28. Law, Accounting & Finance in the ISE

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1 1 of Law, Accounting & Finance in the ISE INFO December 2007 Bob Glushko

2 2 of 35 Plan for Today's Lecture What is a Company Worth? Accounting 101 Accounting and Intangible Assets Intellectual Property 101 New Measures for Intangible Assets and "Intellectual Capital"

3 3 of 35 What is a Company Worth? The Book Value of a company is an accounting concept that measures how much the company would be worth if it went out of business immediately EXAMPLE: ABC Corporation has $1 billion in Assets on the balance sheet and $500 million in Liabilities The Book value of ABC is $500 million. If there are 100 million shares of stock outstanding, each ABC share would represent $5 of book value But ABC stock is trading for $15 on the stock exchange, so its Market Capitalization is $1.5 billion So the Price-to-Book ratio for ABC is 3 (15/5) And Book Value represents 33% of the Market Capitalization of ABC

4 4 of 35 Market Capitalization and Book Value (4 December 2007)

5 5 of 35 Industry / Profitability / Performance Interpreting Market Cap/Book Value Since companies are usually expected to grow and generate more profits in the future, market capitalization is higher than book value for most companies Their ratio is most useful for analyzing capital-intensive businesses or financial businesses with lots of tangible assets A ratio near 1 means that the stock market is saying that the assets are overvalued or that the company is doing a poor job using its assets to create value A company with a very high ratio of Market Cap to Book Value has presumably been earning a very high return on its assets, but that good news has already been factored into its stock price During the "Internet bubble" some companies with almost no Book Value had astronomical Market Caps in the billions of dollars

6 6 of 35 What Drives Corporate Valuation (Forbes 2000 Survey) Customer satisfaction Ability to attract talented employees Innovation Brand investment Technology Alliances 7. Quality of major products, processes or services

7 7 of 35 What Drives Corporate Valuation (Statistical Analysis) Innovation Ability to attract talented employees Alliances Quality of major products, processes or services Brand investment Technology 7. Customer satisfaction

8 8 of 35 Do Our Views on Valuation Reflect the "New" Economy? Many Internet and information-intensive firms provide goods and services whose value depends much more on their intellectual content than on their physical characteristics Some claim that the "the old economy is based on things, and the new one is based on ideas" The importance of intangible assets is the distinguishing feature of the new economy.

9 9 of 35 Creating Value in the "New" Economy Advantages over the "Old" Economy of Things Marginal cost of production for information goods is low or even zero Information goods can grow more valuable the more people use them (network effects) Disadvantages Information goods can be perfectly copied and given away, so their value can't easily be controlled New information goods can quickly and radically destroy the value in existing information goods

10 10 of 35 Creating Value in the "Old" Economy In the Ford mass production system, it was hoped that it would de-skill work and thus make workers as interchangeable as the parts from which the cars were constructed But assembly workers acquired tacit knowledge about what techniques work and the best way to do a job Ford still needed the skills of engineers, metallurgists, paint chemists, and a host of others that today we call "knowledge workers." The Ford assembly line would today be lauded as a business model asset. The Ford brand name was the most recognized in the industry Customer satisfaction was high.

11 11 of 35 Accounting 101: Purposes of Accounting and Financial Statements A company needs financial controls and reports so that it can run its operations effectively, support or prove compliance with laws and regulations, and facilitate strategic thinking The financial reports should provide information about the economic resources of the company, the claims to those resources (obligations of the enterprise to transfer resources to other entities and owners equity), and the effects of transactions, events, and circumstances that change its resources and claims to those resources Companies are required to provide financial information to present and potential investors and creditors and other users to assist them in making rational investment, credit, and similar decisions

12 12 of 35 The Balance Sheet The Balance Sheet is a "snapshot" of the company's assets, liabilities, and equity at some specific point in time The basic equation: Assets = Liabilities + Equity The definitions of these categories are embodied in "Generally Accepted Accounting Principles" that must be followed so that every firm prepares its financial statements according to the same rules Traditional financial statements are largely backward-looking or historical, and focus on the entity s ability to realize value from existing assets

13 13 of 35 Balance Sheet Example (WalMart)

14 14 of 35 Balance Sheet Example (Google)

15 15 of 35 Assets Assets are probable (expected) future economic benefits obtained or controlled by a particular entity as a result of past transactions or events (definition from Financial Accounting Standards Board ["Fazz-B"]) Employees fail this control test

16 16 of 35 Asset Classification Current Assets Current assets have a life span of one year or less, meaning they can be converted easily into cash. Cash and cash equivalents Accounts receivable consists of the short-term obligations owed to the company by its clients (credit extended by the company) Inventory represents the raw materials, work-in-progress goods and the company s finished goods Non-Current Assets Assets that are not turned into cash easily, not expected to be turned into cash within a year and/or have a life-span of over a year. Tangible assets such as land, building, machinery, computers Intangible assets such as goodwill and intellectual property (patents, copyright, trademarks)

17 17 of 35 Intangible Assets Broad Definition -- Intangibles are nonphysical sources of probable future economic benefits to a corporation; alternatively, all the elements of a business enterprise that exist in addition to monetary and tangible assets Narrow Definition -- Intangibles are nonphysical sources of probable future economic benefits to a corporation that have been acquired in an exchange or developed internally from identifiable costs, have a finite life, have market value apart from the corporation, and are owned or controlled by the corporation

18 18 of 35 Intangible Assets - Separable and Contractual

19 19 of 35 Intangible Assets - Separable but Not Contractual

20 20 of 35 Intellectual Property Intangible rights in commercially valuable information permitting owner to control market for products embodying this information: Copyrights for artistic & literary works Patents for technological inventions Trade secrets for commercially valuable secrets (e.g., source code, Coke formula) Trademarks (e.g., Coke) identifies source of goods & services, distinguish from those made by others

21 21 of 35 Why We Have Intellectual Property A grant of rights to creators enhances incentives to invest in innovation & make innovative products available This is especially necessary for "public" goods (especially "information" goods) whose marginal costs of production are close to zero, because markets will otherwise not produce them Trademarks protect against consumer confusion Trade secrets protect against "commercial immorality"

22 22 of 35 US Federal IP Law Begins with IP clauses in Constitution (I/8/8): Congress has the power to promote the progress of science (knowledge) by giving authors an exclusive right in their writings for limited times (copyright part) Also has the power to promote the useful arts by giving inventors an exclusive right in their discoveries for limited times (patent part)

23 23 of 35 "Big Picture" IP Issues IP rules well-suited to manufacturing era, but will they do as well for the information and services age? How to maintain balance in the law when IP scope steadily increasing New technologies distorting the traditional balance More IP is not necessarily better IP

24 24 of 35 Problems with Accounting for Intangibles Accounting for acquired intangible assets follows different rules than for internally developed ones; Goodwill is the intangible asset a firm acquires when it buys something (or a company) for more than its book value Of special concern to technology firms is that the cost of R&D -- which can lead to patents, software, or other value-producing stuff, is treated as an expense and not as an asset Firms have to account for the costs of R&D to create intangible assets when they are incurred, not when they can show probable future benefits

25 25 of 35 The Problem of R&D Undervaluation Accounting's basis in transactions means that it always tracking past events Treating R&D as an expense rather than an investment compounds the problem People are slow to realize how important R&D is in creating value... which is why R&D-intensive firms outperform other stocks after the products and services created by that R&D reaches the market This outperformance means that looking backwards, R&D-intensive firms have had higher costs of raising funds to pay for their internal investments in the meantime This is especially true for small or start-up firms that don't have a track record of turning R&D into value -- and they're the firms that most need to attract investors

26 26 of 35 Tangible vs Intangible Investment Firms might invest in tangible assets to create new value, but often they do so to enable the current production of value (or incrementally increase it) Investing in tangible assets often has very predictable outcomes (which is why we can write a business case that measures the Return on Investment or ROI) Investing in intangible assets is much riskier -- it might result in very high returns, or it might yield absolutely nothing This is because many intangible investments have a high degree of asset specificity (Some tangible investments are also highly asset-specific)

27 27 of 35 Asset Specificity Asset specificity is the degree to which assets are limited to a single or small set of purposes Highly specific assets often result in costs that can't be recovered by selling them to another party Highly specific assets are usually internal or covered by contracts that prevent opportunism in an external transaction

28 28 of 35 Measuring the Value of Intangible Investments If investments in intangible assets are different than investments in tangible ones, does this make it unnecessary to attach a value to them? Some people have proposed methods for scoring intangible investments that don't involve traditional ROI measures, and instead compute value using some arbitrary formulas But would you prefer an investment in tangible assets with a high ROI and an investment in an intangible one with a "high" score? Cost-based measures for intangible assets are imperfect, but they are better than not recognizing that assets exist; there are benefits to disclosing something...

29 29 of 35 A "People Business" -- Barber & Strack, HBR May 2006 A "people business" is characterized by: High overall employee costs High ratio of employee costs to capital costs Limited spending on activities aimed at generating future revenue "People businesses" account for 25% of private sector employment in North America and Western Europe and for over half the employment growth in the past decade They span industries from IT consulting to facilities management, from insurance brokering to telecommunications services; most diversified firms have substantial "people" components Not all services business are people businesses, and vice versa

30 30 of 35 Accounting and Management Implications for "People" Businesses Accounting focuses on capital productivity (return on assets, return on equity) and these measures are inherently less meaningful for firms that don't have a lot of "accounting" assets Traditional measurements of employee productivity (sales or profit per employee) are subject to distortion A firm that outsources the work of half of its employees doubles its employee productivity even if outsourcing doesn't save any money A firm that replaces employees with IT or machinery whose capital costs exceed the employee costs can increase sales/employee while reducing profit/employee "People management" is a core operational process, not just a support function of the HR department

31 31 of 35 Compensation should be performance-based as much as possible to ensure that employee goals are aligned with company goals Intellectual Capital

32 32 of 35 Examples of Scandia's Intellectual Capital Measures Number of employees Average years with firm % annual employee turnover % college graduates % women employees % women managers

33 33 of 35 Criticism of the Notion of Intellectual Capital Measures can be highly subjective and firm-specific Unspecified causal connection to value or new value creation John Rutledge, "You're a Fool if You Buy Into This One," Forbes ASAP, 1997 The leading advocate of balance sheet diddling is Leif Edvinsson, director of intellectual capital for Skandia... He and his colleagues at Skandia built a model that at last count had 164 different variables, not including subcategories, to explain and measure intellectual capital. It must have been a long night when they thought all those things up, because toward the end they had to use "share of employees under age 40 (%)," "number of women managers," and "average age of employees" to pad the list. I can t even imagine what they had in mind with those ideas.

34 34 of 35 We Simply Don't Count Everything That Affects Valuation WE COUNT: Accounting Book Value WE DON'T (MAYBE BECAUSE WE CAN'T) COUNT: Market assessments of differences between accounting book value and the actual value of recognized assets and liabilities Market assessments of the underlying value of items that meet the definitions of assets and liabilities but which are not recognized in financial statements (eg patents generated as a result of internal R&D Market assessments of intangible value drivers that do not meet the definition of assets and liabilities (eg employee morale) Market assessments of the entity's future plans, opportunities, business risks Other factors, including market optimism and pessimism and other market psychology

35 35 of 35

Blinn College EMPLOYMENT REQUIREMENTS AND RESTRICTIONS CONFLICT OF INTEREST

Blinn College EMPLOYMENT REQUIREMENTS AND RESTRICTIONS CONFLICT OF INTEREST DISCLOSURE GENERAL STANDARD SPECIFIC DISCLOSURES SUBSTANTIAL INTEREST INTEREST IN PROPERTY CONFLICTS DISCLOSURE STATEMENT GIFTS ENDORSEMENTS SALES An employee shall disclose to his or her immediate supervisor