Tech Lending: Due Diligence Issues

This article is the third in a series providing an overview of critical considerations for commercial lenders contemplating whether to finance a tech company and how such loans can be secured.

Adequate due diligence is an essential component of every tech lending deal. As previously discussed in this series, tech companies differ from traditional businesses in that most have very few, if any, tangible or hard assets. The majority of tech companies’ assets are intangible IP assets, which makes the borrower’s business difficult to value, increasing the importance of due diligence before entering into financial arrangements.

As a first step, lenders should ensure the company has legal ownership of the IP it purports to own and determine the jurisdictions in which any IP rights are registered and where the IP rights, whether or not registered, are used. Different searches will need to be conducted in each jurisdiction to verify the asset and ownership.

Lenders must identify the entity that owns the IP, not just the entity that uses it. Many companies use entities other than their operating entities to hold IP assets. In those instances, the operating entity may only have licence rights. In an enforcement scenario, a judgment against the operating entity may not be enforceable against the IP holding company. In the case of related party licences, lenders need to determine to what extent there is protection of a borrower’s use of the IP and whether the licensor affiliate should be made an obligor under the financing arrangement.

If the licence is material, a lender should determine if the licensee has unilateral extension rights. Under the Bankruptcy and Insolvency Act and the Companies’ Creditors Arrangement Act, an IP licensee is protected if the licensor enters formal insolvency or restructuring proceedings, or if the licence is disclaimed or the IP is sold in such proceedings, whether by the licensor or its trustee or receiver. As long as the licensee continues to perform its obligations under the licence, it will have a continuing right to use the IP for the remainder of the term of the licence and for any further period by which the licensee is entitled to extend the term. That continuing right may be exclusive or non-exclusive, depending on the grant in the licence. Such an extension right mitigates risks for a lender as there is greater protection for both the IP and the ongoing business operations of a licensee borrower. A lender will have comfort knowing the borrower will not suddenly lose its IP rights if the IP holding company faces insolvency, which would otherwise impact the viability of the borrower’s business and its ability to repay the loan.

This due diligence can be time-consuming and challenging to complete. However, it is crucial to understand the value and ownership of the borrower’s assets to ensure sufficient security in the collateral.

If you require assistance with any matter or question related to tech lending, please reach out to a member of our Financial Services Group.

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