This article was first published in CEOWORLD Magazine, 12 July, 2020.
Intangibles have been largely ignored by accounting standards and traditional valuation methodologies. Consequently, many organizations do not have a clear picture of the economic worth of their intangibles. Given the increasing importance of intangibles in driving growth and revenue, a failure to identify and leverage the value of these assets may result in missed opportunities and risk exposure.
What are intangible assets and why are they important?
Intangible assets are defined by The International Glossary of Business Valuation Terms (IGBVT) as “non-physical assets such as franchises, trademarks, patents, copyrights, goodwill, equities, mineral rights, securities, and contracts (as distinguished from physical assets) that grant rights and privileges, and have value for the owner.” Technology, brands, and data typically comprise the most valuable intangible assets.
Intangible assets have risen in importance with the evolution of an increasingly competitive and digital economy. Companies are turning to innovation and for differentiation and success. It is estimated that intangibles make up 84% of all enterprise value on the S&P 500.
One of the reasons intangible assets have become so economically valuable is due to their versatility and scalability. Unlike tangible assets, intangibles can be commercialized in many different ways, used by multiple parties simultaneously and they don’t depreciate in value through use. This creates a significant opportunity for competitive advantage and growth, which in turn drives value for the owner.
Identifying and leveraging that value requires an appreciation of the unique qualities of intangibles. For example, when aligned to enterprise strategy, intangibles will help to protect revenue streams, foster growth opportunities in existing and new markets, secure positive customer advocacy, and support asset governance and risk assurance.
Conversely, ill-informed dealings with intangibles can expose an organization to risk. For example, the strength of the assets may be dependent upon legal protection, such as in the case of patents and trademarks. Failure to maintain and defend these legal rights may result in a substantial reduction of value. In addition, infringing the legally protected intangible rights of other parties may expose organizations to bad publicity and financial penalties. Business leaders should also be aware of the non-linear relationship between R&D and the resulting intangible asset-heavy investment in R&D will not necessarily result in a high return asset. Finally, the value of intangibles may be dramatically eroded through reputational damage or technical obsolescence.
In order to effectively leverage opportunities and mitigate risks associated with intangibles, company executives must understand their economic worth.
Why do we need to value intangible assets?
Accounting standards make it difficult to capture the value of intangibles in financial statements. Generally, intangibles are not recorded on the balance sheet until after a transaction has occurred. As a result, a substantial portion of enterprise value may not be evident on the face of a balance sheet. This creates a significant information gap for senior management and boards. With intangibles accounting for more than half of the value of most organizations, it is important that their economic value is accurately drawn to the attention of decision-makers, so they can be effectively leveraged, and associated risks mitigated.
When should intangibles be valued?
Ideally, companies should regularly value their key intangible assets, to help inform strategic planning and transparent, informed decision making by senior managers and directors.
Understanding the economic worth of intangibles will be particularly important in the context of developing and implementing key enterprise objectives; commercialization (e.g. licensing or selling intangible assets); investing in R&D; selling or buying a business; raising capital; litigation and insolvency.
A practical illustration of the importance of valuing intangibles in the insolvency context is Nortel. Nortel filed for bankruptcy in 2009. Its physical assets sold for US$3.2 billion. Its patents were noted on the balance sheet as US$31 million, but in fact, sold for a staggering US$4.5 billion.
How can intangibles be robustly valued?
Traditional accounting methods are not well suited to valuing intangible assets. However, there are recognized methodologies that will reliably and accurately determine the economic worth of intangibles. These include qualitative as well as quantitative analysis. In other words, they involve a technical and legal assessment of the quality of the underlying intangible – for example, the scope and drafting of a patent specification; the breadth of classes covered by a trademark registration; the veracity of data; and the structure and maintainability of software code.
Valuation of intangibles should comply with both accounting standards (such as GAAP and IFRS) and recognized international guidance for IP valuation (including the EC’s Report from the Expert Group of IP Valuation; RICS Professional Guidance on the Valuation of IP Rights; and Internal Standard ISO 10668 for Brand Valuation). Ideally, a valuation should be conducted by experts with credentials in the global finance and investment industry, as well as expertise in the relevant underlying assets, for example, a registered patent or trademark attorney.
Intangible assets make a significant contribution to corporate worth. It is possible to reliably determine the economic worth of intangibles, using rigorous and robust analysis. Understanding the quantum value of intangible assets can deliver significant benefits in terms of competitive advantage and risk mitigation.
Senior executives should insist on regular reporting on key intangible assets, including the commercial value of these assets, to promote the best interest of their organization.