Technological Innovation and Intellectual Capital

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BUA5FTS WEEK 1

• Technological Innovation and Intellectual Capital

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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)

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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

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

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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

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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 199710)
• "knowledge, applied experience, organizational
  technology, customer relationships and
  professional skills" (Edvinsson and Malone 1997)

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Intellectual Capital
Intellectual Capital is 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 )
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Intellectual Capital

• Relational capital/customer capital Who you know
  and who knows and values you.

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Intellectual Property
Human Capital
Customer Capital
Structural Capital
Expansion
Start-Up
RD
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Intellectual Capital and Firm Value
Idea generation
Final Product
RD
Prototype
Cash Flows
Value
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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
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Measuring Intellectual Capital

• A model was developed by Skandia AFS

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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

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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.

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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

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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

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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)
         
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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

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Alternative Forms of Business Organization for
Technology Startups

• Partnership
• A partnership has roughly the same
• advantages and disadvantages as a sole
• proprietorship.

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Alternative Forms of Business Organization for
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

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Goals of the Corporation

• The primary goal is owner wealth (value)
  maximization, which translates to maximizing
  firms 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

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(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)

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(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

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(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

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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.

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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

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Early-stage Technology Valuation

• Balance
  Sheet
• Debit Credit

Monetary Assets
Equity
Business Enterprise
Tangible Assets


Debts
Intangible Assets
Asset Liability Equity
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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

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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.

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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

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Income Statement

• Statement of financial performance
• Sales
• COGS
• Other expenses
• EBITDA
• Depreciation and amortisation
• EBIT
• Interest expense
• Taxes
• Net income

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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
• minus Long-term investing activities
• Investment in fixed assets
• plus Financing activities
• Increase in notes payable
• Increase in long-term debt
• Net cash from financing

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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 advantages of the firm, proposals
  include
• broadening of intangible asset recognition
  criteria (i.e. capitalization of RD, 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

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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. Moores 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

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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

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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

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Project Life Cycle

• All technology projects evolve over a number of
  stages, generally from conception to research and
  development (RD) 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.

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A typical five-phase project life cycle sequence
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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.

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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

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Preparing resources

• The focus in FTS is on Financial resources

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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)

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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 ventures 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 RD and marketing
  
• Working capital
• Physical assets

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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

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Financing the entrepreneur firm

• Four factors
• Uncertainty
• Asymmetric information
• The nature of its assets
• Market conditions

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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.

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• Business Strategy
• RD
• Operations
• Growth
• Financing
• Marketing
• Value Creation

• Financial
• Strategy
• Risk
• Return
• Real options

• Sources
• Debt
• Equity
• Strategic Alliance
• Hybrids

Opportunity
Figure 2.5 Financial Strategy
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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

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Critical Variables in Fund Raising

• The following factors determine the nature and
  type of the financing for the venture
• Accomplishments and performance
• Investors 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
• Investors required terms and covenants

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Project Life Cycle Funding
Aeroscape Industry Concept Development gt
Development gt Building gt Launch
Pharmaceutical Industry Basic Research gtPhase
I II gt Phase III gt LT Phase IV gt Pre-clinical
Funds Required
Planning
Development
Implementation
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Technology Valuation

• The project life cycle can be used to defined 3
• key financial concepts
• Funding requirements (timing of funding)
• Risk-return trade-off (cash flow lag)
• Financial strategies (debt or equity?)

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New Venture/Entrepreneurial Finance

• State of play in technology finance
• Most financial techniques or methodologies are
  suitable for mature technology contexts, where
  there is low level of uncertainty.

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FOCUS Technological Entrepreneurial Finance

• Study the issues relating
• 1. Technology valuation
• 2. Valuation of IP/intangibles
• 3. Project financing
• 4. Financing strategy

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1. Technology Valuation

• Highly idiosyncratic and depends on maturity of
  technologies
• Lower maturity results in higher uncertainty
  about cash-flows/marketability

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2. Valuation of IP/Intangibles

• Assessing the value of IP
• Market valuation of IP
• Valuation of RD
• Value of a knowledge intensive firm

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3. Project Financing

• Sources of finance
• Matching sources to projects at different stages
  of maturity

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4. Financing Strategy

• Differences b/w start-ups large firms
• Business plan
• Market signalling
• Relevant financial information
• How information is factored into the value of a
  knowledge intensive firm

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Lecture summary

• Technology innovation and Intellectual capital
• Intellectual capital valuation and firm value
• Cash flow, timing and risk factor in valuation
• Financial strategy framework
• Focus Technological Entrepreneurial Finance