MAKING INTANGIBLES A VALUABLE TANGIBLE ASSET GENERATING VALUE BY RELYING ON INTELLECTUAL CAPITAL Geneva, Switzerland 11 July 2006 John D.
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MAKING INTANGIBLES A VALUABLE TANGIBLE ASSET GENERATING VALUE BY RELYING ON INTELLECTUAL CAPITAL Geneva, Switzerland 11 July 2006 John D. Swaim [email protected] +41 78 808 78 50 REVOLUTIONARY CHANGES IN THINKING ABOUT INTELLECTUAL PROPERTY AND VALUE Economic Paradigm Shift — Relative importance of Intangible Assets/ IP – In the U.S., since 1980, the average ratio of market capitalization to book value has risen from slightly over one to a multiple higher than five. – In 1970, intangible assets represented less than 20% of the market value of the majority of U.S. public corporations. Now they represent 90%. Communication/IT Revolution Mergers & Acquisitions TANGIBLE AND INTANGIBLE ASSETS HAVE VASTLY DIFFERENT CHARACTERISTICS… Value from Tangible Nature v. Value from Property Rights and Intangible Factors One Place at One Time v. Multiple Uses for Multiple Returns — Intellectual Property as a “bundle of rights” Depreciation v. Cumulative Property of Knowledge "Knowledge is cumulative, with each idea building on the last, whereas machines deteriorate and must be replaced." - Baruch Lev …LIKE THE ECONOMICS OF THINGS VERSUS THE ECONOMICS OF INFORMATION Costly Replication v. Zero Cost Replication Diminishing Returns v. Perfectly Increasing Returns Efficient Markets v. Requirement of Imperfect Markets/Tendancy towards Concentration RELATIONSHIPS AMONG THE DIFFERENT TYPES OF ASSETS Highest and Best Use Analysis — Generally achieved within the context of a business enterprise Business Enterprise as a Portfolio of Assets — — — Monetary Assets Tangible Assets Intangible Assets – Intellectual Property Complementary Assets ROLES OF IP IN VALUE CREATION Creating Economic Value Creating Strategic Value ROLES OF INTANGIBLE ASSETS & IP IN CREATING ECONOMIC VALUE Excess Earnings concept — — Intangible assets & Intellectual Property create value when their exploitation enables an enterprise to produce earnings in excess of the returns required by markets on the assets (tangible & intangible) employed in the business. Intangible assets are generally riskier than monetary or tangible assets and require higher returns. ASSET CHARACTERISTICS VALUE IN USE Cash MONETARY Receivables Inventory Return Requirement TANGIBLE INTANGIBLE General Purpose Special Purpose VALUE IN LIQUIDATION 8-10% 10-15% 15-40% Financing Debt Debt & Equity Equity Investment Qualities Liquid Versatile Nonliquid, Narrow Market Source: Russell L. Parr and Gordon V. Smith Valuation of Intellectual Property and Intangible Assets ROLES OF INTANGIBLE ASSETS & IP IN CREATING ECONOMIC VALUE Producing an Economic Advantage — From Direct Exploitation – Increased revenues from new/enhanced products – Reduced costs from proprietary process technology — From Indirect Exploitation – Licensing revenues Raising Barriers to Competition Protecting or Creating a Strong Market Position Use in Financing the Enterprise ROLES OF INTANGIBLE ASSETS & IP IN FINANCING THE ENTERPRISE A business that can generate excess returns is attractive to equity investors. — — — — Traditional view is that intangible assets are financed with equity Investments in Intellectual Property are, in general, relatively risky. Providers of equity are certainly don’t want to lose their money, but they are willing to take higher risks in order to share in the potential upside of an investment. They want potential rewards to match the risks they take. Equity investors face the highest risk of losing their complete investment. Providers of debt want to be repaid with interest. As they do not share in the upside of the investment, they assume lower risk than equity investors. ROLES OF INTANGIBLE ASSETS & IP IN FINANCING THE ENTERPRISE (cont.) Traditional view is changing. — When 90% of the value of corporations is intangible, new lending structures must follow. — IP based debt structures have been growing (at an uneven pace) – Traditional secured debt – Securitization of IP revenue streams – Music Industry – Film Industry – Pharmaceutical Industry TRADITIONAL SECURED DEBT Lender focuses on the credit worthiness of the borrower. — — — Is the cash flow sufficient to service the debt, and preclude abandonment of the business? How much risk is associated with the cash flow forecast? Strength of balance sheet Lender focuses on value of the collateral in case things go wrong. — — Collateral: asset pledged to a lender until a loan is repaid. If the borrower defaults, the lender has the legal right to seize the collateral and it sell it to pay off the loan. The lender is granted a security interest in the property of the borrower. SECURITIZED LENDING Securitization: A device of structured financing where an entity seeks to pool together its interest in identifiable cash flows over time, transfer the same to investors either with or without the support of further collateral, and thereby achieve the purpose of financing. Shifts the burden of repayment from the borrower to a designated pool of assets. Assessment of credit risk shifts from the borrower's financial/business condition to security of the specified stream of cash flows. Use of Special Purpose Vehicles to insulate the collateral from claims of other creditors Requires a legal mechanism for taking security over a cash flow Highly structured nature may be expensive and require relatively large deals. This should improve over time. SECURITIZED LENDING - RISKS TO BE ASSESSED Infringement Technology: market acceptance Technological obsolescence (the corollary for a trademark would be whether the trademark is in fashion and popular) Functional obsolescence Licensee payment risk Servicing risk Legal risks SECURITIZED LENDING - CREDIT ENHANCEMENTS Examples of Credit Enhancements — Back-up servicer — Lower Loan-to-Value ratio COPYRIGHTS: COLLATERAL VALUE /SECURITIZATION POTENTIAL CHARACTERISTICS Characteristics consistent with relatively higher collateral value — — — Currently active literary, dramatic or musical work Text General purpose, versatile software with an established market Characteristics consistent with relatively lower collateral value — — — — High infringement potential Dormant literary, dramatic or musical work Advertising program, training materials Special purpose software specific to company operations PATENTS/PROPRIETARY TECHNOLOGY: COLLATERAL VALUE /SECURITIZATION POTENTIAL CHARACTERISTICS Characteristics consistent with relatively higher collateral value — — — — "Keystone" patent supporting commercially successful product(s) Versatile patent/proprietary technology that could support a wide range of products or be employed in a wide range of processes Market-ready Congruent innovation Characteristics consistent with relatively lower collateral value — — — — — — — — Untransferable technology (much individual know-how / learning involved) Technology supporting commercially unsuccessful product(s) Technologically obsolete Specific / narrow use technology Embedded in a tangible asset (e.g. in machine designs or settings) High development cost for commercial viability / adaptation to another use Incomplete development Discontinuous innovation TRADEMARKS: COLLATERAL VALUE / SECURITIZATION POTENTIAL CHARACTERISTICS Characteristics consistent with relatively higher collateral value — — — Extendable to a wide range of products or services Associated with commercially successful products and services Well established Characteristics consistent with relatively lower collateral value — — — — — Narrowly defined, and identified with only a specific product or service Associated with commercially unsuccessful products and services Newly introduced Jurisdiction regards the granting of a security interest to be the present assignment of an ownership interest Geographically narrow ROLES OF INTANGIBLE ASSETS & IP IN CREATING STRATEGIC VALUE Option or flexibility value — The legal protections afforded IP may allow management flexibility that is not captured using traditional discounted cash flow techniques. Synergy — “Bundle of rights” nature of IP makes IP a particularly flexible tool for entering into transactions that create synergy. REAL OPTIONS: INTELLECTUAL PROPERTY CAN BE LIKE A STOCK OPTION Stock options provide the holder the right, but not the obligation, to purchase (“call”) or sell (“put”) the underlying asset. Holder is able to wait and learn before spending. A patent provides the holder with the exclusive right, but not the obligation to market the product or attack new market segments. Management has a series of options to wait and learn. Before investing in Phase II of a new drug development project (wide-scale deployment), management learns outcome of Phase I (technology risk). Before investing in Phase II, management can reassess market developments (market risk). What is synergy? Whole is greater than the sum of the parts (Type I) — “Synergy is the increase in performance of the combined firm over what the two firms are already expected or required to accomplish as independent firms. Where the acquirers can achieve the performance that is already expected from the target, the net present value (NPV) of an acquisition strategy then is clearly represented by the following formula: NPV = Synergy – Premium” Mark L. Sirower, The Synergy Trap: How Companies Lose the Acquisitions Game (New York: The Free Press, 1997, 2000), 20 & 29 What is synergy? (cont.) Unexpected performance (Type II) — “Synergy means behavior of whole systems unpredicted by the behavior of their parts taken separately….Synergy means behavior of integral, aggregate, whole systems unpredicted by behaviors of any of their components or subassemblies of their components taken separately from the whole.” Buckminster Fuller, Synergetics (New York: Macmillan Publishing Co., Inc.) 1975, 3 — “In management terms, synergy means competing better than anyone expected. It means gains in competitive advantage over and above what firms already need to survive in their competitive markets.” Mark L. Sirower, 77 Sources of “Type I” Synergies Revenue Enhancements — Sell a broader line of products/services over an enhanced distribution network — Increased market power may allow price increases Cost Reductions — Consolidation of functions and positions — Elimination of redundant fixed assets — Spread overheads over a larger revenue base — Greater market power with respect to suppliers can result in purchasing economies Practice Improvements — Leverage technological and process improvements (intangible assets & Intellectual Property) over a broader base Financial Economies — Smaller companies generally exhibit greater risk than larger companies. Acquisition of a smaller company by a larger company can reduce the acquired company’s cost of capital. — Financing costs, for example borrowing costs, may also be reduced. — Greater economies in cash, working capital and fixed assets management — Tax benefits (e.g. use of net operating loss carryovers, transfer pricing benefits) Sources of “Type II” Synergies Increased Core Competencies — “In the long run, competitiveness derives from an ability to build, at lower cost and more speedily than competitors, the core competencies that spawn unanticipated products. The real sources of advantage are to be found in management’s ability to consolidate corporate-wide technologies and production skills into competencies that empower individual businesses to adapt quickly to changing opportunities.” C. K. Prahalad & Gary Hamel, “The Core Competence of the Corporation” Harvard Business Review, May-June 1990. Intangible Assets & Intellectual Property deployed as “strategic capital” to exploit new opportunities. — “Strategic capital…defined…as the value of unrealized opportunities.” F. Peter Boer, The Real Options Solution: Finding Total Value in a High-Risk World (New York: John Wiley & Sons, Inc., 2002), 22 CONCLUSIONS Intellectual capital and intangible assets now drive the world economy. A key success driver for the enterprise in this environment is its ability to profitably exploit its intellectual capital and intangibles.