Why IP reporting and protection should be on your board agenda

In the knowledge economy, directors have a duty to ensure their IP is properly reported on and protected.

The risk posed to companies and their boards by poor understanding and governance of intellectual property (IP) assets has increased as a result of the value contribution of technology, data and brands, more interest from regulators and tax authorities, and litigation trends. As a result, directors should demand IP asset reporting that enables compliance with their duty to act with care and diligence in the best interest of the company.

Intangible economy, digital economy, knowledge economy — the descriptions differ, but there is no doubting the implication: we live in an age dominated by intangible assets. Tech companies such as Atlassian grab the headlines, but to remain competitive, every company has to be both a tech company and a brand company.

This sentiment is supported by fact. Net tangible assets represent only 37 per cent of the enterprise value of the ASX 200. The Nasdaq is further along the asset evolution curve with only five per cent of value contributed by net tangible assets. On both exchanges, only a small proportion of value is explained by those intangible assets on company balance sheets (approximately 15 per cent in each market). This is a function of restrictions placed by accounting standards on capitalising internally generated intangible assets, and as a result, a substantial portion of enterprise value is not explained by balance sheets (48 per cent of the ASX and 75 per cent of Nasdaq).

Assuming that markets provide a reasonable estimate of the intrinsic value of the underlying companies, the bulk of the balance sheet “black hole” is internally generated intangible assets. In most sectors, the key intangibles are technology, brands and data, which can collectively be referred to as “IP assets” as they can be protected by IP rights. Due to high earnings potential and strong legal protection, high-quality IP assets are the crown jewels of intangibles.

Post-merger and acquisition (M&A) financial reporting highlights the value potential of tech and brand assets. For example, up to 70 per cent of the value of acquired biotech companies has been attributed to tech IP (the acquisition of Allergan Inc by Actavis Plc). In the beverage, confectionery and fashion sectors, more than 40 per cent of enterprise value has been attributed to brands (the acquisition of Foster’s by SABMiller). While not yet reaching these lofty valuations, the importance of data assets extends beyond Facebook and digital retailers. Data providing insights to customers and operations are increasingly important in sectors as diverse as insurance and agribusiness.

IP assets: boardroom visibility and duties

Given the economic importance of IP assets, one would assume that the balance sheet black hole is not replicated in the boardroom. Unfortunately, anecdotal evidence indicates that most boards receive little meaningful information regarding the value and risk profile of their IP assets.

This was what emerged from questions put to 45 directors who attended a recent AICD “Monetising your IP” event in Brisbane. About 75 per cent said they don’t regularly receive metrics about the commercial strength, risk and value of IP assets in board packs. This is partly due to IP asset management being unsophisticated relative to physical and monetary assets. It’s also likely directors could ask more probing questions about these. The final question was whether the audience believed a board’s duties are any different for IP compared to other assets. Pleasingly, the answer was “no” — and the Corporations Act 2001 (Cth), of course, doesn’t distinguish between asset categories.

Looking to the US as a trendsetter, several legal proceedings have highlighted the risk to boards of poor IP asset governance, including:

• Class actions alleging the sale of material IP assets substantially below market value, without taking reasonable steps to maximise shareholder value — for example, pharmaceutical company Tibotec-Virco.
• Shareholders alleging directors had breached their duty by not filing for international patent protection, thereby enabling competitors to use their technology in international markets — for example, US computer and network security company RSA Security Inc.
• Action against a board for allegedly failing to stop infringement of a competitor’s patent, which resulted in a billion-dollar judgement against the company — for example, DuPont and the Marvell Technology Group.

Upside potential

IP assets can achieve rapid value growth as a result of favourable economic characteristics:

• They can be simultaneously used by multiple parties, making them highly scalable
• Unlike plant and equipment, IP assets don’t depreciate through use. The value of certain IP can be magnified through use. A network effect occurs when the utility of a platform asset increases as a result of it gaining users
• P assets exhibit a non-linear relationship between cost and value, meaning that an exceptionally high return on investment can be achieved.

One key feature setting IP assets apart from other intangibles are the legal rights that protect the competitive advantage they create. The legal construct of IP refers to rights, which are created or enforceable by law to protect certain outcomes of human knowledge from unauthorised use by others. IP can be both registered and unregistered. Registered rights include patents, trademarks and designs, while unregistered rights include copyright, trade secrets and common law rights in trademarks.

Although each legal right can represent a standalone asset — the strength of legal protection directly influences the economic life and the value of an asset — the term “IP assets” can refer to complementary rights bundled together. For instance, a brand can be protected by registered trademarks, common law rights, copyright in the logo and registered designs; technology can be protected by patents, trade secrets, copyright and designs.

Risk profile

There is fine print associated with the economic characteristics of IP assets. For a start, the non-linear relationship between cost and value is a double-edged sword — high R&D and/or marketing costs can result in a worthless asset.

Another complication is that the value of IP assets can vary significantly under different ownership. For example, the value of a patent portfolio might increase significantly under the ownership of a well-resourced organisation with complementary research and manufacturing capabilities.

The strength of the legal protection enjoyed by an IP asset is fundamental to its value, but this can be difficult to establish. Even after grant, the validity and claim scope of a patent can be uncertain — and IP registrations are usually jurisdiction-specific, meaning the extent of legal protection for a technology or brand can vary significantly.

IP value creation or destruction

There is no shortage of examples of companies suffering sudden and dramatic reputational damage — AMP being a recent case and Arthur Andersen a terminal one. Effective risk-management systems identify events that pose reputational risk, quantify the risk and evaluate the effectiveness of risk-mitigation strategies.

Equally destructive can be the gradual erosion of competitive advantage through technical obsolescence or loss of brand relevance. Effective tracking systems provide early warning of potential loss in value of IP assets.

Disruptive M&A is on the business radar. Corporates are increasingly targeting tech startups to fill the gaps in their innovation pipeline. Due diligence of early stage tech companies requires specialist assessment of the risk profile and earnings potential of IP assets.

The value of IP that has not been commercialised is not immediately apparent. Many corporates hold underutilised IP that could be monetised through sale, licensing or joint venture. IP governance systems should contain tools and processes that gauge the commercial potential of IP and scan the competitive IP landscape.

IP assets are, in general, misunderstood and undervalued by executives and directors. But understanding their value can unleash real commercial potential across many functions — from M&A to business model optimisation, strategic planning to financial reporting. The absence of effective governance systems compromises a board’s ability to ensure IP asset risks and opportunities are adequately managed.