Looking for PROFIT: Investing in Intangibles - TechInvest Magazine Online

Private equity is experiencing a new reality and intangible assets (IAs), knowledge-based and lacking a physical form, are the most remarkable feature. Up until recently, only tangible (material and financial) assets were seen. Nowadays, IAs became the centre of attention. The intangible centricity is changing the funding process for two reasons. First, the lion’s share of startups has mainly or even only intangible assets. Second, the whole modern knowledge economy is inherently intangible with data as fuel. Furthermore, investments in IAs promise a higher-than-average profit and hold more potential for future growth.

Hidden in Plain Sight

In the modern knowledge economy, IAs account for up to 90% of a company’s equity value, yet we are surprisingly ignorant of their nature and features. In its own right, the term itself was popularized by the famous book “Capitalism without capital: the Rise of the Intangible Economy.” [1]. Several international accounting conventions and tax departments have responded to the appearance of IAs from a taxation perspective. [2] However, not every investor is familiar with intangibles, and continuing to invest in limited 10% of assets.

You might think that IAs are a relatively new concept, but Warren Buffet, a prominent investor, referred to intangibles as “franchises,” and explained the advantages of investing in them in the early 1990s. [3] He defines intangible assets as having specific economic characteristics and differentiates them from material assets. We seem to be resembling Moliere’s character who speaks in prose without realising it.

Remarkable Features of Intangibles

Contemporary economic theory and accounting conventions define “intangibles” as assets without a physical form. Intangible capital refers to intangible assets that enterprises use to facilitate their path to profit. Three broad categories of intangible assets are determined by the accounting conventions:

• Software & Computerised Information, including purchased and developed in-house software and databases.
• Innovative Property, including all types of R&D, designs, and artistic works.
• Economic Competences that represent knowledge embedded in human and organisational resources.

Unlike material assets, IAs have a range of specific features including:

• Non-rivalry – intangible assets can be deployed simultaneously by several users.
• Separability – an asset can be easily separated from the place of its creation without loss of value.
• Transferability – an asset can be transferred across enterprises.
• Limited excludability – other enterprises can benefit from this asset. 
  
  The characteristics of the three categories of intangible assets have significant differences. Assets that are classified under “Software & Computerised Information” are fully non-rival, partly excludable, and usually can be separated from their source without substantial loss of value. They even can be tradable in the markets. On the contrary, assets in the category of “Economic Competences” are characterised by rivalry and more excludability. [4]

Investment in Intangibles

Investments in IAs can be lucrative due to their distinguishing features:

• Having no physical form, IAs can easily move around the globe, and geographic boundaries do not limit their business applications.
• Startups can use IAs to scale up and generate more revenue without significantly increasing costs.
• Integrated IAs are “synergistic,” which means they enhance both each other and material assets with a non-additive effect.
  
  Smartly combining these features in intangible-intensive business models can contribute to startups’ profitability and scalability: key factors of investment attractiveness. In contrast to tangible-intensive business models, startups that rely heavily on IAs can reach profitability with 25% of the capital. Furthermore, by employing intangible-intensive business models, startups can become profitable faster than those who rely on tangible assets mainly.
  
  Startups that heavily rely on intangible assets are usually engaged in technology-enabled businesses, and can scale up faster than traditional tangible-intensive enterprises. Such startups own a minimum of physical assets for their core business operations and outsource some less essential operations. The biggest advantage of intangible-intensive startups is that they have lower capital requirements, becoming extremely attractive to equity investors
  
  The Sources of Extra Profitability
  
  The three types of intangible assets play different roles in financial performance. Copyrights for software and databases allow for keeping the costs of its reproduction low to zero and give their owners the power to set high prices. Innovative properties like patents and trademarks give startups pricing power within highly competitive markets. Economic competencies, including effective business models and practices, are difficult to copy and create monopolies for certain products. Furthermore, all three types of intangible assets allow startups to increase profit without increasing tangible assets.

The startups that focus on intangible assets have the following sources of extra profits:

• The predominance of variable costs over fixed costs reduces operating leverage by hiring contractors and using outsourcing instead of full-time employees. Such startups also actively use cloud-based solutions instead of in-house ones.
• Reduced need for upfront Investment to develop intangible-based business solutions. The ability to generate higher revenues with lower investments allows startups to decrease further dilutions of their stock.
• Dynamic scalability due to the predominance of variable costs. The startups can change their expense structure at short notice. It means the startup can be scaled down quickly in a poor market environment, as well as it can be scaled up when business conditions improve.

It is beyond doubt that intangible assets dominate today. In 2021 the ratio of intangible assets to total assets was 72% and growing. Discovering unique features of intangibles, investors are looking for opportunities to invest in this new class of assets. Fig. 1 shows two paths of the investment process from both demand and supply perspectives.

Figure 1 Two Paths of the Investment Process

Through the effective deployment of intangible assets, enterprises can optimise their business operations with low capital investment and maximise profits. In spite of negative market trends, startups are able to respond quickly to market changes, maintaining positive cash flow despite negative market trends.

A Dark Side of intangibles

Despite their inherent advantages, intangible investments have a dark side that differentiates them from tangible investments:

• IAs are “sunk investments” meaning that costs of some intangibles development may be lost entirely if a business fails because there is no market for newly created intangible assets. Besides, currently IAs cannot serve as collaterals, although later this restriction will presumably be lifted.
• IAs can generate “spillovers” which means that investment in intangibles can be used by third parties without any compensation. Competitors can easily copy intangible investments, such as ideas and processes without accusations of copyright infringement.

Spillovers occur when enterprises benefit from intangible resources they never created. To put it another way, the value of some intangibles created within a startup can easily be captured by other startups that did not pay for it (for instance, business solutions, components of the software, etc.). It is necessary to note that spillovers do have not a purely negative meaning. On the contrary, spillovers derived from government-funded R&D grants or open-source software benefits all related startups. Another key point to remember is that it is good to invest in a startup that is capable of acquiring spillovers (See Fig. 2).

Figure 2 Inherited Features of Intangibles

Therefore, from the investor’s perspective spillovers not only benefit startups that created some intangibles but also contribute to the whole ecosystem. By exploiting the spillovers that a startup created, all ecosystems can take advantage of the synergetic effect. Furthermore, spillovers create an opportunity for low-tech startups to raise their technology level at the expense of more advanced enterprises

Identifying and Leveraging Intangibles with PROFIT

There are two ways of identifying intangible assets: accounting and management perspectives. While the first perspective is developing within accounting conventions, the second perspective gives the necessary tools for intangible management. However, estimating the value of IAs is difficult because of the absence of available methods. Therefore, for intangible management purposes, it is reasonable to use proxies. IAs are mostly inseparable from teams, their carriers. The value of any currently available intangibles was created or appropriated due to the founders’ knowledge, experience, and skills. Besides, the team can appropriate some spillovers to their advantage. Thus, the overall startup’s competence as a result of the team’s comprehensive estimation can be used as a proxy to evaluate startups from an intangible perspective.

Using appropriate descriptions of ten key factors of a startup team’s estimation, and an intangibles list, the PROFIT algorithm calculates a comprehensive Team Quality Coefficient. Another important factor in intangibles’ estimation is the Pay Back Period (PBP) which indicates the time it takes to recover the cost of an investment. The algorithm also uses an Industry Benchmark Coefficient that is based on the industry standards of investments that bring the ratio of funds raised to the founders’ salary. [5]

Finally, the PROFIT algorithm calculates a Leverage of the Intangibles Coefficient and Intangible Startup Valuation. The former illustrates a synergistic effect when three types of IAs are combined: Software & Computerised Information, Innovative Property, and Economic competencies. The latter shows the total value of a team with IAs that founders can presumably appropriate. Additionally, the algorithm uses an Industry Benchmark Coefficient based on the ratio between funds raised and the salaries of the founders. [5]

By modelling valuation metrics, founders can answer two critical investors’ questions:
1. Based on founders’ salaries, industry benchmarks, PBP, and a set of intangibles that founders are ready to claim, how real is Ask for funding?
2. Can startup’s intangible valuation be corrected without violating investors’ interests?

About PROFIT.enterprises:

PROFIT.enterprises is a technology platform that is focused on initial sourcing and screening for investments in early-stage startups. The platform kicks startups to get fit for funding and shows investors attractive business opportunities via the discovery and appropriation of intangible assets. As a data intelligence partner, PROFIT.enterprises provides investors with trustworthy and comprehensive information about startups’ prospective profitability and risks, making the deal flow efficient, quick, and convenient.

PROFITTM is a registered Australian trademark No 1949116. All other products and brands mentioned in this document are properties of their respective owners.

References

1. Haskel J., Westlake S. Capitalism without capital: the Rise of the Intangible Economy;
https://media.oiipdf.com/pdf/8688aad9-cb5b-4199-b3ba-803f133313f3.pdf

2. Intangible Assets;
https://www.ato.gov.au/Business/Privately-owned-and-wealthy-groups/What-attracts-our-attention/Business-structure/International-transactions/Intangible-assets/

3. Buffett’s letters to the shareholders of Berkshire Hathaway Inc.
https://scholarworks.umt.edu/cgi/viewcontent.cgi?article=9635&context=etd

4. Bridging the gap in the financing of intangibles to support productivity: Background paper;
https://www.oecd.org/global-forum-productivity/events/Bridging-the-gap-in-the-financing-of-intangibles-to-support-productivity-background-paper.pdf

5. Investment in Intangibles: A Formula of Success. White Paper;
https://profit.enterprises/white-papers/