Intangibles and start-ups

Another oldie but goodie. I found this 2005 interview on start-ups and intangibles — How Can Start Ups Grow? — HBS Working Knowledge:

Assistant professor Mukti Khaire believes that small companies can grow by developing intangible social resources such as legitimacy, status, and reputation. In an interesting twist, her research on this insight is that these intangible resources may be best acquired by following a road of conformity in how your company is organized and presented to the outside world. In start-ups in established industries, conventional business titles such as Marketing Director work better than novel ones like Chief Evangelist.
. . .
Q: Can you tell us about the concept of intangible social resources and how they contribute to a young firm’s growth? How does a firm acquire non-tangible resources such as reputation and status?
A: Intangible resources are non-financial, non-material assets that a firm possesses by virtue of the social structure in which it is embedded. Although firms are economic entities, they are nevertheless affected by social variables such as legitimacy, status, and reputation because all economic transactions are embedded in a social supra-structure. Since most young firms are financially constrained, intangible assets that do not require outlays of financial resources are especially critical to new ventures.
An entity is considered to have legitimacy when its actions are considered proper, acceptable, or desirable under a widely accepted set of beliefs and norms. A new, unfamiliar activity or entity does not possess legitimacy because of its inherent novelty. A new firm, therefore, lacks legitimacy and may be looked upon with suspicion by stakeholders. In order to gain legitimacy, a new firm is required to look like existing organizations, which possess legitimacy because of their familiarity to observers. Hence, mimicry of existing organizations’ structures and activities to a certain extent is essential if new ventures wish to gain legitimacy. A new venture with legitimacy acquired in this manner is more likely to succeed because it then can channel its resources and energy towards its core activity, rather than towards establishing its propriety. By doing so, it can improve performance and grow faster than an organization that does not conform to industry norms. As one founder I interviewed put it, “Customers are used to doing things in a certain way [with established organizations], and if a new agency is too far and out, it will not do well.”
High-status organizations tend to be buffered from environmental shocks and more likely to survive adverse circumstances and perform better than low-status organizations. Organizational status is usually a function of size and good past performance. However, young firms possess neither large size nor a track record of good performance. Although the benefits of status are crucial to their performance, they are unable to avail of them. An alternate way of acquiring status is through high-status affiliations. When a young, unknown firm has affiliations with high-status entities, stakeholders tend to impute the status of the latter onto the former, thus granting higher status to the young firm. I found that young agencies with high-status clients performed better and grew faster than agencies without high-status clients (controlling for the revenues brought in by each client). Thus, status acquired through affiliations provided young firms with the buffering advantage that larger, well-established firms enjoyed due to their status, and enabled them to compete in the same arena as much larger firms.

Bottom line: Status and legitimacy are key organizational intangible assets. I wonder how you measure that?

SOX and intangibles

Today’s Wall Street Journal is running a story about how Critics See Some Good From Sarbanes-Oxley:

But even critics acknowledge the law has done some good. “There is without question greater accountability in the boardroom,” says Thomas Lehner, an official of the Business Roundtable, a Washington group representing big-company CEOs. More boards resolve potential problems “before they fester and explode,” concurs John Olson, a senior partner at Gibson, Dunn & Crutcher who advises directors at about a dozen concerns.

What the story didn’t mention, however, is that SOX is forcing some companies to come to grips with their intangible assets. According to comments by Kimberly Klein Cauthorn at session “Intellectual Property and Intangible Assets: Growth of a New Asset Class” at the Milken Institute Global Conference 2007 (audio available), more companies are conducting audits of their intangibles as part of Sarbanes-Oxley compliance requirements.
To me, that is a big deal. If Sarbanes-Oxley ends up changing how the corporate culture deals with intangibles, it will be a major accomplishment just for that alone.

Valuing Global Brands

BusinessWeek has published its 2007 list of Best Global Brands. Toping the list of most valuable brands are Coke, Microsoft, IBM, GE, Nokia, Toyota, Intel, McDonalds, Disney and Mercedes-Benz. Google came in at number 20, Apple at 33 and Starbucks at 88. According to my calculation, the total value of the top 100 brands is over $1.5 trillion. The US brands are almost $745 billion.
The Business Week story highlights 5 comeback stories: Nintendo, Audi, HP, Burberry and Citibank. It also ranks the biggest gainers and losers:
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A well rounded education

A new study from the Center on Education Policy Choices, Changes, and Challenges: Curriculum and Instruction in the NCLB Era is providing a new spark to the debate over the No Child Left Behind law. The study finds improvement in math and science scores, but at a price. The finds are as follows:

Increased time for tested subjects since 2002. About 62% of districts reported that they have increased time for English language arts1 (ELA) and/or math in elementary schools since school year 2001-02 (the year NCLB was enacted), and more than 20% reported increasing time for these subjects in middle school since then. Among districts that reported increasing time for ELA and math, the average increase in minutes per week since 2001-02 was substantial, amounting to a 46% increase in ELA, a 37% increase in math, and a 42% increase across the two subjects combined.
Reduced time for other subjects. To accommodate this increased time in ELA and math, 44% of districts reported cutting time from one or more other subjects or activities (social studies, science, art and music, physical education, lunch and/or recess) at the elementary level. Again, the decreases reported by these districts were relatively large, adding up to a total of 141 minutes per week across all of these subjects, on average, or nearly 30 minutes per day. These decreases represent an average reduction of 31% in the total instructional time devoted to these subjects since 2001-02.
Increases and decreases more prevalent in districts with schools identified for improvement. Greater proportions of districts with at least one school identified for NCLB improvement than of districts without schools in improvement reported that they have increased time for ELA and/or math at the elementary and middle school levels since school year 2001-02. Districts with at least one school in improvement also reported in greater proportions than districts without schools in improvement that they have decreased time in social studies, science, and art and music.
Greater emphasis on tested content and skills. Since 2001-02, most districts have changed their ELA and math curricula to put greater emphasis on the content and skills covered on the state tests used for NCLB. In elementary level reading, 84% of districts reported that they have changed their curriculum “somewhat” or “to a great extent” to put greater emphasis on tested content; in middle school ELA, 79% reported making this change, and in high school ELA, 76%. Similarly, in math, 81% of districts reported that they have changed their curriculum at the elementary and middle school level to emphasize tested content and skills, and 78% reported having done so at the high school level.

These findings raised concerns as to whether students are getting a well-rounded education. The report recommend the following:

Stagger testing requirements to include tests in other academic subjects. Because our survey data indicate that what is tested is what is taught, students should be tested in math and English language arts in grades 3, 5, and 7 and once in high school, and in social studies and science in grades 4, 6, and 8 and once in high school. These tests should be used for accountability purposes. By staggering the subjects tested, the total amount of NCLB-mandated testing would stay the same, except in states that do not currently test social studies in high school.
Encourage states to give adequate emphasis to art and music. States should review their curriculum guidelines to ensure that they encourage adequate attention to and time for art and music, and should consider including measures of knowledge and skills in art and music among the multiple measures used for NCLB accountability.
Require states to arrange for an independent review, at least once every three years, of their standards and assessments to ensure that they are of high quality and rigor. Because districts in our survey report that they are changing their curriculum to put more emphasis on content and skills covered on the tests used for accountability, states should be sure these tests are “good” tests by commissioning reviews of their standards and assessments by independent organizations or agencies.
Provide federal funds for research to determine the best ways to incorporate the teaching of reading and math skills into social studies and science. By integrating reading and math instruction into other core academic subjects, students will be more ensured of a rich, well-rounded curriculum. Funds should also be provided through Title I and Title II of NCLB to train teachers in using these techniques.

I hope the recommendations will be carefully reviewed in the process of reauthorizing the No Child Left Behind law. Math and reading are foundation skills – however at some point it is necessary to build upon that foundation. Otherwise, you end up with a massive cellar and little living space above. In the I-Cubed Economy, it is important to be able to do your sums and follow written instructions. That is the starting point. But those are industrial era skills. Creativity in numerous areas is the driver of prosperity today. If our schools are not fostering that creativity, then we are preparing our children for 1910, not 2010.

Dualing tax plans

The issue of taxes may be heating up in the Presidential race. Yesterday, Treasury Secretary Paulson teed up his proposals for corporate tax reform with a line up on mostly conservative luminaries, including Alan Greenspan (see Paulson Gets Support for Tax Overhaul – washingtonpost.com and my previous posting). The thrust of his ideas is a return to the 1986 deal of eliminating specific business tax incentives in return for a lower corporate tax rate.
On the other side, John Edwards unveiled his tax reform package that includes an increase in the capital gains tax rate (Edwards’s Tax Plan Focuses On Low, Middle-Income Families – WSJ.com, Edwards Proposes Raising Capital Gains Tax – New York Times and John Edwards for President-Building One Economy With Tax Reform To Reward Work).
Without getting into the specifics of either camp’s proposals, I would raise one very specific issue. If the I-Cubed Economy is fueled by development of intangible assets, how does your tax proposal foster or retard that development? Otherwise, you are just proposing a tax system for the past, not the future.

Knowledge intensive service activities

I recent ran across an OECD study (from last year) on Innovation and Knowledge-Intensive Service Activities:

From research and development to legal and marketing services, a wide range of knowledge-intensive service activities (KISAs) enables firms and public sector organisations to better innovate. KISAs are both sources and carriers of knowledge that influence and improve the performance of individual organisations, value chains and industry clusters across all sectors of the economy.

The study categorizes these services in four ways:

The case studies indicate that different types of KISA contribute in different ways to innovation (Table 0.1). Some KISA, such as R&D and strategic management, aid in firm renewal. Such renewal services are closely linked to innovation, but are relevant and accessible to a limited number of highly capable recipient organisations equipped with sufficient resources. Other, more routine services, such as accounting help maintain and improve existing systems and activities within organisations. Their significance for performance enhancement is highly important for most organisations. Compliance services, such as auditing and some legal services are not obviously linked with innovation, except to the extent that compliance with regulations related to health, safety, environment, etc., can stimulate innovation. Such KISA also offer an access route by which a wide range of organisations, among them the bulk of small businesses, can recognise the importance of KISA to their firm’s performance and begin to engage a broader set of KISA providers. Network services provide an important platform for knowledge exchange within formal and informal networks. They also represent a flexible resource base for the members of the network.
Table 0.1. Types of KISA and their role in innovation
Renewal services: Directly related to innovation, for instance R&D and strategic management consulting
Routine services: Contribute to improvement of maintenance and management of various subsystems within organisations, e.g. accounting
Compliance services: Help organisations to work within the legal framework and various other regulatory regimes, e.g. auditing and some legal services
Network services: Facilitate communication, knowledge exchange and flexible resource allocation,
e.g. informal personal networks and production related networks.

Among the policy recommendations were two I found particularly important:
1) innovation policy frameworks need to respond to the nontechnological aspects of KISA and their impact on innovation capability:

The traditional R&D-based approach to innovation is too narrow and that innovation policies need to recognise the various types of knowledge-intensive services activities that have different roles in the innovation processes. Policy needs to focus more on the interactive people-centred activities, less on the individual firm and more on developing the collective strength of the sector or network. Since typical KISA is mainly based on intangible assets, policies ought to secure sufficient supply of private and public financing for growth oriented KISA. Better understanding of the non-technological elements of innovation and the user contribution to innovation needs to be further developed.

2) a key challenge is improving access to KISA.

This challenge is highlighted by intangibility, complexity and difficulties in assessing the quality and suitability of the services offered prior to engaging with them. Financial assistance is only a partial solution. Awareness of KISA needs to be developed first and knowledge asymmetries between KISA suppliers and users need to be addressed, for instance, by certification of services and through publicly funded demonstration projects.

We often talk about the innovation ecosystem. It is clear that these knowledge-intensive service activities are an important part of that ecosystem – both for their own innovation activities and in how they facilitate innovation in other sectors.
The study also provides us with one more example of how the old boundaries of manufacturing and services are blurring in the I-Cubed Economy. And how we need to continue to change our mindset if we are to come up with appropriate policy responses.

A new metric for intangibles

A recent article in the McKinsey Quarterly proposes a new metric for measuring investments in intangibles: profit per employee:

* Today’s approach to measuring financial performance is geared excessively to the capital-intensive operating styles of 20th-century industrial companies. It doesn’t sufficiently account for factors such as the contributions of talented employees that, more and more, are the basic source of wealth.
* Financial performance—observed through balance sheets, cash flow reports, and income statements—is and always will be the principal metric for evaluating a company and its managers. But greater attention should be paid to the role of intangible capital and the ways of accounting for it.
* The superior performance of some of the largest and most successful companies over the past decade demonstrates the value of intangible assets.
* Companies can redesign the internal financial performance approach and set goals for the return on intangibles by paying greater attention to profit per employee and the number of employees rather than putting all of the focus on returns on invested capital.

The full article is available at the Massachusetts Manufacturing Advancement Center website.
The article is based on a forthcoming book Mobilizing Minds: Creating Wealth from Talent in the 21st-Century Organization by Lowell L. Bryan and Claudia I. Joyce. The book focuses on the issue of organization design in the Intangible Economy. As the authors noted in a recent interview:

We believe the time has come for corporate leaders to view organizational design as a strategic imperative and high-return, low-risk opportunity for investment. The classic definition of “strategy” is a plan for actions to be taken with which to gain competitive advantage. Using this definition, we believe corporate leaders need to invest more energy than they have invested in the past in taking actions needed to create the strategic organizational capabilities that will enable their companies to thrive. We are convinced that in the digital age, if you want to create wealth, there is almost no better use of the CEO’s time and energy than making the organization work better. So if corporate strategy is about preparing the corporation to gain competitive advantage, designing a more effective organization is certainly central to this endeavour.
. . .
We believe that nearly all organizations are replete with opportunities to streamline and simplify the use of hierarchical authority to remove unproductive complexities – while simultaneously increasing that authority’s effectiveness.
The approach we advocate involves redesigning a company’s hierarchical order, thereby improving management’s ability to use hierarchical authority to power a company’s performance. The effort centres on defining a “backbone” or central management structure; and developing general line management or clear decision authority and accountability for operating performance. By a “backbone line structure” we mean a chain of command that puts authority to make tactical decisions close to the front lines. By “frontline manager”, we mean someone with the authority to set aspirations, define tasks and roles, assign people and hold them accountable, mobilize resources, and make decisions for frontline workers.
We have used military analogies to illustrate both aspects of the model. In terms of a backbone line structure, in the military, there is no ambiguity about who a soldier’s commanding officer is, we believe the corporations should move more toward this model, than the traditional multiple bosses matrix approach. We also believe that the frontline manager should have more authority and accountability to make decisions at the front line, as do front-line military officers.

Sounds like an interesting read. But I am especially interested with their notion of using profit per employee as the metric of choice. That is an important step toward getting out financial measures right in the I-Cubed Economy.

Tax breaks

Speaking of tax breaks, here is an interesting story from today’s New York Times Tax Break Used by Drug Makers Failed to Add Jobs:

Two years ago, when companies received a big tax break to bring home their offshore profits, the president and Congress justified it as a one-time tax amnesty that would create American jobs.
Drug makers were the biggest beneficiaries of the amnesty program, repatriating about $100 billion in foreign profits and paying only minimal taxes. But the companies did not create many jobs in return. Instead, since 2005 the American drug industry has laid off tens of thousands of workers in this country.
And now drug companies are once again using complex strategies, many of them demonstrably legal, to shelter billions of dollars in profits in international tax havens, according to their financial statements and independent tax experts.
In one popular accounting move, companies declare their foreign markets as far more profitable than their American businesses — even though drug prices are typically higher in the United States than anywhere else in the world.
Drug makers are not the only American multinationals using tax loopholes to declare large portions of their income beyond the reach of the Internal Revenue Service. The Brookings Institution estimates that multinational companies are using overseas tax shelters to lower their payments to the Treasury by about $50 billion a year.

Interestingly, this investment distorting tax incentive is only discussed in the Treasury Department’s background paper on corporate taxation (see previous posting) in an Appendix on taxing international income.
The story goes on to talk about this relates to the issue of transfer of intellectual property offshore:

Tax experts like Michael J. McIntyre, a law professor at Wayne State University in Detroit, say the drug makers are taking advantage of antiquated rules that work better for manufactured products like steel and automobiles.
Under this system, when companies transfer products between divisions in different countries, they must account for the sales internally through “transfer pricing.” But they have significant discretion in how they set prices for these transactions.
That turns out to be especially so for high-margin products like drugs, which in pill form cost only a few cents each to make once they have been invented, but can be sold for several dollars apiece. The hefty profit margins result in part from patents that can protect the drugs from competition for years. And by transferring those valuable patents overseas, companies can declare that their profits should follow the patents overseas as well.
Under the rules of transfer pricing, if a company moves patents or other so-called intangibles from its United States division to a foreign subsidiary, the foreign unit is supposed to pay the American division a fair-market price. But outsiders have a difficult time determining if companies have properly assessed the value of patents, trademarks and other intangible properties.
To further complicate matters, some corporate subsidiaries in tax-haven countries, like Singapore and the Netherlands, now directly finance research in the United States. So they own the patents without ever having to “buy” them from their American parents, Mr. McIntyre said.
“They don’t even have to push it offshore,” Mr. McIntyre said. “It’s already offshore. And once it’s offshore, they strip the income from the onshore activity.”
In theory, companies are only deferring taxes on the profits they shelter overseas, not permanently avoiding tax. If they bring the money back to the United States to distribute to their shareholders, they still have to pay American taxes on it.
But those rules were temporarily suspended when President Bush signed legislation in 2004 to let companies return overseas profits at a rate of 5.25 percent, far below the official tax rate of 35 percent, if they moved the money back by 2006.

The story concludes with a suggestion:

Some experts now say the current system of taxing overseas profits should be scrapped. Even the companies that take advantage of loopholes might benefit if the system were changed, because they could save money on tax planning and have more certainty that the I.R.S. would accept their returns, said Michael C. Durst, a former I.R.S. official who is now special counsel to the law firm Steptoe & Johnson.
The simplest solution, Mr. Durst said, would be shifting to a system in which companies would assign a portion of profit to each country where they made a sale, relative to the size of the sale. Instead of trying to tax profits made overseas, the United States government would simply take its share of the profits on American sales. Such a system would be harder for the companies to game, Mr. Durst said.
But he and other tax experts say that any effort to close loopholes, to be politically viable, might have to be combined with a lowering of the corporate tax rate from its current 35 percent. And no one expects any legislation of that sort, at least not before the next election.

That is an interesting suggestion. The key will be looking at all the loopholes, not just a few tax incentives like the R&E tax credit.

Tax conference background (advocacy) paper

In preparation for Thursday’s short conference on tax policy and competitiveness (see earlier posting), the Treasury Department has released a background paper that makes the case for ending special tax breaks and reducing the corporate tax rate. According to a story in today’s Washington Post (Reconsidering Corporate Tax Breaks), the paper is not meant to be the final word:

Treasury Secretary Henry M. Paulson Jr. said in an interview that the paper is not intended to state a position so much as to open a public discussion about how to streamline taxes and regulations to help U.S. companies compete.

However, the paper is rather forceful in its tone. As the paper states:

Other countries continue to reduce their corporate tax rates, leaving the United States still further behind.
. . .
Our current system for taxing businesses and multinational companies has developed in a patchwork fashion spanning decades, resulting in a web of tax rules that can harm the competitiveness of U.S. companies.
. . .
However, our tax system disrupts and distorts a vast array of business and investment decisions, leading to an inefficient level and allocation of capital through the economy.

There are other worrisome parts to the paper. For example, in the section on “Distortions caused by tax incentives” focuses almost exclusively on the research and experimentation tax credit and the domestic production provisions. What about all the other tax incentives?
I was especially interested in the section on tangible versus intangible assets:

Income from investment in intangible assets (e.g., R&D and advertising) generally receives more favorable tax treatment than does income from investment in tangible assets (e.g., plant and machinery). Investment in intangibles might be excessively encouraged by the tax system, relative to investment in tangible assets.
As discussed above, the cost of purchasing a tangible asset generally is written off (depreciated) over time to compensate for its decline in value due to wear and tear. In contrast, the cost of investment in intangible assets generally is deducted immediately (expensed). Expensing can give a substantial benefit to intangibles over tangible assets. For example, because of expensing, corporate intangibles face an effective tax rate that is close to zero, whereas corporate depreciable assets face an effective tax rate of around 30 percent.

While immediate expensing of intangibles may confer some tax advantage, I’ve seen no evidence to suggest the result is an over-investment in intangibles. In fact, the accounting side of the expensing on intangibles tends to push management toward treating intangibles as an operating expense to be minimized rather than a long term investment.
Likewise the section on physical versus human capital is interesting:

Investment in acquiring skills and abilities shares much in common with investment in more traditional physical assets. Investment in human capital can be thought of as an intermediate input that can be used to produce a final good. Much of the economic cost of acquiring abilities and skills is incurred in the form of earnings that are foregone during the period of training or schooling. Because these foregone earnings are not taxed (i.e., imputed and includable in income), this treatment, in effect, allows an immediate deduction for such investment. Similar to the discussion above on the tax treatment of investment in physical capital, in economic terms, the “deduction” for investment in human capital (i.e., the nontaxation of foregone earnings) equals the tax on the cash flow from the “expected” normal return on the investment, which eliminates the tax on this part of the return (in present value). To the extent that future earnings exceed the expected normal return – perhaps because of luck, innovation, or successful risk taking – the tax on these higher than expected normal returns will exceed the tax value of the initial deduction and would be taxed (in present value).
Investments in physical capital and human capital are treated very differently in our current tax system. Physical capital is typically depreciated over the life of an asset, while human capital is effectively expensed or deducted immediately because of the non-taxation of foregone earnings. This disparate treatment between physical and human capital discourages investment in physical capital relative to human capital. More uniform treatment would reduce this distortion. [Footnote: Of course, more uniform treatment could involve either expensing or applying economic depreciation to all investment (i.e., human and physical capital).]
The current income tax also offers a number of other incentives for investment in human capital. These include the tax exclusion of scholarships, fellowships, and the value of reduced tuition; education tax credits; deduction of student loan interest; tax advantaged education saving accounts; deductibility and exclusion of employer provided education expenses; deductibility of tuition; and allowing students beyond the normal age cut-off to qualify as eligible children when computing their parents’ earned income tax credit and their parents’ dependent deduction.

Again, I see no evidence that all these supposed tax incentives are resulting in an over-investment in human capital and an under-investment in physical capital. What I do see is a preemptive argument against the idea of a knowledge tax credit.
The paper also mounts a spirited defense of the practice of shifting intangible assets offshore:

Multinational corporations have developed a large number of valuable intangible assets such as patents and trademarks that allow them to earn supra-normal or infra-marginal returns on the tangible capital that is necessary to exploit the intangible. The decision on where to locate the production of a particular highly profitable good or service is usually a discrete one in which a certain amount of plant and equipment is required. The decision on how much to invest in any given country therefore is based not only on the effective tax rate on marginal investment, but also on the taxation of the infra-marginal returns.
A U.S. subsidiary abroad has to pay a royalty to the parent company for the use of the U.S. developed intangible. However, the evidence suggests that a substantial portion of the return to the intangible asset remains in the location where it is produced. Furthermore, under the current U.S. tax system, most foreign royalties are shielded from U.S. tax by excess foreign tax credits flowing from more highly taxed income. Multinational companies therefore have a strong incentive to locate the production of any new valuable products and services in low-tax countries. Lowering the corporate tax rate would make the United States a more attractive location.

Interesting, since they just stated that the US tax system benefits investment in intangibles over tangibles. So why is there then an incentive to shift production of intangibles offshore? And not a word about the issue of transfer-pricing, especially of intangibles — which then IRS Commission Mark Everson labeled in Congressional testimony last year as “a high-risk compliance concern”:

Taxpayers, especially in the high technology and pharmaceutical industries, are shifting profits offshore through a variety of arrangements that result in the transfer of valuable intangibles to related foreign entities for inadequate consideration.

and which, this past April, IRS “estimates that inadequate consideration has resulted in material underreporting of taxable income by U.S. Corporations.”
What is also notable in the paper is what is missing. For example, missing from the paper is any discussion of any form of border-refundable tax that many other nations use to boost exports. Also missing is any discussion of payroll taxes.
I would like to think that the Thursday conference will be an open discussion of the issues. The background paper, however, is a set up to a preconceived solution: lower the tax rate. That may or may not be good tax policy. One would not know that from the one-sided advocacy brief that is being used for the background paper.