Valuing intangible assets is a tough call, especially putting a price on what’s in people’s heads. Andrew MacLeod investigates
In a business world bristling with high-tech systems, the value of the humble employee can be overlooked in the number-crunching grind of due diligence, business advisers are warning.
When one firm cosies up to another with a view to a merger, or eyes a rival for a predatory strike, the role of the workforce – or at least some key employees – can be pushed down the agenda.
Big mistake, says PwC partner Ranjit Auluk, who points out that intellectual property makes up a great part of the value of a modern business – and that the knowledge bank of any company invariably lies in the employees who apply the IP, having in many cases developed it in the first place.
This view is strongly endorsed by Kelvin King, founding director of Valuation Consulting, which specialises in the difficult business of putting a realistic value on the most intangible of assets. He states: “I have known companies acquire other companies purely for a team of ten people. They didn’t want the board, just the key R&D people, so they got rid of everybody else.”
According to King that sort of thing is commonplace in aggressive predatory acquisitions. He makes the point that a company that is already in the drinks business, for example, is unlikely to want factory premises and plant – least of all another workforce – when it launches a takeover bid.
“It already has all of those things,” he says. “All it is after is a set of trademark registrations.”
To get these valuable intangible assets, firms are often prepared to push the bidding to breathtaking levels. The nightmare scenario, however, is that having paid the moon, the acquiring company loses its stars.
There can be serious post-acquisition conflicts when rival R&D departments are merged. Perhaps the biggest flashpoint comes over the distribution of the top jobs.
This, he says, is where expertise can be lost as disgruntled team members can quit unless ruffled feathers are smoothed. Ranjit Auluk comments: “Any company looking to safeguard its IP should ideally have good corporate governance in place in terms of documentation and protection.”
This view can hardly be overstated. No other asset of such value leaves the building as often as the know-how locked up in a key employee’s head, and Auluk believes firms should consider what they would do if one day that person puts on his coat, walks out the door, and never comes back.
Restrictive covenants can be useful to prevent a rogue employee using inside knowledge to set up in business for himself, but these are not foolproof, and are usually time limited. Far better, he says, to incentivise staff following an M&A, locking them in to the enlarged enterprise with generosity rather than compulsion.
“The core to this is understanding exactly where, within your business, the intellectual property lies,” Auluk explains. “Once you know that you can start thinking about how to protect it.”
An inexact science
Some acquirers defer full payment of a consideration until directors and key employees in possession of vital intellectual property complete a specified ‘earn out’ period.
One problem in placing a value on intellectual property is that historically accounting standards have not represented these assets, which have consequently not appeared in company reports, says Kelvin King.
“Lately, we have had some new international finance reporting standards, which have allowed fully listed and AIM-listed companies to show their intellectual property and intangible assets, but only when they purchase another company.”
Since it is widely reported that IP and intangibles make up around 90 per cent of the value of most companies, this is certainly a step forward. King adds: “The second issue, as I know from supporting corporate finance people in their activities, is that the deal is all. The due diligence on what intellectual property and intangible assets you own in this process is not that thorough.”
Matt Waddell, a corporate finance partner with PwC, observes that in general the buyers’ valuation of IP does not appear to be particularly scientific, but tends to be something of a blunt instrument.
He describes this as a “holistic” approach – an awareness of the
IP’s existence and a desire to own it, rather than a genuine understanding of its value.
According to King this is an extremely common situation – he dubs it “gentle” due diligence – in which investigators examine the patents and trademarks that exist, along with copyright.
“But hardly anyone asks about the value of these things during that process,” he adds. “More than that you have a range of intangible assets that include the workforce – the human capital.”
“IP valuers do actually value these assets in the process of general valuation work, for many reasons, but it‘s not normally done in a predatory or a defensive position, which is quite barmy to me.”