The Importance of Knowing your Intellectual Property
Intellectual Property (IP) is the key value-driver for many innovative companies, and yet very little attention is paid to it. In fact, even owners of those companies don’t really know exactly what intangible assets they have got. As a result, they can end up losing out on many advantages of IP, including the use of IP to raise funds. Intellectual Property and other intangible assets drive value in the 21st century. They are, as Mark Getty said exactly 20 years ago, “the oil of the 21st century”. To understand how this works in the real world, just look at the biggest companies today. For companies like Apple, Microsoft and Uber, stock market value is not driven by physical assets, like buildings, equipment, raw materials and ﬁnished products, but by patents, copyright, trademarks, trade secrets and other knowledge-based and intangible assets which they own. Apple – the world’s largest company by market cap – shows a total of $317bn of assets on its June 2020 balance sheet (of $194bn is cash or near-cash) and $72bn of shareholders’ funds; compare that to its current market cap (at the time of writing) of $2.25 trillion. The rest lies in “hidden” intangibles.
The same principle applies to companies at the other end of the size spectrum. In fact, arguably more so; small and medium-sized enterprises (SMEs) with a great, scalable innovation often appear to have very ‘thin’ balance sheets as none of their work requires them to acquire tangible assets. Regardless of size, no company ﬁnds it easy at present to show where its real substance and value lies. This means that if a need arises for, say an arms-length asset transfer, a tax restructuring, or even a rescue or insolvency, the visibility of key assets is often minimal. That’s because current accounting rules date back to the 20th Century and haven’t yet caught up with the rise of IP value and new knowledge economy assets.
Unless acquired through M&A activity, companies are very restricted in the intangible assets they can recognise on their balance sheet, unlike as with physical or tangible assets. Even where they can put IP and intangibles on the balance sheet, entries are only at cost and are required to be amortised.
Registering your IP
Some IP, such as patents and trade marks, has to be registered for it to be protected. Other IP, such as copyright, is automatic and needs no registration in most countries. Where applicable, IP should be registered with the appropriate authorities. In the UK, the registration of patents is done by ﬁling the relevant application form to the United Kingdom Intellectual Property Oﬃce (UK IPO) and the procedure usually takes between 4-6 months. Registering an IP right is one of the most eﬀective ways to protect one’s name, brand and work. IP which is registered, like patents and trademarks, are likely to be seen as more valuable and also more capable of being sold, like physical assets. This contrasts with unregistered rights such as copyright, which can be more difficult to identify and to undertake ownership transfer.
IP experts often refer to Intellectual Property Rights (IPR). This is a catch-all term for registered and unregistered IP rights which are protected by law. So it covers things like patents, trade marks, copyrights, utility models, performing rights and design rights. IPRs are signiﬁcant in many acquisitions and disposals, particularly given the nature of the transactions that are being undertaken in recent times. More businesses are realising the value and importance of IPRs and how signiﬁcant having a strategy for managing IP is in order to maximise value and minimise risks associated with such asset.
IP owners inherit certain exclusive rights to use and exploit their protected assets. Various options include licensing the IPRs to another legal person for a fee (typically in the form of royalties), selling/assigning the IPRs to generate revenue, or using the IPRs as security (e.g. for a loan). It may be the case that a company has valuable IP related to an industry it no longer has any significant interest in; it could raise funds by selling or licensing this IP to companies who wish to use it in the relevant industry sector. Careful consideration is required in such transactions/arrangements as to what this value should be; there is a noticeable gap between the value of IP assets examined for a collateralisation or internal evaluation and the value attached to IP assets in an actual transaction. As a seller of a business, the value of the IP would determine the bargain power on negotiating a sales price with the buyer.
Value of IP
Assigning a numeric value on IPRs (such as goodwill) can be challenging. However, calculating and recording goodwill is an important part of the business valuation. The concept of goodwill often arises when one company is looking to acquire another company where the value of the consideration must be allocated to the acquired assets and liabilities, with the residual value being allocated to goodwill. It is important to get the allocation right, particularly because such allocation impacts, amongst others, the balance sheet and the level of proﬁts and taxes due. Ultimately, this affects the future revenue and prospects of the business.
IP can be sold in relation to a speciﬁc geographic territory, or in certain circumstances, IP can be transferred, sold, or assigned oﬀshore. Identifying valuable IP early on is essential to structuring a compliant oﬀshore asset base in a tax eﬃcient manner. However, it is even more diﬃcult for businesses to locate certain IP in oﬀshore jurisdictions due to the economic substance rules introduced and adopted by many countries who are in the Organization for Economic Cooperation and Development (‘‘OECD’’) inclusive framework. Small and medium-sized enterprises (SMEs) overseas can claim UK research and development (R&D) tax relief – designed to promote private sector investment in innovation. Certain IP, such as trademark, do not require a lot of substance in order to be held oﬀshore. However, most oﬀshore centers have adopted the minimum OECD recommended rules on the economic substance and, therefore, despite the aforementioned difficulties, the thresholds for offshoring IP can generally be achieved by most businesses with expert advice.
Whilst real IP value might be going up, anything on the balance sheet will only go down. That, in turn, means counterparties can’t see the value of a business’ IP and intangible assets.
This is becoming an increasingly important omission. Firstly, the new tax world is being driven by OECD’s Base Erosion and Profit Shifting (BEPS) programme. Tax “arbitrage” by opportunistic geographical location of IP assets is no longer permitted; rather the principle now is that proﬁts are taxed where they are economically generated. The paramount importance of IP here is demonstrated by the fact that IP-based “BEPS” tools are said to be responsible for the largest global BEPS ﬂows.
Secondly, the sharp rise in importance of IP and intangibles can be seen in recent high-proﬁle Chapter 11 cases in the US, for instance J Crew and Revlon. These are complex and on-going cases, but essentially savvy new lenders to the troubled groups have managed to detach the IP assets from the existing lender structures, relocate them in security terms, and then use them to collateralise new lending – they knew that’s where the real value in the group was. Arguably, the existing lenders hadn’t secured those key assets well enough.
Both these examples show the real importance of: 1) Knowing the complete IP asset inventory and 2) The ability to put a realistic and repeatable (i.e. up-to-date) value on the IP mix as a whole. It is axiomatic in business that things which can’t be measured can’t be managed: it is good business practice to identify and value intangibles, and to consider how well they are being protected and exploited, before there is a sudden transactional imperative to do so.