As the importance of intangible assets to a company’s worth grows, better methods of valuing them are emerging, writes Domini Stuart.
The value of the world’s largest organisations once lay in their machinery, land and other tangible assets. Today, value is also found in intangible assets such as people, knowledge, brands and ways of working. Intellectual property (IP) has evolved into a powerful business tool and governing IP is no longer just a matter of trademarks and patents.
“Intangible assets are rapidly becoming the currency of the 21st century,” says Carel Smit, founder and director of patent attorneys Patenteur. “Over the past 40 years there have been remarkable changes to their role in business transactions, profit generation and fund raising.”
Boards have a duty to understand that today’s companies operate in a very different landscape.
“Intangible assets are primary drivers of company performance,” says Paul Adams, chairman and chief executive officer of EverEdge Global, which specialises in intangible assets. “They can generate revenue, strengthen your position in negotiations and intangible assets are increasingly being taken into account by financial institutions when they’re considering funding [a business].”
There are also mounting risks. There has been a significant rise in litigation by companies whose intellectual property has been infringed, and intangible assets are also under threat from increasingly-sophisticated cyber criminals.
“Boards must understand the risks and opportunities associated with their intangible assets and take them as seriously as they do critical machinery, products or a bank account full of cash,” says Adams. “Companies are used to spending a lot of time tracking physical assets. Now they need to spend more time looking after their intangible assets.”
Understanding the value
Boards have developed a deeper understanding of the value of IP.
“Most are aware it’s not simply the quantitative difference between the tangible assets of a company and its sale price, or its market cap, and that it can be very much more than the nebulous term goodwill,” says Karen Sinclair MAICD, principal of Watermark Intellectual Property. “More boards are actively including IP in an organisational structure that enables them to obtain the most value on a balance sheet and are using it in the same way as a tangible asset.”
Globally, this understanding has led to significant deal making based on the transfer of knowledge, people and intangible assets, including IP.
“A recent example is the strategic swap between Sanofi and Boehringer Ingelheim which involves the exchange of Sanofi’s animal health business for Boehringer Ingelheim’s consumer healthcare business,” says Sinclair.
Risk surveys suggest companies are paying attention to their brand and reputation. “These may not be recognised on a balance sheet but they do generate shareholder value – and shareholder value will almost certainly be destroyed if they are damaged,” says Dawna Wright MAICD, a senior managing director and leader of the Australian forensic accounting and advisory services practice of FTI Consulting.
“Customer data is slightly more quantifiable and the value of a customer loyalty program has been known to outstrip the value of the company,” she says
Some boards are coming to terms with the idea that information – and particularly digital information – has so much value.
“Directors must take the time to consider all of the information within the company, the value it brings and whether they would be comfortable for other people to have access to it,” says Shane Bell, a partner specialising in forensic and cyber at McGrathNicol Advisory.
Boards also need to acknowledge there is no longer a clear line separating technology companies from other businesses.
“The reality is most of us are technologists in some form or other because we use technology to function efficiently, to differentiate ourselves and to create a competitive edge,” says Bell.
That competitive edge often reflects the knowledge and creativity of the company’s employees.
“An architect might develop unique house or apartment designs,” says Sinclair. “An e-business might invest in understanding the drivers for search engine optimisation in its business. A manufacturer might come up with a more efficient process. Every company should be thinking about the tacit knowledge brought to work every day by its workers, how they can best use technology to capture and manage this knowledge, and how that technology can become a monetisable IP platform for the organisation.”
Directors should also check existing IP is not overlooked.
“There are many examples of companies that let ideas or intellectual property slip into the hands of an astute third party that turns them into successful products or services,” says Adams. “The board might recommend an expert audit to search out intangible asset risks or hidden pockets of potential revenue.”
Valuing intangible assets
Intellectual capital investment banking firm Ocean Tomo keeps a close eye on large American companies. Its research shows that 40 years ago, intangible assets accounted for less than 20 per cent of their value. By 2015 this had shot up to 87 per cent. Yet this extraordinary shift has had little impact on the principles and methodologies used for valuing intangible assets.
“IP is treated the same as any other asset,” says Wright. “Investors want returns on their investments and will assess the cash flows likely to be generated by the asset, taking the inherent risks into account.”
The most common approaches are still cost, income and market-based.
“The cost method assesses the historical cost of building up the asset and how much it would cost to replicate its value,” says Rachel Foley-Lewis MAICD, a Deloitte board member and a partner in Deloitte’s corporate finance practice specialising in valuations.
“The income method involves the normal discounted cash flow type of analysis – what additional income will be generated by the asset, or how much costs will be reduced. The market-based method relies on comparing the value of IP as like for like. This is difficult because it is very hard to find truly comparable assets.”
For example it’s tricky to assess the value of one brand name or trademark against another. Additionally, valuation methodologies are becoming complex and technical.
But revised accounting standards that require intangible assets to be recognised on the balance sheet are having an effect. Analysis around these assets needs to be much more robust and sophisticated than it was in the past.
More complex risks
The risks associated with intangible assets and IP are also becoming multifaceted. They are much more vulnerable to theft and loss, and a cyber attack can damage a company’s reputation and shareholder value. It is now also much easier to infringe someone else’s IP rights.
“The board should ensure management is taking a strategic approach,” says Wright. “The first step is to identify the assets within the business, both tangible and intangible, which give the company its unique ability to compete. You can then focus your resources on protecting these crown jewels by identifying the most significant threats and the most effective ways of mitigating them. It is also important to think in broader terms about losing control of IP. The recent, worldwide WannaCry ransomware attack clearly demonstrated that being locked out of your own data can be a critical issue for business.”
Bell is pleased most boards now list cyber risk among their top concerns, but believes that that there is still much to do. “The next challenge for directors is to ensure their managers are implementing a robust, information-driven and risk-based plan designed to protect appropriately-classified IP,” he says.
The deliberate or accidental misuse of confidential information is a threat. “A recent study found that almost two out of three departing employees take confidential or sensitive business information with them – and likely straight through the door of your competitor,” says Wright.
Companies considering a merger or acquisition should also pay particular attention to IP. “You need to be sure you will obtain rights over the IP owned by the company you’re acquiring,” says Foley-Lewis. “If you’re selling, you must specify whether the IP is in or out of the deal.”
If it is included, ensure it’s appropriately recognised. If it’s out assess whether the IP will be licenced to the people acquiring the business.
Infringing third party rights
The growth of digital promotional activity is driving a rise in IP infringements. For example, there have been several instances of large retailers appropriating the designs of smaller companies that were advertising online. There have also been expensive legal battles to establish who owns IP.
“Contested ownership can be an issue for companies that use outside contractors or service providers,” says Smit. “If there isn’t an express agreement to the contrary, any IP they develop – and that you have paid for – will reside with the contractor. This is different from the employer-employee relationship where the rights to an invention usually reside with the employer. But even here it is important to have an employment agreement that clearly sets out the fact that IP developed in the course and scope of employment remains in the name of the company when the employee moves on.”
Some companies assume the IP they have developed independently is automatically theirs. This is not always the case.
“You may have been genuinely unaware that someone was ahead of you in developing a particular technology or system, but that is no defence if you’re charged with infringing third party IP rights,” says Smit.
If you are working to solve a particular problem it’s very likely that other companies are doing the same.
“In Silicon Valley the rule of thumb is that there are 20 or 30 different teams working on the same solution at any one time,” says Adams. “You might be first into the marketplace but, if one of those companies has beaten you to the intellectual property rights, you could still face extremely expensive infringement litigation.”
For instance, in 2012 Samsung was ordered to pay Apple US$1 billion for infringing six of its patents. Ultimately, Apple won a permanent injunction that prevents Samsung from selling certain products in the United States.
Sinclair advises directors to take a long-term view. “Infringement analysis tends to focus on the short term but boards need to know they have freedom to operate (FTO) the legal and commercial freedom to execute long-term corporate strategy,” she says. “For example, when a company develops a strategic mission to achieve something over three, four or five years it must have a clear picture of the broad IP environment. It needs to know who their competitors are and whether they might already be developing competing IP, even if they are yet to develop a product.
“It’s not enough to keep an eye on the marketplace – the marketplace is usually at least six months and often a year or more behind what is happening in the IP space. People file applications before they get anywhere near the market.”
Fortunately, technology and big data have made it much easier to track the IP trajectory of competitors and, more broadly, the leading edge of a technology.
“Ten years ago an FTO search would have probably cost $15,000 to $20,000 and taken up to six weeks to complete,” Sinclair continues. “Now there are tools that can pull up a relevant list of patents in a very short time and for a much lower cost.”
The best IP operators not only track what their competitors are doing, they also use the information strategically.
“Some of the big technology companies file patent applications directed at technology they know their competitors are developing to block them, or as a means of building assets to trade with that competitor if the need should arise,” says Sinclair. “They can do that now because parsing patent data is so much easier and more affordable than it used to be – though the main challenge for most boards is still allocating sufficient time, skill and money to these kinds of proactive strategies.”
A culture of respect
It is vital boards allocate adequate resources to best practice in creating, capturing, managing and monetising IP.
“Someone in the C-suite must be responsible for developing and reviewing IP policy and there should be top-to-bottom accountability,” says Sinclair.
Smit advocates sharing the policy with everyone in the organisation.
“People generate ideas, people implement ideas and people create new products,” he says. “The importance of respecting both the company’s IP rights and those of others must be disseminated by way of training and awareness-building to create an IP-friendly culture.”
The last thing directors should do is sit back and ignore IP until it is brought to their attention.
“Despite its importance, many companies only include IP and intangible assets on the board agenda when something goes wrong,” says Adams. “But IP is very much one of those issues where a stitch in time saves nine – it is extraordinarily expensive to fix up mistakes. Boards must do their best to prevent a crisis by working closely with the senior management team to ensure all of the risks associated with intangible assets and intellectual property are proactively managed.”
In many cases, costly outcomes can be avoided by paying close attention to the risks.
- In 2004, the University of Western Australia (UWA) launched legal proceedings against Professor Bruce Gray, claiming that it owned the intellectual property to technologies he invented when he worked there. The court found in Professor Gray’s favour and, in 2010, the High Court refused the university’s right to appeal. Alan Robson, then vice-chancellor of UWA, said this had wide-ranging implications for all universities, one of which could be less money to fund research.
- Procter & Gamble launched Head & Shoulders anti-dandruff shampoo in a distinctively-shaped bottle but failed to file a design registration. When a competitor marketed a lower-priced product in an identical bottle there was nothing it could do to stop them.
- Apple neglected to secure its iPad brand in Asia – and another company registered the iPad trademarks across a number of countries including China. Apple was forced to pay US$60 million to buy them back.
ASSESSING STRATEGIC RISK
A board must assess risk. This requires a deep understanding of the IP that is critical to the value of the business. Dawna Wright MAICD suggests that directors ask management the following questions:
- What differentiates us from our competitors?
- What are the “crown jewels” that enable us to stay competitive?
- What are our IP assets worth?
- What is the value of our reputation and our brand?
- What data do we hold and how can it be leveraged?
- Where is this information held?
- What would be the consequences of a loss?
- How is the information secured?
- How would the business respond to a loss of key IP or a threat to our brand and reputation?
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