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INTRODUCTION:
WHY THE VALUATION OF INTANGIBLES IS A CRUCIAL UNRESOLVED MANAGEMENT ISSUE
by
Farok J. Contractor
In the twentieth century mankind made a transition from a matter-based economy to one based on ideas, from an emphasis on natural resources to thought, design and organization. The things of the spirit were beginning to be recognized as the more weighty aspects of life. A unit of GDP literally weighed less each successive year, over much of the last century, in a majority of nations. There were two reasons. First, services displaced manufacturing as the major component of economic activity. Second, manufactured items themselves were designed leaner -- or more precisely, could produce larger quantities of output from the same or a lighter design.
Many years ago, in a Singapore department store, I saw displayed two toaster ovens. One was a mechanical model for $25. The other, a similar one, had a microprocessor built into it and sold for $27. If anything, the latter weighed less. The $2 increment in value reflected purely the embedded thought of the electronics designer. As companies undertake designs, spend billions in R&D, and create corporate knowledge, how is this knowledge to be valued? This question is relevant not only to value the company itself. Increasingly, selected bits of corporate knowledge are being separated and sold, licensed or shared with other companies in alliance relationships. Let us suppose another appliance company wanted to license the microprocessor design for the toaster oven. How much should they pay? In a typical alliance, such as a licensing agreement, the licensee receives a package comprising legal rights (e.g. patents), unpatented but proprietary designs, and services such as training from the licensor on efficient manufacturing and organization – a bundle of intangibles and services which has to be valued or priced.
The de-materialization of the economy had advanced, by the end of the twentieth century, to the point where 79 percent of jobs, and 76 percent of the GNP in the USA were in the service sector (Survey of Current Business, 1995). Europe and Japan lagged behind, but only slightly. Emerging nations are also moving along a developmental path that ends with intangibles ultimately comprising the dominant portion of the economy’s commercial and asset value. For example, in 1980 services employed 20.9% of the working population in Thailand; by 1990, this proportion had risen to 25.0%. Corresponding figures for Pakistan are 31.4% and 40.1%, and for Turkey, 29.4% and 35.6%, to give only a few examples (UNCTAD, 1992 and 1995). Several developing nations are already at or near the point where the service sector is worth more than half their economy.
The focus of this book is on businesses whose total value greatly exceeds the sum of its physical assets because intangibles comprise the bulk of total value. Ever since Tobin’s Q Ratio (a company’s market value divided by the replacement cost of its assets) analysts have tried to measure the intangible component of value (Tobin, 1969). Lately, the intangible component has grown rapidly. The ratio of market to book value of American companies doubled between 1973 and 1993, even before the run up in share prices in the second half of the 1990s (Economist, 1999). One of the world’s biggest firms, Microsoft, has most of its value in “knowledge capital,” embedded in its personnel, its organization, patents, copyrights, brand value and so on. In early 1999 the market to book ratio for Microsoft was over 25 compared to 3 for Ford. Even discounting the run up in share prices in the 1920s and 1990s, Sveiby (1998) plots a long term rising trend in the “market to book value” ratio over the course of the twentieth century, as one would expect with the growing importance of intangible assets in company operations.
Into the twenty-first century, the question of classifying and measuring intangible assets remains an important unfinished issue in finance and economics theory, and in the practice of management. That a firm is more than the sum of its equipment and tangible assets is accepted as a truism. But how to measure the intangible part is a problem that continues to vex, academics, accountants, M&A advisors, intellectual property lawyers, and joint venture and licensing negotiators.
The valuation problem is even more vexing when transfers of knowledge are made between companies across national borders. To a large extent, the value of any transplanted asset, physical or intangible, is based on its use in a new field of application, territory, or nation. The assessment of market value is all the more difficult in foreign economic, political, regulatory and tax environments. One of the unresolved bones of contention between government tax authorities and multinational companies is the “transfer price” valuation of intangibles in accounting between parent firms and affiliates in other nations, since this directly affects tax collection. In the twenty-first century this will also become a bone of contention between governments. Nations wish to attract foreign direct investment, but are loath to give up tax revenues. Recent empirical evidence shows these two to be rather incompatible goals. Hines (1999) writes,
“…taxation significantly influences the location of foreign direct investment, corporate borrowing, transfer pricing, dividend and royalty payments.”
To summarize: The valuation of intangible assets and proprietary knowledge has become a central issue in the practice of management, for two reasons. Intangibles account for the bulk of economic activity. Second, the need to make valuations grew dramatically in the last two decades of the twentieth century, with a rapid growth in alliances or licensing agreements, mergers, acquisitions, the sale or purchase of brands, and a heightened scrutiny of R&D projects, and international transfer pricing.
THE OBJECTIVES AND COVERAGE OF THIS BOOK
A key purpose of this book is to develop methods, benchmarks, tools and techniques which put a monetary value on intangible assets, in the context of alliance (e.g. licensing and/or joint venture) negotiations, M&A, R&D planning, intellectual asset management, brand equity, international taxation, etc. At the same time, a minority of the papers treat the intellectual property and strategic context for valuation in global companies. The papers cover a stimulating and wide range of topics reflecting the very wide range of circumstances under which valuation of intangibles needs to be undertaken. Chapter 1 by Farok Contractor describes several such circumstances.
Moreover, there are widely differing types of intangible assets. Commercial reasons today require valuation of easily identifiable assets, or formally registered intellectual property such as patents, copyrighted software packages, trademarks, and brands. This is exemplified by Jacob Erlich, in Chapter 5, who tackles the specific issue of determining royalty rates for identified government-owned inventions. But other types of intangible assets may not be codified, registered, or even easily identifiable in the company. Such corporate knowledge is loosely called “knowhow.” This may be deeply embedded in a company. This is exemplified in Chapter 14 by Elizabeth King, who outlines principles for the valuation of human capital -- what she describes as an “assembled workforce.”
Part One of the book develops principles of valuation and lays the context for valuation.
Part Two has four chapters on the important and growing area of alliances (joint ventures, licensing, joint R&D, and other forms of inter-firm cooperation) where valuation of a partner’s knowledge and contributions is a key issue.
Part Three focuses on the Real Options technique which is increasingly being used in mapping strategic alternatives and in valuation. After all, a crucial moderating influence on any valuation exercise is the simultaneous weighting given to alternative courses of action or alternative opportunities facing the firm.
Part Four contains two chapters on international transfer pricing and taxation. Over the past decade, the number of audits of multinational company accounts by tax authorities has increased substantially. Bin Srinidhi’s paper models the impact of income tax rules influencing the location of intangible asset development. Margaretha Haeussler and John Clarry’s analysis of transfer pricing in trademarks, treats a common problem in valuation – unbundling a particular intangible asset from its larger corporate setting.
Part Five is case oriented, and examines valuation of intangibles in the pharmaceuticals, software and data processing sectors. Two other chapters tackle copyright intangibles and valuation of human capital.
Part Six concludes with the role of intangibles in global strategy of companies.
The eighteen chapters in this book are representative of the range and complexity of the topic. The book is about valuing thought, design or knowledge. But this knowledge is very different from a public good in traditional economics where its use by one party did not diminish its use, or value, by another. Thomas Jefferson observed,
“…he who lights his taper at mine receives light without darkening me.”
But corporate knowledge today has rather different characteristics and strategic uses. It is proprietary, secret and sometimes so deeply embedded in the organization, as to be partially inarticulable. Contrary to the Jeffersonian ideal, its use by another company does indeed diminish its potential value to its possessor, by creating a competitor.
The management of corporate knowledge is a key aspect of competitive strategy in the twenty-first century. And the proper valuation of this knowledge is its foundation. This book is dedicated to promoting this skill.
REFERENCES
Economist (1999), “Measuring Intangible Assets: A Price on the Priceless,” The Economist, June 12th, pp. 61-62.
Hines, J. (1999), “Lessons from Behavioral responses to International Taxation,” National Tax Journal, June.
Survey of Current Business (1995), “The National Income and Product Accounts of the United States,” Survey of Current Business, Various series in 1995, especially Tables 6.3B and 6.4C.
Sveiby, K-E. (1998), “Measuring Intangibles and Intellectual Capital – An Emerging First Standard,” Internet Version August, pp. 1-10.
Tobin, J. (1969), “A General Equilibrium Approach to Monetary Theory”, Journal of Money, Credit and Banking, February, pp. 15 - 29.
UNCTAD (1992 and 1995) World Development Report (New York: United Nations)