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Chapter 1
Intangible Assets and The Firm
I.Intangible Assets and the Firm
This is a book about the value, or price, of the firm’s intangible assets. Generally, intangible assets are developed, owned, and used by firms rather than individuals. As a result, the discipline of intangible asset valuation can be viewed as an intersection of corporate finance, business valuation, and the economics of capital and capital formation.
Intangible capital is, obviously, not tangible. Itistherefore inherently more difficult to describe than other forms of capital that you can touch and see. This places a premium on a thorough upfrontdescription of what, exactly, we mean when we refer to “intangible assets.”
In this chapter, we attempt to describe intangible assets in three ways. First, weprovide an overview ofthe basic economiccharacteristics of the firm’s intangible capital, hopefully doing so in a complete enough way that thebasic economics of this asset category are made plain to the reader. Second,we offer a high level discussion of the main determinants of value for intangible assets. Finally, we offer a brief discussion of each of the main intangible asset categories.
II.Key Economic Characteristics
The first, and most obvious, characteristic of intangible assets was noted directly above. That is, intangible capital is, simply put, intangible. One cannot physically touch, or see, or smell, an intangible asset. While one can touch a product, or piece of equipment,that embodies the intangible capital, the intangible asset itself is, at root, just an idea or a relationship. Put differently, intangible capital is that part of the economy’s capital stock that is idea or relationship based.[1]
Take, for example, a patented drug. The drug itself is a pattern, or configuration, of compounds – perhaps delivered through a pill that includes the active ingredient along with other fillers. As such, the drug product is tangible – a tangible good.
However, the fact that the drug embodies a patented, protectable, technology (i.e., a “composition of matter”) means that the owner of the patent has monopoly power over the sale of the drug. If the drug is valued by consumers, this monopoly power means that the patent owner can extract a large amount of the “consumer surplus” (i.e., value) that consumers place on the drug.
Thus, from the point of view of the market, the drug really consists of two things: 1) the tangible matter that comprises the pill, and 2) the patent right to the specific composition of matter that changes the economic relationship between the producer of the drug and the consumer. Obviously, the latter component of the drug, the patent, is not something that one can touch. It is both an idea (the composition of matter itself), and a set of human relationships (the monopoly power conferred on the owner of the patent).
This example highlights the second key characteristic of intangible assets. Because they are intangible, people cannot consume them directly. Consumption, which is the realization of value, can only take place for intangibles if the intangibles are embodied in another good that is consumed directly. This means that intangible assets are always what economists call an “input good.”
The economic significance of this second characteristic has to do with what economists refer to as “derived demand.” A derived demand is a demand for a good that results because that good is an input into another good that is consumed directly. Labor, for example, is an input for which the demand curve is a derived demand.
Derived demand has certain unique characteristics that are well studied.[2] These characteristics apply to intangible assets as well as other input goods, and include the following. First, all else equal, the “elasticity” (price sensitivity) of an input good is determined in part by the price sensitivity of the good for which the input is used in production. Applied to intangibles, this means that, all else equal, if intangible capital is used in products for which demand is highly price sensitive (which generally means that they are sold in relatively competitive markets), then the demand for the intangible asset will also be highly price sensitive (demand for the intangible asset will be “elastic”). For example, restaurant recipes are an intangible asset. However, the most of the restaurant industry is highly competitive, and therefore price sensitive. Given this, the value of recipes is, generally speaking, also price sensitive (and thus limited). Second, all else equal, the more substitutable is the input good for other inputs, the more price sensitive will be the demand for the input good. So, back to the case of the pharmaceutical patent, there is typically little substitutability associated with patented pharmaceutical compounds. As a result, the price sensitivity of pharmaceutical patents is low (increasing their value, all else equal). Third, all else equal, the greater are intangible asset inputs as a share of the total cost of a directly consumed product, the more price sensitive will be the demand for the intangible. Again, in the example of a pharmaceutical patent, if the R&D that led to the composition of matter patent for the active ingredient represents a large proportion of the total cost of the pharmaceutical product, then the demand for the patent will be more elastic.
The third important economic characteristic of intangible assets is that they are durable, and therefore they depreciate. Intangible capital, like all other capital, produces a flow of services for its owner over a period of time. Further, that flow generally decreases in value over time, absent continued “maintenance” of the asset. We examine the subject of intangible property depreciation in some detail in Chapters 2 and 4.
Fourth, like other forms of capital, intangible assets have an associated “rental rate,” or “required rate of return.” That is, there is a “cost of capital” for intangible capital investments, in the same way that there is a cost of capital for other forms of capital investments.
For example, when a firm makes an investment in R&D, that investment is associated with a required rate of return. If we assume that the firm’s R&D investment is $100, that the R&D will be equally productive of revenue and profit in each ofthe next 10 years (meaning that it will produce an “even flow of non-decreasing and non-increasing profit over each of the next 10 years), and finally that the required rate of return to the R&D is 10 percent, then the firm’s required return on its R&D investment is $15.82 per year.[3] In short, the firm must earn back its “principal” (R&D investment), and also realize an “interest” payment on that investment that is determined by the riskiness of cash flow stream that the investment is expected to generate. The required rate of return to intangible asset investments is discussed in Chapter 3.
However, actual (as opposed to required) returns to intangible asset investments are highly variable. This is the fifth important economic characteristic of intangible assets. That is, the difference between the required return to intangible capital investments and the actual return is sometimes very large. Part of the reason for this is that intangible asset investments are inherently risky, and sometimes prove unsuccessful. However, another important reason is that intangible asset investments, when successful, canproduce “monopoly power”for the firm.[4] By this, we mean that intangible asset investments produce monopoly power in the classical microeconomic sense of the term. That is, they either cause a downward sloping demand curve for the firm, or they result in a protectable cost advantage for the firm.[5]
It is important to be precise here about the valuation implications of monopoly power. In every case, intangible asset investments are ex ante expected to generate what we define in Chapter 2 as “residual profit.” Residual profit is the current period return to previously sunk intangible asset investments. As we discuss in Chapter 3, residual profit is profit measured by subtracting the required profits to routine invested capital from the firm’s operating profit. This means that intangible assets are the assets that are the “last claimant” to profit, after other assets have been remunerated.
The reason that we think of the returns to intangible assets in this way is that “last claimancy” over profits is characteristic of monopoly power. That is, monopoly power means that the firm can earn some profits over and above those that would accrue if the firm only owned assets that are readily available in the open market (i.e., routineassets that coincide with competitive markets). Without non-routine intangible assets, the firm would revert to earning “normal profits,” or a competitive rate of return. Given this (given that last claimancy is a feature of monopoly power), and given that intangible assets cause monopoly power, it follows that last claimancy (residual profit) is a feature of intangible assets.
Importantly, the firm’s residual profit may, or may not, be greater than its required return on its prior period intangible asset investments. In other words, the intangible assets may or may not yield economic profit. If, for example, the firm’s intangible asset stock produces a downward sloping demand curve, but does so in a monopolistically competitive environment, then it is likely that ex ante the firm’s investments in its intangible assets are expected to produce residual profit in later periods that are equal in present value terms to the upfront intangible asset investment cost. In other words, the intangible asset(s) generates residual profit but not economic profit. On the other hand, if the intangible assets produce a true barrier to entry, and thereby result in a monopoly or oligopoly market structure for the firm, then it may very well be the case that the residual profit flow resulting from prior period intangible asset investments is greater than the required return to those investments. Put differently, in this case the firm earns economic profit.
Sixth, intangible assets are oftenspecific to a firm or a customer, implying that intangible capital may be non-redeployable to other uses.[6] The specificity of intangible assets means that markets for intangible assets tend to be thin. This is evidenced by the fact that attempts to create markets for intangible assets such as patent exchanges have generally faced severe challenges, and that the most commonly observed “governance mechanism” for intangible asset transactions is tailored long term contracting, as opposed to spot market exchange. The valuation implication of all of this is that market-based methods for valuing intangible assets, while certainly possible, can at times be difficult to implement. The customization, or specificity, of intangible capital means that finding good market comparables for a given intangible asset can sometimes be a challenge.
Another important characteristic of intangible assets, which should be clear from the foregoing discussion, is that investments in intangible assets are risky. Particularly for certain types of intangible capital, failure risk is very high. Pharmaceutical R&D is notoriously risky, as is investment related to brand extensions.[7] The valuation implication of this is that future cash flows related to “in process” investments, such as “in process R&D,” must be probabilistically adjusted to account for the risk of failure.
The eighth characteristic that merits mention is that intangible assets are not always “property,”per se. Some intangible assets, such as certain types of customer relationships, do not have status as property under the law. Further, those intangibles that do have such status generally do not keep it for long. For example, patent rights expire, and trade secrets leak out into the public domain. In short, because patents and trade secrets are ultimatelyjust ideas, these ideas will eventually leak into the public domain and lose their status as legally protectable property.
This does not mean that non-property intangible capital is valueless. In fact, certain non-property intangible assets such as production know-how or customer relationships have very high “value in use” for the firm. The fact that these may not be legally protected property does not necessarily limit their value to the firm, so long as the firm can manage to protect the uniqueness of these assets in some other way. Thus, the lack of legal protection may limit the market value of a piece of intangible capital, but not its value in use to the firm that has invested in the capital.[8]
Finally, intangible assets tend to fall into two broad categories: technology intangibles and customer-based intangibles. Examples of the former include (but are not limited to) patent rights, trade secrets, know-how, recipes and formulations, engineering, and customer specific tooling. Examples of the latter include (but are not limited to) trademarks, customer relationships, customer lists, and rights to exclude potential competitors from exploiting market territories or market segments.
Importantly, customer-based and technology intangibles are usually what economists call “complements,” rather than “substitutes.” That is, the productivity of one is enhanced by increasing the productivity of the other. For example, compare two firms, A and B. Suppose that both firms have identical technology, but that firm A has very deep and broad customer relationships whereas firm B does not. Firm A will be better positioned to exploit the technology than firm B. This implies that the technology asset is more valuable in the hands of A than B.
III.Value Determinants – A High Level Discussion
The previous discussion leads naturally into a discussion of the primary determinants of the value of intangible assets. By “value,” we mean the present value of the cash flows generated by a piece of intangible capital.
Several of theeconomic characteristics mentioned above have direct implications for the value of an intangible asset. Beginning with the “derived demand” characteristics of intangible assets, the substitutability of other forms of intangible capital for a given intangible asset decreases the value of that asset. Similarly, as thecompetitiveness of the downstream market into which the intangible asset increases, the value of the intangible decreases. Finally, as the intangible asset investment cost comprises more of a firm’s total costs, its value diminishes.
The rate of depreciation of an intangible asset has a clear, downward, effect on its value. All else equal, the faster an intangible asset depreciates, the lower is its value. As an example, it is well known that the returns to advertising-related investments are fairly short-lived.[9] This places a natural limit on the expected future cash flows from sunk advertising investments, and thus a limit on value.
The expectedrate of return on intangible capital is obviously also an important determinant of value.[10] As the rate of return to intangible investments increases, so too does the value of the intangibles that those investments create.
Correspondingly, as the required rate of return to intangible asset investments (i.e., the discount rate or cost of intangible capital) increases, the value of the intangibles produced by those investments decreases. This is simply a result of the mechanics of discounted present value.
An interesting implication of this is that as the realized rate of return to intangible asset investments increases, the amount of residual profit in the system rises, which in turn decreases the systematic risk of the residual profit stream. In other words, increasing the firm’s residual profit margin (residual profit / sales) is tantamount to decreasing the operating leverage facing the intangible asset investments. This, in turn, decreases the riskiness of the cash flows generated by intangible asset investments. This increases their value. In short, there is a secondary, positive, value effect of an increase in the rate of return to intangible asset investments – namely, it lowers the discount rate associated with the intangible capital’s cash flows.
The specificity, or re-deployability, of an intangible asset can also affect its value, although the effect on value depends upon what definition of value we are using. A highly specific asset – meaning an asset that is not re-deployable into other uses – is inherently more limited in its market value than a similarly situated asset that has other potential uses. This is obvious – other potential uses are embedded options, and options have value. However, a highly specific asset may have higher value in use, meaning value to the firm that owns that asset, because of its specificity. That is, the specificity of the intangible capital to a given product, or a given customer, may be the very thing that produces monopoly power for the firm. Thus, specificity has an interesting value implication – it may decrease market value, and at the same time may increase value in use.
While we have discussed riskiness, we did so with a focus on “systematic” risk – that is, risk that is not diversifiable. However, the failure risk associated with completion, or ongoing maintenance, of an intangible asset is also value-relevant. All else equal, the higher is the risk of failure to complete, or failure to maintain, an intangible, the lower is the value of that asset.