This article first appeared in The Secured Lender

By Hilco Diligence Services CEO Doug Jung

I’ll begin with an axiom that I’ ve come to realize during my career as an asset-based lender and workout advisor—the quality of your collateral at the beginning of the deal is not the same as the quality of your collater al just before liquidation. Why? For those of you who have gone through a cradle-to-grave situation, you know that the company you underwrote at the outset may have had solid prospects and that your ABL deal assisted the company’s liquidity. However, as time marches on, management is unable to execute their business plan, and the company’s performance deteriorates. They’re fully drawn under the borrowing base, and their situation begins to take its toll on collateral quality.

With poor cash flow, the company begins to lower prices to raise revenue and generate cash, losing margins to cover payroll, rent, other overhead or administrative expenses. To preserve cash for inventory purchases--the lifeline of any company--management reduces other expenditures. At some point, the company is only selling inventory they are currently buying, and whatever remains in the distribution centers is slow-moving. Manufacturers will undertake credit risk to make sales that they ordinarily wouldn’t.

In short, AR and inventory quality deteriorate. Your collateral and the resultant recoveries will be lower than expected--particularly if your last appraisal and field exam are a year old.

What does this have to do with intellectual property values? The same concepts in an AR and inventory deal apply to IP. Just like any other form of collateral, IP requires proper maintenance to hold its value. Here are a few thoughts:

Ownership, Maintenance and Administration

Often, some of these assets are attained through acquisitions, and they may be registered under a long-dormant legal entity. In these situations, it may not be clear that these IP assets exist or what entity may own them. Even if not the case, frequently the management of IP may fall under more than one group in a company. IT, marketing or even legal may have their hands in IP-related administration.

In addition to potential dormant or forgotten legacy legal entities owning certain IP, some companies are choosing to transfer intellectual property assets into an IP Co or an unrestricted entity. This transfer may occur after the deal closes. Although this is a basic credit concept, lenders need to ensure who their borrower is and that their borrower is the unrestricted owner of their collateral.

Trade names, domain names and customer lists all require proper administration. The administrative aspects of IP--such as the ability to access the USPTO site, domain registrars or opt-in records for customer lists--may have been decentralized under the legacy company or may have been lost during the acquisition process.

Although many registrars offer drop-catch services, domain names need to be renewed, so expiries need to be monitored. Customer lists and email/SMS text marketing campaigns need to be maintained in accordance with the CAN-SPAM Act and the Telephone Consumer Protection Act. Both are US Federal laws, but are also specifically regulated at the state level in many jurisdictions. If applicable, the newly enacted General Data Protection Regulation (EU) is relatively broad-reaching and is written with strong consumer protection at its core.

Your borrower should have a centralized department: a function within it to ensure all IP administration and compliance is appropriately and timely managed. If not, their ultimate value in a liquidation situation may be impaired. They may be unsalable due to regulatory reasons, their registrations may have expired, or they do not have the proper logins and passwords.

Current systems supported by their vendors together with service or maintenance contracts are critical as well. The lender should be informed as to the status of their borrower’s principal financial reporting systems, critical business applications, and email systems. In other words, the company’s primary systems should be up-to-date and enjoy the support of its primary vendors—both from a version and a service/maintenance agreement perspective. This is key because the sale of customer lists requires the electronic transfer of those files, and should any technical issue arise in that process, the company or the estate needs to be able to access its software vendors for support.

The costs associated with maintenance and upkeep may be expenses that a company under financial duress could forgo. Therefore, the IP values may erode as a result.

E-Commerce and Customer Database Critical Vendors

Many retailers utilize third-party vendors to support various aspects of its e-commerce platform and to manage its communications with its customers. This includes email hosting and support for marketing campaigns. Costs for digital marketing firms, which promote traffic, may also be vital to an e-commerce platform. Other examples may include expenses for Google Adwords for paid searches and search optimization agencies to increase successful SERPS (search engine results pages), as well as soft-ware tools for web page optimization/personalization. Google Analytics is vital to obtain website performance metrics.

These providers are essential elements to (1) maintain the e-commerce ecosphere and (2) maintain the email marketing database and communications platform. Trimming down or eliminating these valuable tools could diminish the value of the e-commerce platform as its performance, such as conversion rates, click-through rates, add-to-cart rates and others may deteriorate as a result. As those performance metrics decline, so could the value of the IP. Moreover, if database maintenance and email marketing functions are outsourced to third parties, these vendors may be an impediment to customer communications during a liquidation event.

What Should a Lender Do?

To ensure the security and quality of your IP collateral, it’s very simple. Perform your diligence on the prospect/borrower. Keep your appraisal updated and utilize the field exam process to diligence, test and verify all the above. This is key for retailers whose e-commerce platforms provide a significant percentage of revenues to the overall total. Engage with your valuation and field exam professionals about these factors and how your borrower benchmarks against others. At Hilco Diligence, we work hand-in-hand with our intellectual property counter - parts in the Valuation group and the Stream bank trading group, who are in their markets every day and have the practical experience of how these factors affect intellectual property recoveries.

Doug Jung is a financial professional with over 25 years of experience with diverse diligence, credit and lending, restructuring, field exam, advisory, and investigation background. He launched Hilco Diligence Services (HDS) in late 2013. Jung oversees HDS and manages day-to-day client engagements. Jung is a CPA (non-public practicing) who began his career at Ernst & Young. He entered the asset-based lending industry as the field examination manager for Fidelcor Business Credit. There, he managed a team of 25 field examiners in offices throughout the US.

Jung has a BS in Business Administration with a concentration in accounting from the Whitman School of Management at Syracuse University.