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Snowflake could turn out to be the ultimate FinTech company. The brainchild of Andre Lee, a former debt markets investment banker turned technology investor, the company is on track later this year to unveil a new type of bank, into which it hopes large companies will deposit intellectual property and from which SMEs will borrow to bolster their own new product development. It will also unveil a new type of limited recourse lending for product development, filling a crucial financing gap, which commercial banks do not currently meet with loans. “The typical choice even for well-established SMEs seeking to finance new product development is between giving up equity to venture capitalists – which is anathema to most SMEs especially family-owned ones – and tying up all their limited spare cash flow,” says Lee.
“There are also government grants but these are often given as reimbursements. Companies have to raise the money in the first place and governments then match or refund it. But banks won’t lend against ideas. They see too much uncertainty as to whether a new product will ever progress through development and sell. Banks only want to lend against the security of a company’s hard assets.”
Snowflake’s ultimate ambition is no less than to nudge a global financial system that grew up in the industrial age, with commercial banks, investment banks and investors financing tangible assets – land, property, manufacturing, consumption of products and their cash flows – towards the financing of intangible assets – ideas, technology and innovation.
Snowflake focuses on innovation |
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Source: Snowflake |
These are often illiquid and very hard to value. Innovative technologies may only find successful commercial application in fields far away from those their inventors originally intended, and sometimes only when combined with other owners’ innovations. And these surprising combinations are hard to bring about when the assets are static and separate. The marketplace for exchange and for the attribution of value and pricing has yet to appear. But it’s important for all of us that it does.
Lee takes matters back to basics. “There are only two ways to grow an economy: increase the amount of labour, basically the number of workers, or increase productivity, or both. A lot of developed economies have ageing populations and so productivity is vital. The key driver of productivity is innovation and the key driver of innovation is technology. If you don’t have access to it, you are at a very significant disadvantage.
“Intangible assets are becoming the main drivers of economic and wealth development. But those assets are not easily exchangeable. And as for financing them, banks are still in the industrial age while the real economy is moving into the knowledge age. When a bank looks to fund the building of a data centre, it’s still likely to be lending against the collateral value of the land and ignoring the much higher value of the data itself because it’s hard to measure it precisely.”
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Andre Lee, the |
Lee argues that most thinking around intellectual property still stems from a defensive mindset – protecting assets from other rival users with patents and trademarks – and has yet to progress towards finding ways to exchange and monetize these intangibles. This is reflected in accounting, which casts intellectual property as a wasting asset that companies must depreciate or capitalize. That is unlike, say, land, which can be revalued upwards and accounted as profit, even if a company does nothing with it.
Lee says: “It is only with the comparatively recent advances in computer power, digitization, cloud technology and the rest that we now have the potential to sift, parse, segment and value these intangible assets. But you cannot truly know their value until you first extract them and put them on platforms where an informed marketplace can make judgments about whether to buy, sell or rent them.”
Lee set up Snowflake in 2011 after a varied and at times turbulent career starting as a trader and head of fixed income in the emerging Asian high-yield corporate bond market in the mid-1990s, that stalled when his group was blamed for the collapse of Peregrine Securities during the Asian crisis. Peregrine had accumulated exposures to unrated borrowers, which could not be refinanced when the Asian bond markets collapsed at the end of 1997. Lee had hoped to pioneer a new market to help unrecognized Asian firms finance themselves and after reveling in early successes, first at Lehman and then at Peregrine, now found his business swept away in the Asian meltdown. In the aftermath, regulators banned a number of senior Peregrine figures, including Lee, from managing a company in Hong Kong for four years.
Euromoney interviewed Lee in forensic detail on all this in 1998.
Reinvention
Lee, who is half Canadian, half Korean, reinvented himself. He initially created a business to assist SMEs in capital raising and financial restructuring, but found they had big needs far beyond capital. He became enmeshed in helping SMEs in many different industries with product development, business model creation, branding, business development, supply chain and manufacturing.
In 2005, he arrived at Intellectual Ventures to co-found an investment fund backing inventors – primarily from major universities, small companies, and individuals – along the path to commercialization of their innovations. It was the first time a fund had been tried to invest globally and at scale to build a comprehensive IP portfolio that could be licensed later on to companies seeking solutions and ideas to build new products around. “To get an idea to market you need capital and the marketing and business infrastructure to commercialize it and turn it into a product. Most inventors don't have any of that,” says Lee. “So we set up an investment fund to work with a network of inventors, to patent innovations and take them to companies that might license them and build them into products.”
Number of patent filings*(Resident + Non-Resident) |
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Source: Snowflake |
It was a long game though. It might take an inventor three years just to obtain a patent, the fund itself as many as seven years to build a diverse portfolio of these, more years to license these patents out to companies that might take two more years to develop products. “We set the fund up in 2007 thinking it would take 10 years to work,” says Lee. “By 2010 we had built an impressive investing platform that I believe will do very well over time but I was looking to move on. It was fascinating to spend so much time with technologists and scientists. You learn, for example, that the best inventors are very good at precisely defining a problem and that by process of doing that, the solution often emerges. But even though I also enjoy grappling with complex problems that require disbursed solutions, I am not a scientist or a technologist myself. I am more transactional and by 2010 I was hankering to deploy all the lessons I had learned going back to Peregrine to creating a new liquid marketplace around intangibles.”
Snowflake has developed two models that adapt traditional financial technology to provide rudimentary mediums of exchange, valuation and pricing on intangible assets that combine new technology and innovative ideas.
The first is the bank, into which Lee has spent the past four years encouraging large multinational corporations in the US, parts of Europe and Asia that own most of the world’s intellectual property rights relating to new technology to deposit these rights. Lee has also spent time with hundreds of SMEs in target markets such as Finland, Austria, Korea and China that might borrow from the bank. National and regional governments, keen to boost job creation through the SME sector, and seeing the competitive advantage of developing innovation, are also supporting the venture.
For the moment, large multinationals with big R&D departments that can fund early-stage developments, simply store large warehouses of intellectual property whose potential use might not help their main product lines, while only deploying a small fraction, perhaps just 5%-15% of their IP portfolios, themselves. When these owners do license IP assets to other users, they typically do so only at very high cost on contracts that only other large companies can afford.
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We’re hoping this becomes a new asset class and Andre Lee |
Small and medium-size enterprises, at the centre of job creation in most developed economies, are thus excluded from large stores of potentially useful intangible assets, even ones their own creators are not using. These assets sit idle when they could potentially, when identified and perhaps bolted on to other ideas and technology also protected by IP rights, have productive uses that the originators had never even dreamt of. “Technology doesn’t care what the inventor thought it was for,” muses Lee.
The new bank-like entity, called Tech Reserve, aims to pay owners a modest deposit rate by allowing smaller and medium size companies to borrow that intellectual property. “Intangible assets are the lightest in the world,” says Lee. “And some large companies have many tens, even hundreds of thousands of them. When you look through the R&D departments of these large multinationals, they’re sitting on a treasure trove. A company that could generate $100 million in profit just from depositing its unused IP assets would achieve the equivalent of building a $1 billion a year revenue new product with a 10% profit margin.”
Deposit rates will ratchet up when an SME successfully adapts IP it has borrowed into a product with sufficient commercial value to drive sales that the SME itself takes off as a business. At that stage, the deposit rate would shift back up to the higher commercial rates at which multinationals typically license intellectual property to each other.
“Tech Reserve is a platform that takes previously inaccessible assets and makes them accessible, almost like Airbnb has done with people’s spare rooms,” says Lee. “We are doing it with intellectual property because the vast majority of the world’s IP is owned by, at most, 1,000 large companies whose own business development plans are focused on bringing to market new $1 billion revenue products, or at doing deals with peers that at least move the needle on group profit and revenue. That simply cuts out arranging lots of small licencing deals with the 130 million odd SME companies in the world.
“And so there is a moat around a lot of that IP that cannot be crossed by smaller companies which, if only they had access to that technology and innovation, might derive huge amounts of value from it. And because they are resource and capital constrained, SMEs actually tend to be quite conservative with tech development.”
Big companies invest a lot of capital in developing their technologies, and as a result, have a lot of technologies that are far closer to being ready to be commercialized; the big companies by virtue of this investment have de-risked the technology. SMEs, resource and capital constrained, are largely conservative in technology adoption, and that’s why Tech Reserve provides a good match – if they could access these technologies it would help SMEs accelerate their product time to market with reduced risk.
Further reading |
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While technology and innovation have expanded in the past 10-15 years, they have also become more specialized, more segmented and more expensive. Lee says: “I have conversations with SMEs that have a great new innovation but have just one technical problem that holds them back in getting it to the market. That problem may have already been solved elsewhere by someone else, but the SME has no access to it. They can’t find it and they can’t acquire legal access to use it. And so that company strives to reinvent the wheel someone else has already invented at great cost and work around it. They miss their big chance to win in the market because the solution they need is stored away in the garage of another company, languishing unused.”
He cites as an example an Austrian SME in the specialty cleaning business for food and beverage producers. “If you’re a beverage company and you’re going to change a production line from making, say, chocolate soda, to producing lemon soda, you have to clean that line very thoroughly with high-pressure cleaning chemicals, then check that it’s all sterilized before you start up production again. Every minute the line is down costs you money and you absolutely want to minimize that. This Austrian cleaning company had developed an indicator solvent that would spray areas as it went along and then show green on areas that were thoroughly clean and red on those that were not sterilized yet, so that you would only have to go back and re-clean the red areas, not the whole line.”
But to make this work down the pipes of its customers required an optical colour censor, which the Austrian company did not have. “And so they tried to build the optical censor, not realizing that another company, in the quite detached wafer etching business for semi-conductor manufacturing, had already developed it. For such an SME you can search in the Tech Reserve Bank and find that one last piece you need so that a whole new key technology can become commercially viable.”
To help match up the Austrian cleaning company with the new solvent to the optical censor developed by the wafer etching company, Tech Reserve has signed up a network of experts, including business consultants and technologists. These act almost like deposit brokers, helping the SME borrowers to identify and withdraw the right licences, or combinations of licences, to solve their problems. “The experts are a crucial part of the eco-system,” says Lee. “They can deposit their own IP and know how, as well as combing through packages of deposited IP. And by helping SME borrowers adapt these to solve their problems, the experts can negotiate their own royalties.”
Game-changer
Lee has spent four years developing Tech Reserve, talking to hundreds of big and small companies. He hopes to launch it in the next few months and scale it to bring in tens of thousands of IP deposits, maybe 1,000 experts, and thousands of SME borrowers.
But it is his second platform that might be the game-changer. This is the product development company (PDC), a new type of limited recourse vehicle for companies to fund new products through.
Lee has been talking to institutional investors that now allocate money to private equity about putting money into a fund that Snowflake Capital will manage. This fund will extend revenue loans to SMEs seeking capital to fund product development projects. The product development companies will own the IP and associated licences relating to new products under development. SMEs will capitalize these product development companies by putting in these licenses and also injecting some cash equity – perhaps 20% of the PDC’s capital – with options attached to increase their holdings over time to 100%, as interest and principal on the revenue loan is paid back.
The fund lends money to the PDCs, secured against the IP collateral. In exchange for the financing, the company developing the product agrees to share in the revenues flowing from sales of the developed product for a finite period of time. Once the loan has been repaid, the investment fund releases the collateral held in the PDC back to the product developer so that they own their product rights fully.
The fund’s principal exposure can also be de-risked and loans amortized by taking in grants, which governments will often provide to support exactly such innovation, but only after companies have raised funding themselves. “In our discussions with so many governments over Tech Reserve, we’ve learned an awful lot about the availability and processes for applying for these grants, which many SMEs are only vaguely aware of,” says Lee.
If the SME that originally set out to develop a new product loses heart, fails or changes strategy, the fund can simply take the product development company containing the IP licences and rights to future revenues and pursue the project with another company.
“We’ve talked to large numbers of SMEs in Europe and Asia and this resonates deeply with them as exactly the kind of capital they need but can’t get anywhere else,” says Lee. “It’s important to note that it’s not cheap capital. It is as expensive as equity. But it does not require SMEs that have been in operation for many years to grant ownership or voting control to outside venture capitalists.” He adds: “Even some of the very large multinationals we have talked to about depositing IP into Tech Reserve are interested in spinning off some of their R&D into limited recourse ventures and funding it through this form of capital.”
It’s not surprising that banks haven’t been keen to lend like this, given the equity like nature of the risks. A lender would need both the technology skills and traditional business skills to understand the feasibility of the technology and the concept behind a new product, the capacity of the SME to develop that product, the market for it if it ever emerges and the competitive threats.
“From the point of view of investors in a fund that makes such loans, there is certainly equity-like upside if the product sells. But the exit is a natural one: repayment of the loans out of cash flows,” Lee says. “The fund receives fixed annuities on loans that pay down principal, as well as interest, over their term. It is not at the mercy of stock market conditions to exit lumpy positions through IPOs or trade sales.”
How big could this become? Lee says: “When you see some multinational companies funding development projects worth $50 million at a time, it’s clear that this could be a multi-billion dollar global market very soon. It will grow if investment banks and commercial banks get involved and see it as an application for existing financial technology. It’s easy to envision portfolios of revenue loans, once they have seasoned somewhat, as collateral for securitization.
“We’re hoping this becomes a new asset class and a way to help so much of the speculative capital in the world currently chasing diminishing returns on financial assets to become productive capital.”
Is this all wishful thinking? It would be unwise to dismiss it as such. Governments are big believers in innovation as a key ingredient towards producing sustainable economic growth. In its test pilots, Snowflake has cooperated with local governments that have introduced the company to their SMEs. Over the past four years, Snowflake has developed relationships with 33 national governments, more than 50 provincial and municipal governments, totaling relationships with around 170 ministries and government agencies in North America, Asia, and Europe. Lee views governments as important participants in the Technology Reserve platform and Snowflake will continue to work closely with them in the future.
