Aurora Borealis
4 April 2019 CFA Institute Journal Review

Creditor Rights and Innovation: Evidence from Patent Collateral (Digest summary)

  1. Clifford S. Ang, CFA

Contrary to conventional wisdom that suggests intangible assets have little, if any, collateral value, the author’s findings reveal that intangible assets—in particular, patents—are pledged as collateral to raise significant debt financing. The author finds that patenting companies raised more debt and spent more on R&D when creditor rights to patents increased because of several court decisions.

How Is This Research Useful for Practitioners?

Prior researchers have shown that innovation depends more on equity financing than on debt financing. This finding could imply that innovative firms, whose value relies mostly on intangible assets, are credit constrained, potentially because of a lack of access to collateral. The author demonstrates that this conventional wisdom may not be correct for all forms of intangible assets.

He focuses on patents and has several interesting results that could be useful to practitioners. First, innovative firms’ ability to use patents as collateral to secure debt financing has increased as creditor rights related to patents were strengthened following four court decisions from 2002 to 2009. Second, the author finds that firms that have not already pledged their patents as collateral are more likely to do so following the increased pledgeability of patents. Third, these firms use the borrowed funds to expand R&D and subsequently produce more patents.

As the author acknowledges, this research has some limitations. First, the results are applicable to mature publicly traded firms because publicly available data for startups are limited. Second, the data do not allow the author to attribute all collateral value to patents because other assets may have been pledged alongside the patents as part of the same loan agreement.

How Did the Author Conduct This Research?

The author begins by constructing a dataset of patents pledged as collateral in the United States. He uses public information in the Patent Assignment Dataset of the United States Patent and Trademark Office, which he downloads from the Google Patents website. He then matches the patent collateral data to firm identifiers provided by the Patent Data Project of the National Bureau of Economic Research to obtain information on patent grants, citations, and classifications. For analysis requiring financial data, the author uses information from Compustat.

Using four US federal court decisions from 2002 to 2009, he conducts a “natural experiment” to isolate the collateral value of patents. The court decisions determined that federal patent law is relatively narrow in its intent to preempt state property law, leading to a consensus that ownership of patents, like that of other assets, is primarily a matter of state law. The author’s strategy is to study changes in financing and investment by Delaware-incorporated firms around these decision dates. This strategy isolates those characteristics that changed around the decision dates for Delaware-incorporated firms relative to other firms. The decisions affect only a narrow issue—that is, the importance of state laws in governing patent ownership. Therefore, these court decisions affect no other characteristic of the firm and no other asset class. Using Compustat company files, the author identifies firms’ state of incorporation, then codes all Delaware-incorporated firms as “treated” and all other firms as “untreated.” The resulting sample contains 11,212 unique firms, of which 65% are treated.

The author applies a difference-in-difference approach, which begins with isolating an event window extending eight quarters before and after each court decision date. He then stacks the four windows on top of each other and runs a single regression, which averages the treatment effect across the four court decisions.

The patent-backed loan market is widespread, with 38% of US firms with patents pledging them as collateral. The number of patents pledged as collateral in the United States has doubled since 2000. The typical borrowing firm is in the high-tech industry with low and declining levels of cash. The proceeds of loans are typically used not for capital expenditures but to increase R&D spending, which leads to an even greater portfolio of patents. Patents that are more highly cited in other patent applications, especially across industries, are seen to have greater value as collateral. 

Abstractor’s Viewpoint

My main takeaway is that the increased pledgeability of patents has occurred because the four court decisions increased the protection of creditor’s rights to the cash flows generated by the patents in the event of default. These court decisions do not change the cash flow–generating capabilities of the patents. Instead, they change the expected cash flows to the creditor from these patents in the event of default. Ultimately, the increased pledgeability of patents is due to the increase in value of the patents to the creditor because of these court decisions.

In addition, although the paper is carefully written and methodologically sound, the author does not really address the most important group that this issue should affect: innovative startup firms. The pecking order theory offered by Myers and Majluf (Journal of Financial Economics 1984) suggests that equity financing is the most expensive form of financing. Accordingly, it is less costly for firms to borrow money than to raise equity.

The author suggests that innovative firms are typically thought of as credit constrained and, as such, more reliant on equity financing. This view is likely truer, however, when the innovative firm is a startup rather than a mature innovative firm. The author acknowledges that the results of his research are applicable only to mature firms, but by definition, a mature firm has a long track record that creditors can consider, which includes a history of operations and debt repayment. Therefore, how these results transfer to startups, which do not have a long track record, is unclear.

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