«Research commissioned by the Intellectual Property Office, and carried out by: Martin Brassell, Kelvin King This is an independent report ...»
Because of substantial differences between companies, debt levels, and associated interest payments, it is common practice to compare debt-free or interest-free market multiples. Rather than analyse price/earnings multiples in isolation, enterprise value is compared to both earnings and revenues, namely EBIT and EBITDA. Enterprise value is equal to the total market value of a company’s total equity plus all interest bearing debt less cash.
Consideration of numerous factors and inputs results in a calculation of the cost of equity. The WACC will then be calculated based on an industry-derived appropriate capital structure using the cost of equity and the cost of debt capital. After applying the calculated WACC to the net cash flows, and residual value, there will be an indicated enterprise value. Sensitivity analysis on 206 The role of intellectual property and intangible assets in facilitating business finance this value may be run by varying key valuation inputs such as the discount rate. This analysis can therefore indicate an enterprise value range and place the value of IP contextually.
The cost approach measures the value of an asset by the cost to replace it with another of similar utility. When applied to the valuation of equity interests in businesses, value is based on the net aggregate value of the entity’s underlying assets. The technique involves a restatement of the balance sheet of the enterprise substituting the fair value of its assets and liabilities for their book values. The resulting equity value is reflective of a 100% ownership interest in the business. This approach is frequently used in valuing investment companies or capital-intensive firms.
In March 2012, the UK Government announced corporate tax reforms, implementing a wideranging programme of changes, one of which was the introduction of the ‘Patent Box’. This aims to create a more competitive tax environment for companies developing and exploiting patents in the UK, and thereby to establish an incentive to retain and commercialise patents and encourage investment in growth.
How Patent Box works Additional guidance is now being produced to indicate how Patent Box rules will be applied.
The most recent indications are that involvement in development leading to or arising from a patent will be regarded as important. If a company owns an exclusive license of a qualifying IP right and/or receives income from a qualifying IP right, this may fall within the Patent Box.
Acquired patents and patents developed under partnership, joint venture and cost sharing arrangements may also fall within Patent Box.
Qualifying IP rights include patents granted by the UK IPO or European Patent Office, supplementary protection certificates (i.e. biologically active agents and similar), regulatory data protection and plant variety rights, secret patents and patents granted by regimes with similar rules (for example Austria, Bulgaria, Czech Republic, Demarks, Estonia, Finland, Germany, Hungary, Poland, Romania, Slovakia and Sweden). However, utility or ‘petty’ patents are excluded.
Profit that qualifies is effectively a proportion of worldwide profits (referred to as relevant IP income or ‘RIPI’) from any of the following: licensing income (royalties and others), sale of a patented invention and rights, sales of products significantly incorporating a patented invention, use of a patented invention in a company’s trade, damages and proceeds from infringement claims and insurance and income while a patent is pending (though these can only be included later, once a patent is granted). Profits that do not qualify include routine profit of manufacturing or development, exploitation of marketing intangible assets such as trade marks and brands, profits from non-exclusive patent rights, income from copyright and income from passive ownership.
There are various stages in calculating the profit. The detailed provisions can be briefly
summarised as follows:
• From taxable trading profit (total gross income of the trade excluding finance income) it is necessary either to apportion (standard calculation) total profits in the ratio RIPI to total gross income or as an alternative and if not appropriate, to perform a streaming calculation allocating expenses on a just and reasonable basis which is in practice a divisionalisation between RIPI and non-RIPI
• In this process it is necessary to remove routine return on costs which for example is provided as 10% of relevant tax deductible expenses (e.g. outsource costs, material costs) to arrive at Qualifying Residual Profits (QRP)
• In further calculating the available profit the return on marketing assets is removed from QRP; the remainder is Relevant Profit (RP). Thus a complex calculation which first establishes routine profit and reduces that to residual profit and results in Relevant IP Profit for Patent Box purposes 208 The role of intellectual property and intangible assets in facilitating business finance
Implications of Patent Box
The opportunity to make a significant difference to a corporation tax calculation is of interest to patent-owning businesses of all sizes. Whilst the measure has obvious and immediate applicability to multinational organisations operating in science or technology-intensive areas, it is equally capable of being used by SMEs, which (based on the patenting statistics discussed in Chapter 5) should include a reasonable proportion of manufacturers.
Whilst the measure places UK tax legislation on a more equal footing with other countries seeking to incentivise innovation and growth, those who will benefit most in the first instance are those who have innovated historically. There has been debate in the IP industry as to the ultimate contribution of the measure to growth, and its impact on the frequency and strength of patenting activity. In particular, concerns have been raised that the tax incentive will encourage businesses to create weaker or more highly specialised patents which do not in fact contribute the same level of enterprise value.
Chapter 10 Conclusions and recommendations Report findings Introduction The central question behind this report has been: is there more that companies and financiers could do to leverage the value inherent in IP and intangible assets? The answer is an emphatic ‘yes’.
In the course of reaching this conclusion, the authors have studied and incorporated information on a wide range of operational and technical matters relating to IP and intangibles; to obtain insights from a wide range of practitioners; and to obtain statistical information which helps to quantify both the issues identified and their significance. This approach has led inevitably to the production of a lengthy, detailed study, but the subject matter deserves no less.
The issues identified in this report represent a particular challenge for the development of the knowledge economy, but also place potentially serious constraints on the growth of companies in traditional industries. There are two overarching principles advocated by this study; ten more detailed recommendations follow them.
Below are set out the study’s main conclusions, in the order in which the report has examined them. The authors then make ten recommendations based on two overarching points of principle, set out at the end of this final Chapter.
Attitudes and practices in lending Clearly, banks understand that there is a connection between a business’s IP and intangibles and its cashflows; or, as an ACCA report put it, that “intangible assets provide the basis of superior profits and enterprise value beyond that determined by competitive market conditions142”. Whilst intangibles do not emerge as the ‘asset of first choice’, a high proportion of commercial lenders interviewed for this report had an awareness of their value and felt that more could be done with them – to improve control, inform appetite, or both.
142 SME Intangible Assets, ACCA Research Report no.93, Dr Chris Martin & Julie Hartley, 2006. However, this report also observed that “the lack of concrete form and the general absence of functioning markets for intangible assets make their valuation problematic in comparison with that of physical assets that are regularly bought and sold in transparent markets.” 210 The role of intellectual property and intangible assets in facilitating business finance
Under most circumstances, it is clear that the information provided to lenders on IP and intangibles is imperfect. As things stand, it is not unreasonable for banks to pay very little attention to the intangibles commonly found on balance sheets; these indicate expenditure, but do not confirm that assets exist (unlike tangible fixed asset accounting).
The difficulty is that few banks are currently probing any deeper.
Similarly, it is hard to criticise the prevailing banking view that IP lacks the transparent markets which exist for commodified tangible assets. However, that does not mean it is not valuable (as the authors hope this report has amply demonstrated). It is also the case that where a relationship exists between specific intangibles and cashflow – arguably, more often the case than not – it is very hard to dispose of the business successfully without its IP.
It follows that, if it is to make better use of IP, mainstream lending will undoubtedly need to adopt standardised, affordable assessment methods that are capable of being integrated within its culture and processes, including systems for considering value and evaluating default probabilities. This has to start by requesting and gathering information on IP and intangibles within formal and informal lending applications. It stands to benefit borrowers as well as lenders.
Feedback from those who have used IP in financing strongly suggest that loss levels are low.
This appears to be attributable to two factors. The first is that these lenders have been satisfied that the particular IP being funded is a core business asset that underpins customer service and cashflow. The second factor, harder to measure but nonetheless present, is that senior management often have a personal and financial stake in the IP they have created. Accordingly, obtaining proper controls over IP can perform some of the ‘focusing the mind’ benefits that banks traditionally associate with personal guarantees.
which is acknowledged to be a useful vehicle for IP-centric businesses. The recent independent report for BIS appears to confirm that it offers real additionality to companies who take it up.
Levels of usage of the scheme are running substantially below what they have been in the past, and this appears to be attributable to a perceived high risk of default (combined with other factors, such as the 9.75% cap on the government guarantee explained in Chapter 2). However, given that recent research143 concludes that £33.50 of benefit accrues to the economy for every £1 the scheme costs the government, EFG looks like a missed opportunity both for banks and for IP-owning businesses lacking tangible collateral.
Attitudes and practices in investment
The prospective returns available to an equity investor are of a different order of magnitude from debt funding. That said, equity investors in general, and (arguably) business angels in particular, accept a far greater risk of losing all their money than a bank could. They are highly motivated to address risk (including a business’s intellectual capital) in all possible ways, because all their capital is in jeopardy.
Investors regard a protectable competitive advantage (barriers to entry) and freedom to operate as being fundamental preconditions for getting involved with a business – both of which are directly connected to IP, though not necessarily registered IP. Also, where they are involved with comparatively early stage businesses, investors are used to working in circumstances where there are very few fixed assets on the table and making decisions based on what they perceive to be the quality of the off-balance sheet intangible assets.
In other ways, the interests and concerns of equity and debt financiers are quite well aligned.
Both have a strong vested interest in whether a business has market traction, contracts, cash flows and profits. Both also recognise the importance of quality and experience in the management team. And equity investors appear to experience some of the same issues as lenders in finding business that properly understand their own IP and intangibles.
The Big Innovation Centre’s recent report concluded that equity funding is inherently more suitable for funding innovative and growth businesses. The ability of angels and venture capital providers to spend sufficient time to understand what makes a business ‘tick’ may be part of the reason for this.
Unfortunately, the fact is that only a small minority of businesses are suitable for, and successfully access, informal or formal equity funding from business angels and venture capital companies.
Many are perfectly viable businesses, but cannot raise this form of finance because they will never generate the types of returns that equity investors require.
This model is starting to change with the ‘democratising’ effect of crowdfunding platforms – but these have a long way to go before they can make a really substantial impression on the overall funding landscape.
143 Ibid 212 The role of intellectual property and intangible assets in facilitating business finance
point that IP and intangibles need to be identified to ensure that value can be retained within the organisation if it gets into difficulties.
The main challenge in terms of achieving value in distress is perhaps the lack of confidence that it is there to be had at all. Several interviewees expressed the view that if a company fails or gets into difficulties, it suggests that the underlying IP was of poor quality or little interest. However, this is inconsistent with the experiences or preferences of investors, many of whom have experienced great IP which has not been successful because of failings on the part of the management team. It is therefore a non-sequitur.