Capitalization Of IP Must Become The Norm To Avoid Investor Misinformation

Summary

• The writing down of intangible intellectual property (IP), and ultimately modern innovation itself, is creating an increasing distortion in modern valuation and investment theory.  It can no longer be ignored.
• The methods for capitalizing and valuing IP are not straightforward and inevitably require future views. (This scares most accountants).
• But a multi-faceted approach to IP valuation, rather than, the search for a single solution may be the way to start taking this issue forward.

Recently I have worked on a number of financing for mid-market fintech companies that had substantial EBITDA and profitability, but the bulk of their assets were intangible. When many banks and financiers looked at these businesses, they wanted to write-down the intangible assets to get to a tangible asset figure. Well, in doing so, you often ended up with negative tangible assets and therefore, on this basis, the ROE was negative. The result of the write down of the intangibles was clearly producing accounting nonsense and misleading investor information.

This might be all well and good if it was just an isolated problem, but in fact as we enter the tech age, IP is becoming one of the most dominant items on many company’s balance sheets – not to mention Amazon (AMZN), Google (GOOGL), Twitter (TWTR), pharma cos and increasingly many other sectors where technology or biotechnology is becoming a key driver of value. We are dealing here with the very essence of the valuation of innovation, one of the key drivers of value in our modern economies.

It, in other words, is just another step in the economic revolution that I wrote about in one of my previous Seeking Alpha articles on the need for a new macro-economic and investment textbook (see: Fed Policy - Does The Tech Age Indicate It's Time To Re-Write The Whole Economic Textbook?). It is a part of the work of the think tank maxos.ai and other academic finance writers (Sullivan P. 2000, Scicluna 2002, et al), as well as noted economists at MIT such as McAfee and Brynjolfsson. But the problem is just no longer an academic one as it was 10+ years ago. The prevalence of IP in our corporate balance sheets is now so significant that both macro-economic policy making and investment analysis is simply misleading in many cases unless there are real attempts to capitalize IP. Every investor needs to focus on this issue now.

The accounting profession has also been grappling with the problem in a limited fashion and FAS 141 and 142 do, for example, make real steps toward trying to address the problem. FAS 141 insists on the breakdown of “goodwill” in a merger into its IP components, while FAS 142 stopped the unrealistic amortization of goodwill. However, accountants given that they intrinsically want to record historic facts (whereas IP value if based on future performance), are probably not the ones who are going to crack this problem wide open.

How adequately to capitalize IP with its intrinsically futuristic and volatile value is an extremely difficult problem. But I think the central difficulty many academics and the accounting professionals have is that they are seeking a one fits all solution. This is just not available. Instead, one has to treat the valuation and capitalization of IP on a bespoke, case-by-case basis depending on the nature of the IP, the scenario under which the intangible arises, the sector and the extent of assumptions needed in a given case. In other words, IP can be treated in a range of ways depending on the circumstances:

• It could be (initially) capitalized at cost and then either kept at cost or be subject to some form of either depreciation or appreciation test. How it gets depreciated or appreciated depends on reviewing comparable sales of IP that occurred at future dates. In this way, the IP is effectively marked-to-market on a periodic basis. What is not done, is that the IP immediately or slowly is written off (as if to wish away the problem) as that simply does not capture the reality of ongoing value and potentially increasing value in IP.
• The identification of goodwill on the merger of two businesses triggers an implicit IP valuation in many cases. As per FAS 141, there is a sense in breakdown of the goodwill into its implicit component - IP elements. This too would need subsequent mark-to-marking of the IP as time progressed.
• The use of multi-scenario discounted cash flow analyses – this effectively would become something like Monte Carlo type simulations. Not easy as it involves envisaging multiple future scenarios for IP and the whole problem with IP is that it often behaves in a very binary fashion (it either turns out to be incredibly valuable or to have very limited value). But this type of approach is not dissimilar to J-curve type DCF’s that are used for early stage tech businesses as a whole.
• Option analysis – it has long been known that a young business can be analyzed as an out-of-the-money option. It is a theoretically sound idea, but difficult in practice since, for example, determining the volatility of the notional option depends on your view of the likely future performance of the business. But applying option analysis to IP may be more workable precisely because of the above mentioned binary nature of the value of IP. A data set of relevant IP performance (i.e. historic performance of other patents or IP applications could be built up), from which some type of volatility database could conceivably be built.
• In the absence of exact quantification of IP, an already mooted accounting practice should become compulsory, whereby a central feature of any company’s accounts would include a section on the description of the business's IP. This would at least demand that there is a qualitative, even if not quantitative, section in the accounts describing the IP central to the performance of the relevant enterprise.

Other methodologies may abound, and the trick may be to triangulate between these methods as in any good company valuation. Either way, for the investors, this can no longer wait. It is no longer a theoretical matter. Vast amount of value will simply not be captured (and is not being captured) in investment analysis and in our macro-economic records (e.g. of GDP) unless we start very seriously finding ways of valuing and recording IP going forward.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.