Monday, April 16, 2007

The IP in VOIP: A Vonage Story

On March 23rd 2007, Vonage Holdings Corp., the voip (voice over internet protocol) giant, lost a key hearing in its patent infringement dispute with Verizon. Since that ruling and the following injunction issued April 6th 2007 there has been rampant speculation as to possible solutions for Vonage Holdings. One possible work-around is an acquisition. Analyst Jon Arnold of J. Arnold & Associates believes Vonage Holdings may simply purchase a company like VoIP Inc., which operates its own telecommunications network and holds a variety of patents, some of which might help Vonage Holdings sidestep Verizon's patents. Another possible solution is intellectual property rights securitization through bonds also known as Bowie or Pullman Bonds.

Vonage Holdings Corp. would create a "separate, wholly owned, bankruptcy-remote subsidiary"—essentially a company within a company. Called Vone IP (for Vonage intellectual property), the entity would issue $250 million worth of bonds backed by the intellectual property of the Vonage brand. Vonage Holdings could pay a royalty fee of 5.5% to Vone IP to license the Vonage brand. This would be the same 5.5% of revenue the court has ordered Vonage Holdings to set aside to pay Verizon while it awaits its appeal. Vonage Holdings will have to wait two years for its
US circuit court appeal, and according to 2007 and 2008 revenue estimates Vonage Holdings will set aside approximately 103.67 million for Verizon during those two years in addition to the 58 million it currently owes Verizon in back royalty fees.

Intellectual property bonds got their start with an unlikely financier: David Bowie. The rock star floated $55 million worth in 1997, backed by 287 song titles, with the interest covered by royalty payments from the songs. The ‘Bowie Bonds are asset backed securities of current and future revenues from the first 25 albums (287 songs) of David Bowie's collection recorded before 1990. Issued by David Bowie in 1997, they were bought for $55 million by the Prudential Insurance Company. The 287 included songs also acted as collateral to insure the bond. The Bonds were a ten-year issue, after which the royalties of the songs would return to David Bowie.

The principle of valuing intellectual property (IP) is to determine the future income associated with its ownership. Intellectual property is generated mainly through research, development, and advertising (IP generating expenses or IGE), making it hard to assess the effectiveness of IGE as the value of IP is generally independent of its cost. Determination of future income requires estimating the income due to the intellectual property in each of all future years over its life; i.e., the amount sold and the net income per unit after routine sales costs are deducted. If the intellectual property is used internally, then the savings due to owning it can be similarly estimated. The risk that intellectual property becomes obsolete is high, and reduces the current value. Without risk, future income is discounted by using a risk-free interest rate. Risks include unexpected competition, unauthorized copying, patent breaches or invalidation, and loss of trade secrets. With such risks, discount rates increase, based on the expected Beta coefficient. With high discount rates, sales that occur far in the future have little effect, simplifying the determination of the net current value of the included intellectual property.

Based on analyst from Haye Capital Group, the best possible bond structure would be a $250 million bond with a 3yr issue and a 5.5% yield. Note that Vone IP could end up paying a possible premium of two basis points on the current 5.5% court ruling giving their bond a yield as high as 7.5%. The bond could have a rating of Ba, with the calculated yield and rating due to the risk affiliated with owning this company’s debt while awaiting the outcome of their court appeal.

The company would create the payments in order to issue the bonds. Vonage Holdings Corp. would, in essence, create licensing income. First it transfers ownership of its brand’s name to Vone IP. Now, Vone IP charges Vonage Holdings Corp. royalty fees to license the Vonage brand and uses the royalties to pay the interest on the $250 million bonds issued by this intellectual property rights securitization. Vone IP sells the bonds to a wholly owned Vonage Holdings Corp. insurance subsidiary, where, like any other security on an insurer's books, it serves as protection against future loss. The insurer, meanwhile, protects Vonage Holdings Corp. from financial trouble by issuing either business interruption insurance or financial loss insurance—and because it's a captive insurance company, it does so at a lower premium than Vonage Holdings Corp. could get from an outside insurance company. The payments net out to zero because Vonage Holdings Corp. would own every piece.

An alternative for Vone IP is to sell the new bond issue to an outside insurance company for the $250 million which Vone IP could use to finance the court ruling of 5.5% of annual revenue, litigation costs, the possible acquisition of another player in Voip field, or use it as an emergency line of credit. They could also sell the bonds to an outside insurance company for a financial loss or business interruption policy for Vonage Holdings Corp. in anticipation of their court appeal. Concurrently Vone IP could work out licensing agreements with other Voip carriers to use its trademark to sell their voip service, creating another revenue stream from licensing fees to help offset potential Verizon fees and court costs.

Whenever stripping away valuable - albeit, intangible - assets from a company will only serve to make issuing old-fashioned debt more expensive for the company in the future. But, if the gain from the IP securities is greater than the fall in the old debt, then it is worth the risk. Vonage, which on April 24th 2007, won a stay of an earlier decision barring the company from recruiting new customers, must now focus solidly on the future of the company while it awaits its patent infringement appeal. They are going to need to aggressively identify and execute alternative solutions to maintain their viability. Maybe the IP in VOIP should stand for intellectual property as Vonage fights to keep dial tone.

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