Most weeks we see 10 to 15 “new” ideas. They come from all over: from startups to major multi-nationals. Some are great, some aren’t. Some will change the world, other won’t make it out of the garage or lab. The one thing they all have in common is that the promoter thinks they are highly valuable. Those who have been asked to invest in or pay for these ideas tend to be a lot more circumspect. Interestingly, it’s not always clear who is more right. Case in point: a Singapore company recently approached us to provide an independent valuation of an idea presented to them by a start-up: the price tag – a cool $100,000,000. That’s a lot of dineros for just an idea. The irony is that the company’s modelling suggested it could be worth at least that or even more. What to do?
Valuation of intellectual property (hereafter the broader term, intangible assets) is one of the most important and vexed issues in finance, investment and commercialisation today.
It’s important (and will only become more important) because intangible assets now account for over 87% of all company value - in technology orientated companies and start-ups that proportion is higher still. Intangible assets are everywhere: data, software code, content, confidential information, brands, regulatory approvals, product designs, inventions and industrial know how. These assets are not just the largest repository of value today but they are also the primary drivers of future company performance – which is fundamentally what drives today’s share price. It’s also extremely important for tax as virtually all transfer pricing schemes are based on intangible rather than tangible assets. Likewise purchase price allocation exercises.
It’s vexed for several reasons:
§ the area is extremely poorly understood, even among the most reputable accounting firms - there is very little agreement about how to value intangible assets.
§ It requires an in-depth understanding of intangible assets - the ability to analyse and accurately comment on complex interactions between multiple assets as diverse as data, plant variety rights, patents, brands and software code (as in one recent example we faced). This kind of deep technical and intellectual property skill set is almost entirely absent from most accounting firms.
§ International accounting standards aren’t particularly useful when it comes to valuing intangible assets. Under IFRS and GAAP these assets typically don’t make the balance sheet and when they do they are either simply put under “good will” or on at cost.
§ The assets themselves are not physical – you can’t perform a stocktake or inventory.
§ By definition intangible assets are more or less unique and differentiated – meaning establishing a benchmark or comparator is challenging and there is often no liquid market to price seek against.
Unfortunately, despite what IFRS and GAAP would have us believe this isn’t an issue that can be swept under the carpet or off the balance sheet. These assets now account for too larger share of company value, and valuation issues crop up so frequently (be it in tax, M&A, investment or day to day transactions), that they can’t be ignored.
To summarise thousands of pages of accounting theory (I can hear the accounting professors sobbing – apologies!) traditional intangible asset valuation approaches effectively boil down to two broad camps: cost and cashflow. Regrettably, neither are especially helpful. This is particularly true where (as is often the case) the intangible assets in question either don’t have cashflows directly attributable to them or they relate to new or uncertain projects.
§ Cost Basis: First, capital providers (internal or external) generally don't care much about your sunk cost for a non-revenue producing asset. The money is gone and just because it was been spent doesn’t mean it was spent wisely. Second, there is zero relationship (either positive or negatively) between the cost to build these assets and their actual value. There are too many examples of this to cite here but the case of Instagram is useful: https://www.entrepreneur.com/article/223310. When we see an intangible asset on the balance sheet for cost the one thing you can say for absolute certainty is “that number is wrong”.
§ Cash Flow Basis: new intangible asset rich projects usually have no cash-flow to conduct an NPV analysis on. The general response is to forecast (imagine) them. In other words, project future revenues and bring them forward for valuation purposes. This is why zero revenue companies can be worth billions (on paper) - the valuation represents the expectation of tens of billions in the next 20-30 years. Sometimes the billions eventuate, more often they don’t. However, it also works the other way: where intransigent buyers or investors steadfastly refused to recognise value. Google and Excite (remember them?) fell apart over a measly $250,000 to buy all of Google for $1M. Five months later Google raised $25M. The rest is history.
We are uncomfortable with the NPV reasoning that dominates much valuation methodology for new intangible asset rich projects (in isolation of other triangulating factors) for one simple reason: the one thing we know with absolute certainty is that the future is guaranteed to be unlike the present. Very often those real cash flows evaporate or the imagined ones never coalesce into reality. Intangible asset valuations drawing primarily on NPV analysis should be used with caution.
Once a new project or intangible asset matures to point where you have stable, directly-attributable revenues these traditional approaches can be useful. However, before that point they suffer from significant inaccuracy and deviation from the reality of value “on the ground”.
Despite the issues raised above there are methods of valuing intangible assets that can reliably and accurately predict future value. In other words – that work. They are more complex and they involve an assessment of factors that are generally foreign to traditional skill sets such as asset quality, valuation proxies and comparative transactions. Critically these techniques cannot be used in isolation. Like ancient sailors navigating at sea a single sighting is unreliable but multiple readings combining different stars and landmarks over time can pinpoint your location in a vast ocean with remarkable accuracy. You need to understand what stars to look for and how to combine the findings.
The difference between a traditional intangible asset valuation and the new mode is stark: it can be seen even in the format of valuation itself. An intangible asset valuation should typically feature a lot more prose and fewer numbers – it’s about building a solid interlocking framework of multiple, well researched factors that together produce a numerical value that can be relied on. In the final estimation valuation is about confidence and building a stable, evidentially backed case that supports a $ figure people will stake capital and careers on generally makes a lot more sense than endless spreadsheets, which anyone who has spent even more than a cursory amount of time around recognise can be manipulated to produce whatever number you need.
By way of example: we were recently asked by a start up to complete a valuation for their new technology and business model around a major infrastructure play. They needed to raise $100M. A traditional valuation from a major accounting firm generated even at its most frothy a number around $40M. The CEO approached us for a critique. It rapidly became clear that the valuation hadn’t captured anywhere near the value of the venture. We prepared a new valuation. It would be fair to say the reaction from the accounting firm was incredulity – no venture could be worth this much they argued. However, entrepreneurs don’t typically take no for an answer and this Founder was no different. He took our valuation to a major investment bank, who enthusiastically adopted the valuation as the centre piece of the investment memorandum. The result: the company raised $100M at a $200M valuation in record time. They have subsequently raised a further $300M. The highest largest in terms of pre-revenue capital raised by a start-up in the Asia Pacific ever. You can more about this here http://www.everedgeglobal.com/blog/2017/7/11/everedge-benchmark.
Valuation of an intangible assets and intangible asset rich initiatives is becoming increasingly critical. Any valuation exercise is inevitably grounded in some form of numerical analysis but accurate and reliable valuation of intangible assets needs to adopt new methods driven primarily by qualitative factors. Traditional NPV and cost approaches risk becoming lost in the numbers and producing results that bear little resemblance to the reality of value. The take-home message is that this is not a mathematical exercise, it is a business-focused conversation about deriving real world values for the most valuable and important company assets today.