Intellectual Capital

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1 Intellectual Capital Dr Theresa A K Gow June 2002 DDA 6.06 Kelvin Campus West Of Scotland Science Park Glasgow G20 0SP 1

2 List of Contents Background to Study 3 Introduction 4 Methodology 8 Results 8 Components of Intellectual Capital 8 Methods for Measuring Intellectual Capital 10 Scandinavian Perspective 15 UK Perspective 18 MARIA Project 22 Other European Perspective 22 MAGIC Report 24 US Perspective 26 4ip 26 Financial Valuation Group 27 TRRU 31 Econometrics Perspective 32 Software Tools for Non-financial Performance Measurement 36 Risk Management Software 36 Managing Human Capital 37 Value-added Intellectual Capital 38 External Communication of Intellectual Assets 39 Discussion 40 Conclusions 42 Acknowledgements 45 Annex A Component of Intellectual Capital 46 Annex B List of Methods for Measuring Intellectual Capital 47 Annex C A Template of Intellectual Capital Account Measurements 49 Annex D List of Financial Valuation Group s Valuation Related Services 50 Annex E Patent Valuation Information Request Checklist 51 References 54 2

3 Background to Study 1.1 Targeting Technology Ltd. (TTL) is a public sector technology consultancy and offshoot from Scottish Enterprise (Glasgow). It provides mentoring, support and advice to small businesses, aimed at reviving local business via technology. TTL believes that small businesses, even more than the larger ones, are in a highly vulnerable commercial position not only if they fail to identify the sources of their success and the particular advantages they possess as a business, but moreover, if they fail to safeguard such intellectual assets. 1.2 Targeting Technology believes that there is an economic benefit to Scotland to be had from providing services to help SMEs manage and protect their intellectual assets and have requested assistance from the DDA (as a co-operative project under the auspices of the partnering agreement between SE(Glasgow)/TTL and the DDA) to assist them illuminate a number of background issues associated with Intellectual Asset Management for SMEs. 1.3 The work will draw upon the Knowledge-Driven Enterprise Model developed by DDA (1) to illustrate their activities in the management of Intellectual Assets within the UK Ministry of Defence. 1.4 This report comprises the output of the last of four studies to be undertaken by DDA for TTL and SE (Glasgow), namely an overview of Intellectual Capital and the means of recording it. The first three studies comprised a report on Intellectual Asset Profiling Tools (2); a review of Intellectual Asset Registers (3) and an overview of Knowledge Capture Tools (4). The rationale behind this current study is that if TTL are to assist SMEs to effectively manage and sweat their Intellectual Assets they first require to understand and establish if and how other countries currently assign a stockmarket value to companies, based on their intellectual assets. Furthermore, once intellectual assets have been identified and recorded, they need to be given a monetary value that can be assigned to the SME s market value. TTL need to undertake a review of what processes are currently deployed to undertake these tasks and this report delivers an overview of those processes. 3

4 Introduction 2.1 The management of intellectual assets used to be consigned to research laboratories or to file drawers in the offices of patent attorneys. If they were managed at all, they were mostly managed defensively, so when a company's labs developed something new, the legal department would get a patent and try to ensure that third parties didn't infringe on it or otherwise misappropriate it (5). Too often, hugely promising inventions were unused by the companies that owned them and, at the same time, were off-limits to third parties who understood their true value. Moreover, some companies developed and patented devices and technologies not to exploit them commercially, but to prevent competitors from doing so or to avoid undermining current businesses. 2.2 As the return on investment in physical assets has declined, the return on intangibles has soared. Along the way, many obstacles to commerce in intellectual assets have been overcome. For one thing, it is easier for companies to find and manage what they need thanks to the emergence of the Internet, intellectual-asset databases and intellectual-asset management software. What is more (5), the availability of data on many deals involving intellectual assets helps sellers and buyers set the terms for licensing and acquiring them. As a result, marketplaces for intellectual assets have begun to emerge. 2.3 The value of the seller's role is evident from the nearly $1 billion a year in royalties that IBM collects and from the over-inflated valuations of start-ups having minimal or no revenue, that were acquired by technology and Internet giants during the dotcom boom. Texas Instruments, one of the companies that pioneered the idea that licensing should be treated as a profit centre, has collected more than $2.5 billion in royalties over the past six or seven years. Analysts estimate that each of those years licensing income has represented between a third and a half of Texas Instruments' total profits. For buyers too, intellectual assets can represent a powerful stream of revenue (5). 2.4 Many large companies are much more proficient at commercialising products than at developing them. Systematic sourcing of intellectual assets created by others could allow such companies to maximize the economic returns from their core assets 4

5 by leveraging these complementary assets. For example, in 1997 the top ten pharmaceutical companies derived 34 percent of their revenue from products licensed from other companies, up from 29 percent in 1992 (5). 2.5 Most companies still expect to develop internally most or all of the innovations required to enhance their product lines. However, a few leading companies do recognize that in their business environments where innovators, large and small, abound internal efforts alone are not likely to keep them at the cutting edge (5). 2.6 In the early 1990s Cisco Systems launched an effort to acquire small companies that had developed complementary innovations. (Cisco favours acquisition over licensing because the former brings valuable human resources along with the intellectual assets). This effort has generated more than 30 acquisitions in the past three years. Cisco has also linked the development of businesses and products to ensure that make-versus-buy questions are resolved in an explicit and rational way. In some cases, it has even adopted another company's technology when a competing project was already under way internally. By pursuing innovation both within and outside corporate boundaries, companies like Cisco maintain competitive product lines in rapidly changing environments (5). 2.7 A company may also adopt the strategy of competitive hedging by licensing or acquiring competitive technologies that threaten its core business, because by doing so it gains an option to play if they take off. This strategy is particularly advisable in very uncertain markets. 2.8 Companies that can't maximize the value of their own core technologies would be wise to license those assets to all key market players including dangerous competitors to create new standards or to accelerate times to market. Some creators of intellectual assets don't have what it takes to bring them to market at a competitive cost. Such companies can reduce their exposure to risk and extract the value of their creations by finding suitable partners perhaps through a licensing, jointventure, or a merger agreement (5). 2.9 Almost every company has exploitable intellectual assets, but few companies systematically explore the opportunities they create. Companies that do take 5

6 advantage of them share three characteristics. Firstly, they make their executive teams aware of the importance of exploiting intellectual assets. Secondly, they continually assess their use of those assets and have formal processes for identifying internal and external opportunities. Finally, they build strong organisations, attracting skilled and motivated people to discover opportunities, negotiate intellectual-asset transactions, and manage the ensuing relationships under the supervision of a senior business executive. This is no easy formula to implement, but the rewards can more than justify the effort (5) As organisations shift from tangible assets to intangible knowledge-based assets, it becomes apparent that traditional measures of worth are insufficient. For example, in June 1997, the ratio of market to book value for all of the Dow Jones Industrials was 5.3 in contrast to a ratio of over 10 for knowledge-intensive companies such as Microsoft and pharmaceutical companies (6). In 1999, knowledge was America's most valuable export - the country took in $37 billion in licensing fees and royalties, vs. $29 billion for aircraft (7). Swenson (8) in reviewing the value of information reported that the intellectual assets of a corporation were usually 3-4 times its tangible book value and that businesses in the US paid $1.5 billion in 1996 to consultants for knowledge management. This figure was expected to rise to about $5 billion a year by In addition, we can gain some sense of how much knowledge people buy and sell by the amount of it that is stolen. The cost to U.S. corporations of misappropriated intellectual property--purloined secrets, infringed patents, and the like is estimated at $250 billion a year (7) Intangibles are not derived from the same sources of knowledge as are standard balance sheet and income statement data. The invention of double entry bookkeeping by Luca Pacioli, an Italian monk and mathematician, 500 years ago led to the development of modern financial reporting in the 19th century. The majority of bookkeeping in those days was on commodities such as coal, iron, and cotton textiles in which England was the world's leading producer. With the large British capital flows to all corners of the globe the income statement surpassed the balance sheet as the most important piece of the financial statement. Increasingly, business audiences found that measuring the actual flow of monies was more and more valuable, which led to the development of the funds statement in the early 20th century, now required to be included in annual reports. Consideration of intangibles 6

7 and the role they played in the economy began to emerge during the first half of this century with the achievements of the entrepreneur named Henry Ford who created the modern automobile industry (9) Ford's great achievement was not invention of the automobile itself. Rather, there were two concepts that differentiated Ford from his competitors: firstly design of the intangible business process called the assembly line and secondly the $5 a day wage, which was the first modern acknowledgement of human capital's contribution to value creation The assembly line proved to be the most effective way to leverage the benefits of standardisation and was built on the research done by so-called "time and motion" study experts. Ford and his managers then conceived a system that took account of the multidimensional factors contributing to cost and to productivity and were able to reduce inventory and production costs and increase production speed while offering the consumer a consistent, reliable, and affordable product In addition, Ford understood that by paying slightly above market, he would attract a more highly motivated and skilled worker from whom he could demand more. Secondly, Ford believed that to truly achieve what we would now call "scalability," he needed to create a market for his product. By paying $5 a day, he was putting his product within the financial reach of his own work force and those like them (9) Today's management teams have a new challenge. They can no longer rely on reporting of their past and current financial performance. They are not only getting an incomplete view of their enterprise, but they are missing a forward view of their company and a significant opportunity to improve operating and capital market performance. In addition, intangible value drivers complement each other in ways that traditional financial measures do not. It is difficult to separate one intangible from another because they function in such an interconnected fashion. This creates problems for the current management system and measurement methods that are not widely understood or commonly used today will be needed to explain how intangibles create value. With intangibles contributing so dramatically to the value 7

8 creation process, it is becoming increasingly clear that financial results themselves explain less and less about corporate performance. Methodology 3.1 This report was compiled using information gathered from Internet searches using the search engine Google and searches of the Dstl Webcat database together with personal communication with Prof Baruch Lev of New York University and James Rigby of Financial Valuation Group, USA. Results 4.1 The following section provides an overview of current literature in the area of Intellectual Capital. The information was pulled together from a variety of subject sources research material from the areas of Knowledge Management and Econometrics; company promotional material and company annual reports. Components of Intellectual Capital 4.2 Edvinsson and Malone (10) are pioneers in working with intellectual capital with the objective of explaining its importance in organisations, including its key features, measures, and management approaches. They view management of intellectual capital as a vital step in building a wealth-enhancing and value-sustaining organisation. According to Edvinsson and Malone (10), intellectual capital takes three basic forms: human capital, structural capital, and customer capital. 4.3 Human capital includes knowledge, skills, and abilities of employees and is an organisation s combined human capability for solving business problems. It is inherent in people and cannot be owned by organisations, therefore, it can leave an organisation when people leave. It also encompasses how effectively an organisation uses its people resources as measured by creativity and innovation. 4.4 Structural capital is everything in an organisation that supports employees (human capital) in their work. It is the supportive infrastructure that enables human capital to function and is owned by an organisation and remains with an organisation even when people leave. Structural capital includes such traditional things as buildings, hardware, software, processes, patents, and trademarks. In addition, it includes such things as the organisation s image, organisation, information system, 8

9 and proprietary databases. Because of its diverse components, Edvinsson and Malone (10) classify structural capital further into organisational, process and innovation capital. Organisational capital includes the organisation philosophy and systems for leveraging the organisation s capability. Process capital encompasses the operational side and includes the techniques, procedures, and programs that implement and enhance the delivery of goods and services. Innovation capital includes intellectual properties and intangible assets. Intellectual properties are protected commercial rights such as copyrights and trademarks and intangible assets are all of the other talents and theories by which an organisation is run. 4.5 Customer capital is the strength and loyalty of customer relations. Customer satisfaction, repeat business, financial well-being, and price sensitivity may be used as indicators of customer capital. The notion that customer capital is separate from human and structural capital indicates its central importance to an organisation s worth. The relationship with customers is distinct from other relationships either within or outside an organisation. 4.6 There are of course variations on such a classification. Edvinsson and Malone (10) for example, report 90 measures in 5 groups which were developed by the insurance company Skandia, namely : Financial (20): income per employee, market value per employee etc. Customer (22): number of customer visits, satisfied customer index, lost customers Process (16): administrative error rate, IT expense per employee Renewal and Development (19): training per employee, R&D expense/administrative expense, satisfied employee index Human (13): leadership index, employee turnover, IT literacy. 4.7 Brooking (11) has many of the same objectives in writing as Edvinsson and Malone except that she views the components of intellectual capital for audit purposes. She emphasizes the processes of identifying, documenting, and measuring intellectual capital and describes an audit methodology for helping organisations achieve their goals through proper management of intellectual assets. Brooking (11) suggests that intellectual capital is comprised of four types of assets: (1) market assets, (2) intellectual property assets, (3) human-centred assets, and (4) 9

10 infrastructure assets. A listing of the assets that Brooking assigns to each of these categories is provided at Annex A. Methods for Measuring Intellectual Capital 4.8 Sveiby (12) reports that research into measuring the Intangible Assets or the Intellectual Capital of companies has produced a number of proposed methods and theories over the last few years (see Annex B for list). These approaches fall into at least four general categories of measurement approaches: 4.9 Direct Intellectual Capital methods (DIC): This method focuses on components of market assets such as customer loyalty, intangible assets such as patents, technology assets such as know-how, human assets such as education and training, and structural assets such as information systems. Once these components are all measured, they can be aggregated to derive the total value of a company s intellectual capital (13) Market Capitalisation Methods (MCM): based on the capital markets premium, this method reports the excess of a company s market capitalisation over its stockholders equity as its intellectual capital (12). Thus, if based on share price quotations, a company s market value is $100 million, but its stockholders equity is only $10 million, then its intellectual capital must be $90 million. To more accurately calculate MCM, the historical financial statements must be adjusted for the effects of inflation or replacement costs. Using historical data may distort the measurement particularly in industries with particularly large balances of old capital assets such as steel companies (13) Return on Assets methods (ROA): uses the average pre-tax earnings of a company for three to five years. This average earning is then divided by the average tangible assets of the company over the same period of time. The resulting ROA is compared with the company s industry average to calculate the difference. If this difference is zero or negative, the company does not have an excess intellectual capital over its industry average. Thus, the value of intellectual capital is assumed to be zero. However, if the difference between the company s ROA and its industry average is positive, then the company is assumed to have excess intellectual capital over its industry. This excess ROA is then multiplied by the company s average 10

11 tangible assets to calculate an average annual excess earning. Dividing this excess earning by the company s average cost of capital, one can derive an estimate of the value of its intellectual capital (13) Scorecard Methods (SC). The various components of intangible assets or intellectual capital are identified and indicators and indices are generated and reported in scorecards or as graphs. SC methods are similar to DIS methods, except that no estimate is made of the financial value of the intangible assets. A composite index may or may not be produced (12) Sveiby (12) suggests that the methods offer different advantages. Financially based measurements determine the value of intellectual assets in financial terms at the organisation level without reference to individual components of intellectual capital. Shareholder value is a key indicator in today s economy of how effectively managers employ intellectual and other assets. Therefore, measures expressed in financial terms that take into account the synergistic effect of intellectual assets at the organisation level provide a key measure of progress and value (14) Stewart (15) suggests three measures of intellectual capital at the organisation level: market-to-book ratio, Tobin s q, and calculated intangible value. The general idea with these measures is to determine what value the stock market gives a company compared with the value given the company as indicated on the company s balance sheet. Any difference is ascribed to the intangible value of intellectual capital not captured by traditional accounting systems The market-to-book ratio assumes that a company s approximate worth (tangible assets plus intangible assets) is indicated by its market value the market price per share of common stock multiplied by the number of shares outstanding. Therefore, the difference between book value shown on the company s balance sheet and market value gives an approximate measure of the intellectual capital that is part of total company worth that does not appear on the balance sheet. Luthy (14) considers that this measure by itself has limited value for several reasons. Firstly, stock prices are affected by many economic factors not associated with a company s tangible or intangible assets. Secondly, book values represent depreciated historical 11

12 costs that rarely coincide with the true value of revenue-generating tangible assets. A better number, especially for company-to-company comparisons, is the ratio between market and book values. This number is felt to be a more reliable and useful because factors such as interest rates and general economic cycles affect all companies more or less equally. Therefore, some extraneous factors get filtered out when using a ratio and a more reliable comparison between companies is provided James Tobin, a Nobel prizewinning economist, developed a measure, q, to help predict investment decisions. Tobin s q is essentially the same as the market-tobook ratio except that Tobin used replacement cost of tangible assets rather than book value of tangible assets in the calculation. The theory is that if q is greater than 1 and greater than competitors q then the company has the ability to produce higher profits than other similar companies. The company has something intangible intellectual capital that gives it an advantage. Tobin s q can be calculated by taking the book value of a company, adding back accumulated depreciation, and making appropriate adjustments for price changes in different classes of assets from the time of purchase. This procedure neutralizes many of the difficulties with the market-tobook ratio (14) Calculated intangible value does not have the precision of other balance sheet numbers, but it is useful in a number of ways. As a benchmark measure, calculated intangible value can help judge whether an organisation is fading or is one that has value not reflected in traditional financial measures. Management might view a strong or rising calculated intangible value as an indicator that their investment in knowledge assets is paying off. An US Internal Revenue Service (IRS) Ruling describes a process for calculating the fair value of intangible assets for tax purposes. Researchers have refined this process and Stewart (16) discusses how it can be applied to the measurement of intellectual capital. Luthy (14) provides a worked example of the calculations. A knowledge-based company with few tangible assets might take calculated intangible value to the bank along with their traditional financial statements as evidence of the company s true value. Intellectual capital isn t collateral in the traditional sense, but its value in creating future cash flows may be more valuable than any other asset shown on the balance sheet. 12

13 4.18 These methods offering financial valuations, such as ROA and MCM methods are useful in merger & acquisition situations and for stock market valuations. They can also be used for comparisons between companies within the same industry and they are good for illustrating the financial value of intangible assets, a feature, which tends to get the attention of the CEOs. Finally, because they build on long established accounting rules they are easily communicated in the accounting profession. Their disadvantages are that by translating everything into money terms they can be superficial. The ROA methods are very sensitive to interest rate assumptions and the methods that measure only on the organisation level are of limited use for management purposes below Board level (12) One of the advantages of the component-by-component DIC and SC measurement approaches is that they can create a more comprehensive picture of an organisation s health than financial metrics and that they can be easily applied at any level of an organisation. They involve using units of measure appropriate for each component. For example, market share, the value of patents, and the number of work-related competencies each have unique units of measure. In addition, different measures have different relevance and usefulness at different levels in an organisation. For example, quantity measures are usually more relevant at the work unit level and financial measures are usually more relevant at the organisation level To be effective, all of these measures, whatever the unit of measure or where ever used in an organisation, must be aligned so they reflect a common understanding of purpose and direction when looking at the organisation as a whole (14). They measure closer to an event and reporting can therefore be faster and more accurate than pure financial measures. Since they do not need to measure in financial terms they are very useful for non-profit organisations, internal departments and public sector organisations and for environmental and social purposes. Their disadvantages are that the indicators are contextual and have to be customised for each organisation and each purpose, which makes comparisons very difficult. The methods are also new and not easily accepted by societies and managers who are used to seeing everything from a purely financial perspective. The comprehensive approaches can generate oceans of data, which are hard to analyse and to communicate (12). 13

14 4.21 Skandia s Intellectual Capital reporting is based on the DIC method. Skandia, a Swedish insurance and financial services company, published a supplement to its 1994 annual report entitled Visualizing Intellectual Capital in Skandia (17). The philosophy behind the report was that traditional financial statements represent only past financial information about an organisation. Additional information about intellectual capital is needed to understand both the current and future capabilities of an organisation. To fill this void, Skandia developed a reporting framework that combined traditional financial reporting with measures of intellectual capital. This framework is called a navigator for two reasons. First, it is intended to guide an organisation in managing intellectual assets. Secondly, it is intended to guide people through a comprehensive set of measures that represent the true resources, capabilities, and the future potential of an organisation (14) Brooking s (11) audit methodology identifies and measures attributes of an organisation that do not appear on traditional financial statements. The audit model consists of seven elements: the goal, intellectual capital, dream ticket, audit, index, target, and measures. The goal provides the context for the audit and the reason why the intellectual assets are being measured. Intellectual assets are those components listed at Annex A. The dream ticket describes the set of intellectual assets that must be present for the organisation s goal to be met. The audit is the activity of gathering information about the strengths and weaknesses of the intellectual assets that make up the dream ticket. Using data from the audit, an index is constructed by comparing audit results with the dream ticket for each intellectual asset. If the status of the intellectual asset matches the dream ticket, it is given a high score. If the asset is very weak in relationship to the dream ticket, the asset may be given a score as low as zero. Scores for each intellectual asset are then plotted on a target that is used to represent the status of all intellectual assets. The target provides a quick view of the strengths and weaknesses of intellectual assets along with an assessment of whether the situation is expected to become better or worse. Audit results for each intellectual asset provide the basis for actions to improve their value (14) However, no one method can fulfill all purposes; one must select an appropriate method depending on purpose, situation and audience (12). 14

15 Scandinavian Perspective 4.24 In 1995, the Danish Trade and Industry Development Council initiated a survey on intellectual capital accounts. Prior to that survey, a number of reports had stressed the importance of the topic A Danish Trade and Industry Development Council report (18) also underlined that there was a special problem for SMEs, which often feature several types of intellectual capital, but have difficulty in rendering them visible. It established that innovative SMEs lack capital opportunities because financial agents and other interested parties have difficulties in seeing through the future-oriented prospects of a knowledge-intensive company. It stated that innovation projects and intangible assets often receive only little attention from investors partly due to difficulties in understanding the significance of intangible assets and partly due to lacking possibilities of providing collateral The Survey on Intellectual Capital Accounts survey (reviewed below) was aimed at establishing why and how companies which actually prepare intellectual capital accounts do so. Therefore the intellectual capital accounts of ten companies were analysed through interviews. The ten companies came from different industries in Sweden and Denmark, but were mainly knowledge-intensive The purpose of the examples was to illustrate companies motives for the work with intellectual capital accounts and to provide concrete examples of ways to structure and apply them. The survey was performed by a task force, coordinated by Henrik Jensen from the Danish Agency of Trade and Industry. This work resulted in a comprehensive memorandum prepared by Mouritsen and published in May 1997 by the Danish Trade and Industry Council and which is reviewed below. It focused on intellectual capital accounts as a tool to measure, manage and report corporate intellectual capital The intellectual capital (IC) accounts illustrate the scope of the intellectual resources and competencies of a company and the consequences of the management activities to manage and develop these. In the paper, a template of the contents of these accounts is introduced together with specific proposals for key figures for measurement of the various elements constituting IC accounts. This was 15

16 done on the basis of the experiments and experiences with external IC accounts of ten Danish and Swedish companies (19) Intellectual capital, also termed knowledge capital, helps to explain the difference between the company s market value and book value because the intellectual capital is not included in financial accounts. This applies particularly to innovative companies where the difference is more distinct than in connection with other types of companies The ten companies forming the basis of Danish paper all worked actively to develop their intellectual capital accounts. They show the development of some of the circumstances underlying the company s future growth. Consequently, the measurements of the intellectual capital accounts are closely related with the strategy of the company. These two cannot be separated. Most of the measurements of the intellectual capital accounts are not linked in a consistent model; they tend to be put together or next to each other. Therefore, communicating how they inform about corporate strategies and future visions are imperative to the companies The term intellectual capital accounts is not an authorized accounting term and the companies experimented with new reporting models. The ten intellectual capital accounts share several common features, but are different in many other ways. Measurements constitute a special combination of the following resource categories: Human resources. This category covers statements about the composition, management and satisfaction of the human resources. Customers. This category covers statements about the composition, management and satisfaction of the customers. Technology. This category typically covers statements about the scope, function and application of the IT system. Processes. This category typically covers statements about the scope, equipment and efficiency of the business activities Measuring and reporting on these aspects of the company can reveal the sources which will create future financial results and thus growth as the IC accounts 16

17 disclose growth-creating progress factors. Results within each of the four categories will, over time, be reflected in the financial accounts of the company. In this way, they identify the growth-driving areas of the company The report discusses why intellectual capital accounts and intellectual capital are important. The emphasis of OECD, EU and the Danish Ministry of Business and Industry on the need to expose the intellectual capital of the companies is described. On the basis of this exposure, the companies development of their intellectual capital must be managed, for example, through employee training. Intellectual capital must be supported and developed to ensure both the development of the nations and the viability of the companies (19) The appendix to the report includes several measures to initiate the work with the intellectual capital accounts. Examples of key figures are provided together with a selection of success criteria of the work with intellectual capital accounts. A template of intellectual capital accounts measurements is provided at Annex C. Examples of ways to compute such key figures is provided in some detail in the paper itself (19) Of course, no discussion of the Scandinavian experience is complete without mention of Karl-Erik Sveiby and his co-workers. Publication in 1989 of The Invisible Balance Sheet by the KONRAD group (so named because they first met on November 12 which is Konrad Day in the Swedish calendar) sparked off the "Swedish movement" in measuring intangible assets. It outlined the theory that underlies the three "families" of Intangible Assets and it also coined the labels. Both the categorisation and the labels (below) have since become close to a standard in Scandinavia and are gaining acceptance world wide. Swedish Kundkapital Strukturkapital Individkapital (Human Kapital) English Customer Capital Structural Capital Human Capital 17

18 4.36 The book inspired a large number of Swedish companies to start publishing their intangible assets. The theory and the Swedish labels have been widely used in Sweden since 1987 and they became internationally known when Skandia used it in their Annual Reports from 1991 onwards. This project, led by Leif Edvinsson the world s first corporate Director of intellectual capital, resulted in the IC-Navigator. Since 1994 Skandia has used non-financial ratios and publishes them in its annual reports. The concept was also used by the Swedish Council of Service Industries for a recommendation issued in 1993 on how to report intangible assets. It is currently being considered by EU as one of the possible new formats for Annual Reporting. UK Perspective 4.37 A study by Bosworth et al (20) extended the tradition of applied econometric research on the valuation of intangible assets. This has been given renewed emphasis by the growing interest in intellectual capital, which, broadly speaking, focuses on the leverage of knowledge into value added for the firm. Thus, the role of R&D and patents, which pervade the earlier valuation of intangible assets literature can be reinterpreted in the light of the stages of the various activities companies go through in accessing and managing knowledge to produce competitive advantage. The authors employed a financial market value based measure of firm performance and several measures of intangible assets, which can also be thought of as proxies for the various stages in the process of accessing and leveraging knowledge into intellectual capital The pros and cons of the use of financial market valuations as a measure of firm performance have been widely discussed in the literature (20). It has the merit of being forward-looking but it is dependent on the accuracy of the market in making such assessments. The choice of proxies for intangible assets is based upon the common theoretical proposition that R&D, patents, and trade marks reflect the accumulation and exploitation of intellectual capital. R&D is seen as a process by which the firm accesses and produces new knowledge, while patenting and trade marking are processes the company uses to appropriate the value-enhancing benefits of such knowledge. Thus, the companies stocks of R&D-knowledge, patents and trade marks are potentially valuable intangible assets. 18

19 4.39 Bosworth et al s paper (20) per explores the relationship between intangible assets and the dynamic performance of UK companies measured by an approximation of the Tobin q ratio, the ratio of the firm s marginal financial market value to marginal replacement cost. Under the assumption of efficient capital markets, q is used to infer the value of intangible assets. The aim of the study was to estimate the actual contribution of measured intangibles to the variation in q across 146 UK production companies over the period 1990 to 1994 inclusive To date such studies have most often been applied to US data, largely because of the relative abundance of R&D and patent data for the USA. The measures of intangible assets used included the flow of R&D expenditure, the stock of R&D knowledge, unexpected R&D, patent or innovation variables, and patent stock variables. The paper was one of the first to study the effect of trade mark activity. There are several reasons why trade mark activity might be expected to promote the dynamic performance of firms. First, it is associated with the proliferation of brands, reflecting the modification of old products and the launch of new products. Second, it is associated with brand-name advertising, reflecting the reputation and market position of the firm and thus represents a potentially important source of competitive advantage (20) Overall the results of the analysis suggested that the market considered only a relatively few firms capable of generating substantial if indirect returns to their intangible assets. This was entirely consistent with previous findings relating to the value of patent protection and previous empirical research on the value of venture capital investments. It also suggested that market sentiment was based crucially on the specific characteristics of those firms The results showed that the stock of measured intangibles failed to explain variations in market values, both within and across firms. Nevertheless, there was evidence of systematic differences in the performance of firms that are captured by the firm fixed effects and not by the measured variables. The results show that the variation in firm-specific effects, and thus the variation in the firms q ratio, was positively related to both the average stock of trade mark applications and the average stock of patent publications. Bosworth s main conclusion, therefore, was that 19

20 the value of firm-specific factors was linked to the firm s accumulated patenting and trade mark portfolio Innovation proceeds by firms generating and applying knowledge to the design of new products and to improving their processes of production (21). Firms which undertake R&D are thus seen as flagship developers of new products and processes, but these will become the subject of imitation as they become diffused throughout the relevant markets. If firms are able to acquire intellectual property (IP) rights then they can delay any immediate imitation, or charge fees for any licences offered to other firms during the period of their temporary monopoly. Following this process of creation and acquisition of private rights in intangible knowledge assets, it is to be expected that research active firms will gain in terms of value added per firm over their rivals. Researchers have argued that R&D is not only directed towards invention, but also to being able to imitate and adopt other firms inventions. Thus we might expect to see firms which do not engage in R&D falling behind more active firms, which are both innovative and use part of their research budget to search for and adapt improvements pioneered by others (21) In consumer theory, new products are seen to be competing for a place in the characteristics frontier from which consumers selected their purchases. If innovative products embody higher quantities of the desired characteristics at similar or lower prices, then new products can quickly displace old ones, rendering them redundant in the marketplace (21) Thus firms are engaging in a race in which they have to expend R&D effort to keep up with others and, far from enjoying long periods of private monopoly from their IP assets, any advance they make on rivals can be eroded quite quickly by advances and imitations made by other firms, displacing their products and processes from the frontier. Seen from the perspective of the firm, its R&D and IP activity is an investment in a depletable private knowledge stock which is subject to a high rate of obsolescence (21). Certainly the evidence of studies of the registration and renewal of patents is consistent with the view that, of the many patents which are registered, few are renewed to full term, giving rise to short median durations and to extreme skewness in the implied private value of patents. 20

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