Intangible Assets and Directors’ Duties: Why Directors Should Understand the Economic Value of their Intangibles

Karen Hallenstein, Co-Founder & Managing Principal at ipervescence, discusses why the value of intangible assets is important due to their increasing role in driving growth and revenue. She will dive further into this topic in her upcoming presentation at the IP Fundamentals: Trade Marks webinar on Wednesday 28 October 2020, where she will also discuss the impact of COVID-19.

Company directors are under increasing scrutiny from stakeholders and regulators. Consequently, now more than ever, directors must have a sharp focus on understanding the scope of their fiduciary duties. A key aspect of directors’ duties is to diligently manage all company assets. Directors must be sufficiently knowledgeable and informed about both their tangible and intangible assets in order to fulfil this duty.

Intangibles are playing an increasingly important role in driving growth and revenue. However, they have been largely ignored accounting standards. As a result, many organisations do not have a clear picture of the economic worth of their intangibles. This gives rise to a significant information gap, making it difficult for directors to competently fulfil their duty. A commercial valuation of key intangible assets may play a critical role in addressing this gap.

Why are intangible assets important?

Intangible assets are non-physical assets that provide value for the owner.¹ They include data, technology, inventions, brands, confidential information and processes. Intangibles have risen in importance with the evolution of an increasingly competitive and digital economy. Companies are turning to innovation and for differentiation and success. It is estimated that intangibles make up 84 per cent of all enterprise value on the S&P 500.²

Intangible assets are versatile and scalable, which makes them economically valuable. Unlike tangible assets, intangibles can be commercialised in many different ways, used by multiple parties simultaneously and they don’t depreciate in value through use. This creates a significant opportunity for competitive advantage and growth, which in turn drives value for the owner.

Identifying and leveraging that value requires an appreciation of the unique qualities of intangibles. For example, when aligned to enterprise strategy, intangibles help to support asset governance and risk assurance, protect revenue streams, foster growth opportunities in existing and new markets and secure positive customer advocacy.

Conversely, ill-informed dealings with intangibles can expose an organisation to risk. For example:

• the strength of intangibles may depend on their legal protection, which is in the case for patents and trade marks. Failure to maintain and defend these protections may result in a substantial reduction of value
• infringing the legally protected intangible rights of other parties may result in negative publicity and financial penalties
• the non-linear relationship between R&D and a resulting intangible asset means that heavy investment in R&D won’t necessarily produce a high return asset
• the value of intangibles may be dramatically eroded through reputational damage or technical obsolescence.

To effectively leverage opportunities and mitigate risks associated with intangibles, directors must understand their economic worth.

Why should intangible assets be valued?

Accounting standards make it difficult to capture the value of intangibles in financial statements. Generally, intangibles are not recorded on the balance sheet until after a transaction has occurred. As a result, a substantial portion of enterprise value may not be evident on the face of a balance sheet.

This accounting approach to intangibles creates a significant information gap for managers and board, making it difficult to make informed decision about the management of a material class of assets. With intangibles accounting for more than half of the value of most organisations, it is important that their economic value is accurately drawn to the attention of decision makers, so they can be effectively leveraged, and associated risks mitigated.

Directors must approach intangible assets with the same due care as they would any other corporate asset.

How are intangible assets relevant to directors’ duties?

Delivery of value from the assets of their organisation is one of the key responsibilities of directors. Directors owe a fiduciary duty of care and diligence to their company as a whole.³ It is expected that directors will diligently manage all classes of assets of their organisation – which includes intangibles. Directors must therefore approach intangible assets with the same due care as they would any other corporate asset. This requires directors to be sufficiently knowledgeable and informed about the intangible assets of their organisation to make diligent decisions. Failing to understand and manage the value of intangible assets may make it difficult to competently fulfil their duty, potentially exposing directors to penalties for breach.

In the US, there have been a number of legal proceedings filed against directors as a result of poor governance of intangible assets. For example, shareholders of RSA Security Inc alleged that directors were in breach of their duty because the company had not filed for international patent protection, thereby enabling competitors to use the technology in international markets, significantly undermining financial returns.⁴ In another case, the Superior Court of Delaware acknowledged that corporate officers and directors may have an affirmative duty to monetise their corporation’s intangible assets, including the use of litigation if necessary.⁵

There’s no reason to believe that Australian directors have a lesser duty with respect to intangible assets, particularly in light of the Hayne Royal Commission and ASIC’s Director and Officer Oversight of Non-Financial Risk Report⁶.

When should intangibles be valued?

Ideally, companies should regularly value their material intangible assets, to help inform strategic planning and transparent, informed decision making.

Understanding the economic worth of intangibles will be particularly important in the context of developing and implementing key enterprise objectives, such as:

• commercialisation — for example licensing or selling intangible assets
• investing in R&D
• selling or buying a business
• raising capital
• litigation

A practical illustration of the importance of valuing intangibles in the insolvency context, is Nortel. Nortel filed for bankruptcy in 2009. Its physical assets sold for US$3.2 billion. Its patents were noted on the balance sheet as US$31 million, but in fact sold for a staggering US$4.5 billion⁷.

Is there a robust methodology for valuing intangibles?

While traditional accounting methods may not be well suited to valuing intangibles, there are recognised methodologies that will reliably and accurately determine the economic worth of intangibles. These include qualitative, as well as traditional quantitative, analysis. In other words, they involve not only financial review, but also technical and legal assessments of the quality of the underlying intangible. For example, a qualitative assessment would include consideration of the:

• scope and drafting of a patent specification
• breadth of classes covered by a trade mark registration
• veracity of data
• structure and maintainability of software code.

A valuation of intangibles should comply with both accounting standards⁸ and recognised international guidance for IP valuation⁹. Ideally, a valuation should be conducted by experts with credentials in the global finance and investment industry, as well as expertise in the relevant underlying assets, for example a registered patent or trade mark attorney.

Conclusion

Intangible assets make a significant contribution to corporate worth.

It is possible to reliably determine the economic worth of intangibles, using rigorous and robust analysis. Understanding the quantum of value of intangible assets can deliver significant benefits in terms of competitive advantage and risk mitigation.

Directors should insist on regular reporting on key intangible assets, including the commercial value of these assets, to ensure compliance with their duty to act with care and diligence in the best interest of their organisation.