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«Research commissioned by the Intellectual Property Office, and carried out by: Martin Brassell, Kelvin King This is an independent report ...»

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It needs to be shown that the development expenditure was undertaken because there is a reasonable expectation of specific commercial success or future benefits arising from the work, either from increased revenue and related profits or from reduced costs.  In addition there can

only be future benefits of the expenditure if:

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How accounting rules affect business behaviour Impact on SMEs As will be evident from the preceding sections, acquired IP and internally generated IP are treated in fundamentally different ways. The implications of accounting policy for SMEs have been studied and summarised very effectively for the World Intellectual Property Organisation by Dr Roya Ghafele, its then Associate Economic Officer, IP and Economic Development Department. This section owes much to her piece, Getting a Grip on Accounting and Intellectual Property134.

Accounting has so far developed a very scarce vocabulary and syntax to communicate the value of IP to investors and managers. In accounting, the financial position of a company is phrased in terms of profits or losses, assets or liabilities… Internally generated IP is treated as an immediate expense. The same applies to Research and Development (R&D) related to the creation of IP. This means that the balance sheet offers distorted information on how IP is made. The costs incurred for the creation of IP are reported at one single point in time, while the IP is accounted for only in the context of a commercial transaction. However, this approach is not exclusively reserved for IP, but reflects the general way in which the accounting profession approaches a business.

Unlike internally-generated IP, acquired IP is reflected on the balance sheet; for example, according to US GAAP, IP is valued at its acquisition cost and amortized over a maximum period of 40 years. However, this may lead to serious confusion;

whereas internally-generated IP is considered to be worth nothing, the IP that change hands may be worth hundreds of millions of dollars. Thus, a company which decides to sell or license internally generated IP appears to create profits virtually out of nothing, as the IP that generated these profits does not appear on its balance sheet.

To outsiders, this might look like magic, whereas it is nothing but the expression of unfortunately stated information135.

Dr Ghafele makes the point that IP exists independently of a product or service, and therefore has business value regardless of whether or not an adequate reporting system exists. However, the difficulty raised is that the profit and loss account of the company may not reflect its economic

profitability if IP underpins the business model and/or business strategy:

As IP is not explicitly stated on the balance sheet and investments in creating IP are usually expensed as they occur, both the earnings and the book value of equity are understated by the accounting model136. The consequence of this is twofold. Firstly, the cost of capital increases, meaning that IP-intensive SMEs may find it even more 134 www.wipo.int/sme/en/documents/ip-accounting 135 Comment attributed to Licensing Executive Society, 2002 136 Attributed to Caninbano L./Garca-Ayuso M./Sanchez P., 2000; Lev B./Zarowin P., 1999; Brown S./Lo K./Lys, 1999) 194 The role of intellectual property and intangible assets in facilitating business finance

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Dr Ghafele summarises the difficulties that are caused by the lack of transparency in language reminiscent of the characterisation of the ‘information asymmetries’ referred to in numerous

government publications on access to finance:

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Dr Ghafele suggests that quoted stocks in sectors that have a strong IP dependence are also considered riskier and experience greater volatility than those of industries which have a stronger tangible asset base. She attributes this not only to the inherent technological risk factors, but also the inadequacies of communication about IP in capital markets. She also suggests that the

lack of visibility of IP has an effect on company valuations:

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Implications for IP management Dr Ghafele also believes that the scarce reporting on IP has an impact on the management process, in particular that it makes it hard for management to think about developing and honing

strategies to exploit IP:

Since the bulk of the space on the balance sheet is occupied by tangible assets, the focus of management is concentrated on these assets, which, in an increasingly knowledge-driven economy, are no longer the main determinants of the success of an increasing number of businesses in not only high-tech industries, but in all knowledge intensive and/or creative industries.

She quotes Roger Carlile as saying:

Companies today are spending a majority of their time managing a minority of their assets (the tangible ones). With the pressure on management for bottom-line results, it is difficult to persuade CEOs to spend money on installing processes for managing IP company-wide if they cannot see any value.

As further evidence, Dr Ghafele cites estimates by Rivette and Klein that 67% of US companies own IP that is in no way commercially exploited138.

And in her article she also quotes McKinsey & Company research139 which found that:

In the US, companies create on average not more that 0.5% of their operating income from the licensing of IP. McKinsey, however, calculates that firms could earn up to 10% of their revenues from the sale or licensing of IP.

138 Rivette K. G./Kline D. 2000 139 (Elton J./Shah B./Voyzey J. 2002) 196 The role of intellectual property and intangible assets in facilitating business finance

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In 1999, Dr. Margaret Blair of the Brookings Institution studied the shift in the mark-up of company assets of thousands of non-financial companies over the 20-year period from 1978 to 1998, and found a significant shift in the relationship between tangible and intangible assets over time. Her study140 indicated that in 1978, approximately 80% of corporate value was due to tangible assets, with 20% accounted for by intangibles.  By 1998, the proportions had been reversed, with 80% of corporate value associated with intangible assets and only 20% with tangibles.

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Clearly, the companies included within this analysis are not the same across the period sampled, but the chart makes the point that the nature of the businesses which are regarded as the largest and most significant players in the quoted market has fundamentally changed.

Interviews with valuation practitioners also indicate that this 80/20 rule is frequently evident when valuations are performed in post-acquisition accounting in line with IFRS3 rules. Whilst the position varies by sector, with manufacturing businesses typically having rather more fixed assets and software companies rather less, informal soundings confirm that it is common to find only 20-25% of the purchase price of a company being accounted for by tangible assets, with the remainder attributable to a combination of specifically identifiable intangible assets and goodwill.

IP & intangibles valuation standards

Making best use of the value inherent in IP, and not otherwise visible, requires there to be standard approaches which have an appropriate degree of acceptance and professional oversight. This is particularly important where the asset is to be attributed a specific value, for instance in the context of a pension-related transaction.

Royal Institution of Chartered Surveyors (RICS) and the revised Red Book

The RICS Red Book established the benchmark for real estate valuation in the early 1980s. The Red Book is recognised worldwide as a gold standard of valuation and can only be carried out by a qualified chartered surveyor. Red Book is fully compliant with and incorporates International Valuation Standards (IVS) and is mandatory for all RICS members practising valuation globally.

The new IVS came into force in January 2012 and RICS responded to the latest changes with an edition of Red Book that has been completely updated to be fully compliant with global IVS requirements.

For years the business and intangible asset valuation industry has not been bound by such standards. RICS picked up the baton establishing a Valuation of Business and Intangible Assets Group. Similar to real estate practice RICS felt Guidance Notes were needed to help members who undertake business, intellectual property and intangible asset valuations and incorporated two new chapters in Red Book. These notes set precedent, mandatory rules and best practice for valuers specialising in these areas.

The purpose of RICS Standards is to provide users of valuation services (typically and substantially lenders) the confidence that a valuation provided by a RICS qualified valuer has been undertaken in compliance with high professional standards. It also assures users that the valuation is independent, objective and consistent with the internationally recognised standards set by the International Valuations Standards Council (IVSC); standards that set out procedural rules and guidance for valuers and now within RICS Rules of Conduct and best practice in the execution and delivery of valuations for different purposes. There is a mandatory obligation on the individual valuer or firm registered for regulation by RICS to follow these standards and effective sanction if there is a material breach.

198 The role of intellectual property and intangible assets in facilitating business finance The IVCS of which RICS is a sponsor publishes and periodically reviews IVS. These are adopted and supplemented where appropriate by RICS and reflected in successive Red Book editions as part of the overall framework of standards which is backed by the comprehensive scheme of regulation to ensure effective implementation and delivery. While some Standards are occasionally presented in a different way to those of IVS, the principles, objectives and defined terms of the same. Thus RICS considers that a valuation that is undertaken in accordance with Red Book is also compliant with IVS.

All this means that, as historically is the case with Chartered Surveyors and real estate Red Book valuations, the RICS Registered Business Valuer credential will establish a similar reputation and deliverable for lenders, ensuring operation to the high standards of best practice for business and intangible asset valuation.

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The following are extracts and summary from the Guidance Note concerned with the valuation of intangible assets, reproduced with the kind permission of RICS. It does not deal with the valuation of land, plant and machinery, or other tangible assets that may sometimes constitute part of a business, or indeed the valuation of the businesses themselves.

As defined by International Valuation Standard 210, an intangible asset is “...a non-monetary asset that manifests itself by its economic properties. It does not have physical substance but grants rights and economic benefits to its owner.” An intangible asset can be identifiable, i.e. separable, capable of being separated or divided from a business entity and sold, transferred, licensed, rented or exchanged individually or with a related asset, liability or contract. Nonidentifiable intangible assets, arising from contractual or other legal rights which may or may not be separable from the entity or other rights and obligations, are generally termed “goodwill”.

Following IVS and International Financial Reporting Standards intangible assets include:

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Artistic related – assets arising from artistic products or services which are protected by • a contractual or legal right, for example copyright and design, and giving rise to benefits including royalties from artistic works such as plays, operas, ballet, books, magazines, newspapers, musical works, pictures, photographs, videos, films, television programmes Technology related - assets representing the value of technological innovation or • advancements, and can arise from non-contractual rights to use technology, or be protected through legal or contractual rights (patented technology, computer software, unpatented technology, databases, trade secrets, in process R & D, manufacturing processes and know-how) Some intangibles are contract-based, namely assets representing the value of rights which arise from contractual arrangements (licensing, royalty and standstill agreements, contracts for advertising, construction, management, service or supply, lease agreements, construction permits, franchise agreements, operating and broadcasting rights, use rights such as drilling, water, air, mineral, timber cutting and route authorities, servicing contracts, employment contracts). Within each of the classes referred to above, assets may be either contractual or non-contractual.

The importance of these definitions within the project brief is that accounting and financial regulators have, after significant and lengthy due diligence, established these assets as identifiable and capable of rigorous valuation.

A major intangible asset is goodwill. It is a future economic benefit that arises from a business or interest in a business, or from use of a group of assets. The benefits that may form part of goodwill include synergies that follow a business combination and are company specific, for example economies of scale not otherwise reflected in the values of other assets, growth opportunities such as expansion into other markets, and organisational capital, e.g. the benefits obtained from an assembled network. Goodwill is often perceived to be the amount remaining after the values of other identifiable tangible and intangible assets have been deducted, from the overall value of the business.

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