BUA5FTS – WEEK 1

1. BUA5FTS – WEEK 1 Technological Innovation and Intellectual Capital

2. Bontis on Intellectual capital • Intellectual capital has been considered by many, defined by some, understood by a select few and formally valued by practically no one. (Bontis, 1998: 622)

3. Technological innovation is defined as: ‘A unique chronological process involving science, technology, economics, entrepreneurship, and management is the medium that translates scientific knowledge into physical realities that are changing society. This process of technological innovation is the heart of the basic understanding which the competent manager, the effective technologists, the sound government official, and the educated member of society should have in the world of tomorrow’ James Bright

4. Could you please identify some industries that have strong technological innovation?

5. Introduction • The dominance of intellectual capital in wealth creation in all industries is highly evident today and some of the technologies are: • Superconductivity • Virtual Reality • Robots • Artificial Intelligence • High-tech Medicine • Biotechnology/Genetic Engineering • Telecommunications

6. Intellectual capital concept • First use of the term Intellectual capital in 1969 (Hudson 1993) • Not yet agreed on its definition, its decomposition and methods for valuation. • The intangible assets of skill, knowledge and information (Wall et al. 2004). • "packaged useful knowledge" (Steward 1997:10) • "knowledge, applied experience, organizational technology, customer relationships and professional skills" (Edvinsson and Malone 1997)

7. Intellectual Capital Intellectual Capitalis defined as: 'Intellectual material that has been formalized, captured, and leveraged to produce a higher-valued asset.' (Professor David Klein and Laurence Prusak of IBM )

8. Human capital Intellectual capital Structural capital Relational capital Intellectual Capital • Relational capital/customer capital: Who you know and who knows and values you.

9. Intellectual Property Human Capital Customer Capital Structural Capital Expansion Start-Up R&D

10. Intellectual Capital and Firm Value Idea generation Final Product R&D Prototype Cash Flows Value

11. Valuation of Intellectual Property Company Market Value Added Microsoft $253 billion Intel $78 billion Merck $62 billion Pfizer $131 billion Cisco Systems $45 billion Bristol-Myers Squibb $119 billion Logitech $2 billion Source: Yahoo Finance, December 2009 MVA =market value of equity - equity capital supplied Table 2.1 Creators of Wealth - 2009

12. Market Value Financial Capital Intellectual Capital Human Capital Structural Capital Customer Capital Organisational Capital Innovation Capital Process Capital Measuring Intellectual Capital A model was developed by Skandia AFS:

13. Economic Benefit • The primary objective of the firm is to maximise shareholders’ wealth • It is typically accountable to a dispersed group of stakeholders – lenders, customers, investors, governments, employees, community members, suppliers, citizens • The value of an intellectual asset is measured by the benefit it generates to the stakeholders and firm • ‘Benefit’ would normally refer to monetary gain or economic value to the shareholders and firm • Definition of economic value is the present value of the expected earnings from using the asset

14. Economic Benefit • Strong competition • Associated rapid diffusion of innovations • reduce the returns to innovation • an appropriate framework of intellectual property rights is important to ensure that innovators receive an adequate return on their investment while at the same time encouraging the rapid diffusion of these innovations (OECD 2000). • Lehman (1996) suggests that economic growth and competitiveness will be determined by the ability to create, own, preserve and protect intellectual property.

15. Intellectual Capital Financial Management Framework • Involves the process of analysing the financial issues facing a technology start-up • In terms of economic trade-offs or financial implications in relation to decisions about business investment, operations or financing • The process entails understanding the business environment by evaluating and then developing a proper financial strategy for the venture

16. Intellectual Capital Financial Management Framework • Incorporates the optimal business structure for the venture as well as utilising the appropriate tools for evaluating the financial problem or issue

17. Value of Equity Value of the Firm - Growth - TV EBIT/EBT Free Cash Flows CAPM WACC Discount Rate Financing: Venture k Debt IPOs Other Traditional DCF Static Analysis Investment Decision NPV Start-up Project Dynamic Analysis Technology Start-ups Valuation Framework Option-based NPV Model Real Options Valuation Abandon (Put Option) Defer (Call Option) Expand (Call Option) Source: Oh (2002)

18. Alternative Forms of Business Organization for Technology Startups • Sole proprietorship Advantages: • Ease of formation • Subject to few regulations • No corporate income taxes Disadvantages: • Limited life • Unlimited liability • Difficult to raise capital

19. Alternative Forms of Business Organizationfor Technology Startups • Partnership A partnership has roughly the same advantages and disadvantages as a sole proprietorship.

20. Alternative Forms of Business Organizationfor Technology Startups • Corporation Advantages: • Unlimited life • Easy transfer of ownership • Limited liability • Ease of raising capital Disadvantages: • Double taxation • Cost of set-up and report filing

21. Goals of the Corporation • The primary goal is owner wealth (value) maximization, which translates to maximizing firm’s value. • The factors that affect value of the firm are: (i) Projected cash flows to owners (ii) Timing of the cash flow stream (iii) Riskiness of the cash flows

22. (i) Cash Flow • Long-term source of funds for the firm • Internally generated • Net income • Retained earnings and depreciation provisions • Free cash flows • No historical data in most cases and this makes it difficult to forecast cash flow patterns (i.e. economic fundamentals and comparable firms analysis)

23. (ii) Timing of Cash Flows • Implications for the owner wealth • A dollar received today is worth more than a dollar received sometime in the future (time value of money) • Opportunity cost • Discounting and compounding

24. (iii) Riskiness of Cash Flows Factors that affect the level and riskiness of cash flows: • Decisions made by financial managers • Investment decisions • Financing decisions (the relative use of debt financing) • Dividend policy decisions • The external environment

25. New Technology Venture Finance • Focuses on how firms, both start-ups and large firms, manage the financial process of new product/technology development from conception to ultimate commercialisation • requires managers to understand • the balance sheet; • valuation; • financial tools; • financial markets, and • related issues and their impact on the financial performance of the firm.

26. Early-stage Technology Valuation Business Entity and its Value: • Generally, comprised of the same basic elements being monetary assets, tangible assets and intangible assets • More intangible assets • Their aggregate value represents the value of the business enterprise • The financing of these assets could come from two basic sources, namely equity and debt

27. Early-stage Technology Valuation Balance Sheet Debit Credit Monetary Assets Equity Business Enterprise Tangible Assets = = Debts Intangible Assets Asset = Liability + Equity

28. Balance Sheet Monetary + Tangible Assets + Book Value + Stock Price Premium Equity Intangible Assets Internal R&D Processes Culture Knowledge External Customers Supply Chain Others = + = Debts Firm’s Market Value Total Assets Total Capital

29. Financial Statements • They are important because they portray the underlying financial performance and position of the project. They are also a tool used for monitoring investment and business activity • IAS 38 ‘Intangibles Assets’ standard -specifies and requires certain disclosure criteria to be met by intangible assets

30. Financial Statements Contentious issues: • It specifies that internally generated intangible assets such as goodwill, brands, mastheads, publishing titles, customer base and the likes should not be treated as assets; • IAS 38 does not allow an assignment of infinite useful life to an intangible asset; and • Many acquired intangible assets will not be allowed to be re-valued upwards because of the absence of an active market for such assets.

31. Balance Sheet • The balance sheet (statement of financial position) attempts to show the financial position of a project at a point in time and shows all the resources controlled by the enterprise and all the obligations due by the project. • The balance sheet equation: Assets = Liabilities + Equity

32. Income Statement Statement of financial performance: Sales COGS Other expenses EBITDA Depreciation and amortisation EBIT Interest expense Taxes Net income

33. Cash Flow Statement Operating activities Net income Add –Sources of cash Increase A/P Increase in accruals Depreciation Less –Uses of cash Increase in A/R Increase in inventory = Net cash provided by operations minusLong-term investing activities Investment in fixed assets plusFinancing activities Increase in notes payable Increase in long-term debt Net cash from financing = Net change in cash Add cash at the beginning of the year = Cash at the end of the year

34. Financial Reporting for IC • The economic rationale by the proponents for recognition of intellectual capital in financial reporting focuses on the balance sheet treatment of competitive advantagesof the firm, proposals include: • broadening of intangible asset recognition criteria (i.e. capitalization of R&D, marketing and human resource expenditures) • measurement of contractual positions at fair value • new definition of ‘revenue accounting’ to capture the critical events of the value creation cycle of new economy firms

35. Technology Valuation • Implications of Technological Development for Business: • Globalisation: resource allocation, manufacturing, MNCs and comparative advantage/competitive advantage e.g. India in software development • Time compression: shortened product life & life cycle of a project e.g. Moore’s law (i.e. from initiation to completion), decreasing payback periods • Technology integration: for development and commercialisation, e.g. IT + Biotech (see core technologies) • Costs: better economies of scale and efficiency

36. Technology Valuation • When technology is not mature, more time is needed in the early stages of the project • If only incremental technology innovation, or when technology is mature, the early stages may be short and activities are likely to be confined to the execution and implementation of the project • The project life cycle

37. Project Life Cycle • Early-stage technology is defined as technology that has not been commercialised or proven beyond laboratory experiments and this broad category includes: • Untested ideas • Bench-top technology • Prototype technology

38. Project Life Cycle • All technology projects evolve over a number of stages, generally from conception to research and development (R&D) to commercialisation. The exact specification of the stages will depend very much on the nature of the project and the industry in which the technology is applied.

39. Cost Conceptual Definition Production Operation Divestment Time A typical five-phase project life cycle sequence:

40. Project Life Cycle In the pharmaceutical industry the stages are: Preliminary research (before filing a patent); Preclinical studies (done prior to an initial new drug application - IND), and Clinical trials – Phases 1, 2 and 3. In the aerospace industry the stages are: Concept definition; Concept Development; Implementation, and Launch and operations.

41. Other IP Valuation Purposes • Other than for determining how much money is required for a technology start-up, there are other reasons why intellectual property is valued: • Transaction support sale • Bankruptcy • Licensing • Strategic alliances • Infringement damages • Intercompany transactions • Collateral based financing • Accounting requirements • Regulatory requirements

42. Preparing resources • The focus in FTS is on Financial resources

43. Financial Strategy Framework The three financial management decision areas common to all business are: • Investment decisions; • Financing decisions, and • Dividend payout decisions (in the case of technology ventures: exit options)

44. Financial Strategy Framework I. Investment decisions • The efficient allocation of resources to develop the new technology for commercialisation • They are the source of future cash flows, growth, support for the venture’s continued viability and are based on detailed plans (capital budgets) for committing new funds to predominantly three areas of activity: • Major spending programs such as R&D and marketing • Working capital • Physical assets

45. Financial Strategy Framework II. Financing decisions • Form of financing: • Debt, • equity or • convertible securities (Is this a good option? Why?) • Optimal capital structure consideration • May varies over different stages • Owner facing trade-off decision • Other potential financiers of the venture, such as venture capital companies • Profit allocation decision

46. Financing the entrepreneur firm • Four factors: • Uncertainty • Asymmetric information • The nature of its assets • Market conditions

47. Financial Strategy Framework III. Dividend payout decisions (exit options) • For a venture, the relevant decision in this context would be the exit options available to the entrepreneurs and equity funding parties.

48. Business Strategy • R&D • Operations • Growth • Financing • Marketing • Value Creation • Financial • Strategy • Risk • Return • Real options • Sources • Debt • Equity • Strategic Alliance • Hybrids Opportunity Figure 2.5 Financial Strategy

49. Critical Variables in Fund Raising Gompers et al. (2002) identified four broad categories of factors that influence the source of funds are identified as: • Uncertainty: the dispersion of potential outcomes relating to information, competition, marketing etc.; • Asymmetric information: moral hazards and adverse selection problems; • Market conditions: supply of capital, cost of capital, capital structure, and • Monitoring and evaluation: relationship between investors and entrepreneurs

50. Critical Variables in Fund Raising The following factors determine the nature and type of the financing for the venture: Accomplishments and performance Investor’s perceived risk Industry and technology Venture upside potential and anticipated exit timing Venture anticipated growth rate Venture age and stage of development Required rate of return (IRR) Capital required and prior valuation of venture Founders’ goals regarding growth, control, liquidity and harvesting Relative bargaining position Investor’s required terms and covenants