What College Doesn’t Teach You about Sale License-Backs (But Should)

It’s summer intern season and Carthage Intellectual Capital is in full court press to get its share of the best and brightest.  As bright as they are, the sale license-back is completely unknown to interns. So here’s the primer we are using to get them engaged in the biggest financial revolution yet of the 21st century:

1. Suppose a company has 5 patents all of which are valid for 10 years. The patents originally cost the company $1000 in R&D.

2. Now suppose that Carthage (or a financing company licensed by Carthage) agrees to acquire all 5 patents for $1000. (How we figure this out relies on other patents under license to Carthage).

3, Carthage also agrees to license-back all of the patents to the company to use for 10 years in exchange for a royalty of $150 each year. This works out to $1500 for 10 years. (Again how we figure this out relies on other patents under license to Carthage).

4. Suppose the company has a tax rate of 40% on income only. Assume the $1000 it gets from Carthage is not taxed (more on this in future blogs). Carthage is organized like a partnership and pays no taxes.

5. The $150 the company pays as a royalty is an expense each year and reduces the income by $150. This reduces taxes payable by the company by 40% of $150/yr or $60/yr which is a tax credit and which is like getting cash refunds of $60/yr. ($600 for 10 years).

6. Now we can calculate how the sale license-back affects the company and Carthage over the 10 year agreement as follows:

                                                         Carthage                                         Company

Purchase Patents                             -$1000                                             +$1000

Pay Royalties                                   +$1500                                             – $1500

Tax Credits (40%)                            $   000                                            + $   600

Profits(+)/Losses(-)                        +$   500                                             +$   100

Carthage makes money because the royalties it receives are more than it paid for the patents (+$500). But the Company also makes $100 because its tax credits plus the sale price are more than the royalty payments. This the financial power of licensing versus borrowing.

Now suppose the company had decided to borrow $1000 for 10 years in exchange for paying back the principal of $1000 plus $500 in interest. It still gets $ 1000 but pays back $1500. What then?

The difference is in the tax credit. You only get a tax credit on interest paid on a loan, not the principal. The 40% tax credit on $500 in interest is $200. So instead of paying $1500 pay to the bank, the company pays $1300 net of tax credits which means it costs the company -$300 to borrow $1000 for 10 years. In our examples here licensing-back a $1000 patent pool is $400 cheaper than borrowing $1000. This part is not an invention of Carthage- it is the pre-existing rules of the IRS.

And this is what our interns will be explaining to our clients this summer. Perhaps they will have an opportunity to enlighten your interns as well.

What if Productivity is really IP?

In a down economy, increasing productivity is one remedy for beating the financial blues. But would you believe intellectual property might be a better cure? Productivity, economists tell us, is about getting more output from the same or less input. We typically measure productivity against labor costs, since down economics means lower demand with less use of bought assets. So what makes for more labor productivity? Theory X managers (always popular in recessions-not!) will tell us that the fear of unemployment will wring the sloth out of otherwise un-motivated workers. Theory Y guys will counter that the human need to better their group (i.e. company workforce) will make solutions that do more with less. This creativity impulse is what makes intellectual property (IP).

So who is right? The answer is probably ‘yes’. Theory X managers use hard times to isolate the slackers and boot them out of business. Since slackers weren’t contributing their fair share of the effort in the first place, eliminating them shows the real output of those survivors who minimize their slacking. And pay the survivors less while you’re at it. Theory Y guys usually have more faith in the company HR to keep slackers out in the first place. If the Y guys are right, then eliminating workforce really puts more work on the survivors on a unit labor basis. So you really have to work smarter and the ‘smart’ usually means creating new IP.

Let’s hope the Y guys are more right. IP is property and property is an asset. Getting money for assets is SOP for financing businesses and managing business finance. But who knew that downsizing in hard times might actually create a property –IP- windfall.
The other thing about down economies is losses or to put it more kindly, negative profits. This drags down investor confidence which lowers equity value. More bad news to be sure but curiously there may be an IP upside to this. Now it helps to know accounting and tax regulations to fully appreciate the next part, but common sense works almost as well so here goes. If a business loses money, you can earn back money or sell at a profit with no taxes until you breakeven. That is US tax policy and it makes common sense because if the IRS taxes you when you are already down, it increases the likelihood that you will go out of business. You will then fire your entire workforce and there will be nothing to tax in the future. The government lives off taxes so killing off taxpayers, financially speaking, is a bad idea. So the government let’s you recoup your business losses which lets you keep your workforce employed and you can live another day when you will indeed pay taxes to the IRS.

So what can you do with your tax losses? Well one thing you can do is sell off some of the IP you made in the hard times or even some of the IP you made when times were good. The profits of IP can be 100% of the sale price so that can quickly use your tax losses and earn quick tax-free gains. But you still need to use the IP so how does that work once you’ve sold it. Simple answer – license it back. FYI the royalties you pay on a license-back are 100% tax deductible. Want to learn how to turn your doom times into boom time? Contact us at Carthage Intellectual Capital Management info@CarthageIC.com. Productivity IP can indeed be very profitable.

Litigate, Liquidate or License-Back?

For patent watchers, the last 12 months have been a truly big year. First was the Nortel bankruptcy auction that fetched nearly US $5 billion for creditors. Second, we witnessed the spectacle of corporate raider Carl Icahn selling off Motorola Mobility (a patent pool actually) for US $12.5 billion. Third, Apple and Samsung are locked in a patent war to see who will control the intelligent telephony platform (i.e. phony computers). Finally, last week Microsoft was the successful bidder at US $1.1 Billion for 800 AOL patents that drive internet business models and processes. So far we see the litigations and liquidations of patents. But where are the sale license-backs? My point exactly.

Now here’s the really weird fact. In financial parlance litigation and liquidation are ‘fear-motivated’ responses to bad circumstances. And ‘fear finance’ usually means selling out of bad situations. But sell-outs tend to depress prices and the exact opposite is happening in our big patent year. The average price of patents in all these event s are going UP in a big way (about 70%/year). And these patents are functionally similar to each other. Go figure.

For those of you hearing about a ‘sale license-back’ for the first time, let me explain. A sale license-back (SLB) is where an investor acquires patents (or other intellectual property for that matter) for a large lump sum and licenses it back to the patent seller in exchange for royalties for the rest of the patents’ legal life. Sound familiar? If any of you have heard of a REIT then you completely get the SLB. A REIT is a pool of real properties that their owners have sold off for a lot of cash and re-leased for their future business use. The REIT uses a sale lease-back to accomplish the same thing financially as a sale license-back. Only the property is different between the REIT and SLB. And also the SLB is patented. Go figure.

Are REIT’s profitable? You bet. Like their financial cousins, the equipment sale lease-backs, a prudently financed lease back arrangement can reliably turn a 25-35% annual IRR on invested capital.

SLB’s are about ‘greed’ finance and I mean that in a most positive way. Greed finance is about acquiring and/or selling into a profitable deal. And SLB’s are financially greedy for both patent owners and investors. So if fear finance has been driving patent prices UP 70% in a year what do you suppose SLB’s will do to patent pricing? Way, way UP! I figure it’s time to get greedy. For more information contact us at info@CarthageIC.com.