisticated algorithms based on data analysis and use this information in the lending approval process, should support a switch to an evidence-based rather that personal contact-based finance system. The use of hard evidence on the value of IP and intangible assets should help reduce bias in the lending process.

 

 

Other legal and/or regulatory changes that would help facilitate IP-based finance

Aside from changes to International Accounting Standards and International Valuation Standards, changes may be needed to other regulations and laws – and some are already in progress.

In England and Wales, lenders already have the ability to take security over identifiable IP to use as collateral for lending. As mentioned above, that was not until recently the case in Scotland, but in May 2023 Scotland passed the Moveable Transactions (Scotland) Bill. This will allow the widespread use of intangible collateral to support the growth and development of innovative SMEs based in Scotland. Inngot is involved in discussions with the team tasked to develop the required registers for this.

There is another key regulatory change, however, that would really kick-start the whole private lending market – and that is the acceptance by banking regulators, firstly, that intangibles do have intrinsic value, and, secondly, that this value can be reliably predicted.

Currently, banks cannot claim capital relief on loans where IP has been accepted as collateral, although they can for tangible assets. Yet if the financial crisis and the COVID epidemic have shown anything, it is that the value of tangible assets can plummet when large amounts of it are on the market. Arguably, IP is always unique, and so will hold its value.

If the rules for banks can be changed so capital relief can be given for intangibles taken as security under the right conditions, that then sets in train a radical change in the financing of growth companies.

There are ways around the IP-as-collateral problem; one is to insure the value of the IP taken as collateral. We have been informed by banks that they have had counsel’s advice that such Collateral Protection Insurance contracts can be offset against capital adequacy requirements.

While there is research that supports the proposition that IP and intangibles drive value, we accept that more data (beyond what the BBB cites in its report referenced above) is needed to support the argument that taking IP as security can reduce default rates.

We are working towards providing that at volume, with major partners in the lending and insurance industries. However, there is an element of ‘chicken and egg’ here. To provide that data, loss behaviours need to be collated; but this in turn requires banks to accept IP as collateral for loans.

We are hoping that the launch of IP-based finance products by three of the biggest UK banks, which should come to pass within the next few months, will help provide more data.

 

Government policy issues 

Should the Government do more to enhance SME access to finance? And, if so, what? 

We believe that IP-based finance offers a model for supporting IP-rich, tangible asset-light companies, particularly scaleups, to access the private lending market.

The Government, via GOTT, is already putting the spotlight on the identification and monetisation of IP and intangible assets developed across Government Departments and Agencies. Similarly, the IPO is now committed to starting a discussion process about how IP-based finance could best be implemented in the UK.

The key areas where Government action would help influence the development of IP-based finance in the UK, and so help IP-rich SMEs, would be to further support the activities of organisations such as GOTT, the IPO, and Innovate UK, as well as to open a dialogue with major UK lenders and the accountancy bodies about how best to make IP visible so its value can be leveraged.

As Director General of WIPO, Daren Tang, said in his introductory speech at the launch of WIPO’s initiative to grow IP-based finance globally, the invisibility of intangible assets:

“…is not healthy for our most innovative entrepreneurs and enterprises, who need to unlock new avenues of financing for growth, using their most valuable assets, and especially in times when money supply has shrunk substantially. It is not healthy for our regulatory, financial, accounting and valuation frameworks that are not able to adequately understand, measure and analyse what is increasingly the key asset of enterprises they regulate and support. And it is not healthy for our economies and financial markets, when the understanding of the role that intangible assets play in trade, finance, economic growth remains unclear.”

 

September 2023