Rethinking the Valley of Death

Over at Andrew Hargadon’s blog, GreenTech Media, he has posted an interesting take on the Valley of Death problem. The Valley of Death is usually seen as a financial issue: how to get funds to move from early stage research to later stage commercialization. Hargadon points out that the issue is not just lack of money. There may be very good reasons why the project does not attract funding — it may lack other forms of capital:

In addition to financial capital, there are three other forms that at different times can be significantly more valuable: physical capital (the physical resources someone has already acquired and organized), intellectual capital (the knowledge and skills someone has acquired and organized), and social capital (someone’s social network, or access to the capital “stocks” of others). [Note that we normally refer to all three of these as parts of intellectual capital.]
While a startup’s balance sheet might clearly show where they stand with respect to their financial and physical capital, it does little to reveal their intellectual and social capital. And yet for companies to avoid their own untimely demise, they depend as much or more on knowledge, experience, and the ability to manage their company’s fortunes — and on their social networks to discover, guide, and acquire the critical resources they will need to succeed.

So the solution to the valley of death funding problem is not just more money — but a careful look at all the forms of intellectual capital needed to make the project work. For this reason, I have been advocating programs to do more to help companies and entrepreneurs better manage their intellectual capital. Those services could be offered as part of SBA and EDA programs, built into business incubator programs, and be the core services of a specialized center, such as Glasgow’s Intellectual Assets Centre and Hong Kong’s Intellectual Capital Management Consultancy Programme. And, as I noted last week, that analysis and evaluation can be tied directly to the funding process — as the Hong Kong center just announced.

One other point, Hargadon’s comments were made in the context of green tech.
As I noted earlier, the Department of Energy encourages applicants for the clean energy production loan to put up their IP as collateral. DOE is not necessarily looking to recoup funds by selling the IP if the loan goes bad. They what to control the IP and the technology if they have to step in and finish the project.

So the elements is understand the key role of intellectual capital are beginning to take shape. We need to push the process along.

Cloud manufacturing

Are you ready for “cloud manufacturing”? That is Tom Friedman’s new term for the global supply chains and contract manufacturing in low cost countries. In a recent column, he hails the ability of new US start-ups to utilize cloud manufacturing to quickly bring a product to market. Taken as a example of business success, that may be a good thing. Unfortunately, Friedman misses a bigger issue and continues to fall in the trap of thinking the US can survive on only a part of the value chain:

What’s in it for America? As long as the venture money, core innovation and the key management comes from here — a lot. If EndoStim works out, its tiny headquarters in St. Louis will grow much larger. St. Louis is where the best jobs — top management, marketing, design — and shareholders will be, said Hogg.

In other words, we don’t need manufacturing in the US, we can survive as executives. Again, possibly a workable strategy for a company; not a way to create a healthy and sustainable economy for a country.

A more realistic view come from the special report on innovation in The Economist: The World Turned Upside Down. It is clear from this report that the international division of labor implied in Friedman’s piece (we do the thinking; they do the making) will not save the US economy. First of all, the “developing” world is not interested in staying in its place — they want to and are actively working on moving up the supply chain. As the lead into to the special report says, “The emerging world, long a source of cheap labour, now rivals the rich countries for business innovation.”

Second, value added and knowledge intensive activity can be found everywhere on the value chain — including manufacturing. As I have noted before, it is important to have manufacturing nearby in many innovation-driven activities. Manufacturing itself can be a source of innovative competitive advantage. Rather than secede manufacturing to the other nations (under some nice sounding phrase like “cloud manufacturing”), we need to make sure that startup companies can find the manufacturing resources close by. That will help the companies with the ability to continually improve the product and the process — something that the outsourcing to the “cloud” makes difficult. It will also help companies better manage their supply chain – which the recent grounding of air traffic has shown can be vulnerable.

Strengthen manufacturing in the US will require that we recognize that manufacturing is already an intellectual capital intense activity. As our recent Policy Brief–Intellectual Capital and Revitalizing Manufacturing outlines, there are many steps we can take in that regard.

But the first and foremost we need to remember that manufacturing matters. All else follows.

Intangibles and M&A

Thanks to Joff Wild over at the IAM blog for a heads up on a new report: The silver bullet of success: Winners and losers in the M&A game. The report, by the consulting company the Hay Group, surveyed corporate executives on M&A activities and intangibles. Their findings should not surprise any regular reader of this blog: “Companies that reviewed intangibles during due diligence are more than twice as likely to consider their merger a success compared with those who did not.”

The good news is that a majority of the executives get it: “Two thirds of respondents (66 per cent) believe an increased focus on intangible capital would improve merger success.”

The bad news is that they don’t know how to do this: “Most business leaders (61 per cent) plan to increase their focus on intangibles but need guidance on how to capture data about intangible capital during M&As.” This shows the need for intangible asset /intellectual capital management services for both ongoing businesses and for M&A analysis (which is probably the point this consulting company is trying to make with this report in the first place).

I do have a concern with the report on the data on valuation. The study finds that “executives typically value intangible capital – including culture and customer relationships – at just 30 per cent of market capitalization.” They compare this to the figure used by some of intangibles as 75% of market capitalization. They then assert that this proves that executives are undervaluing intangibles. It may however prove the opposite. I have always been skeptical of the 75% numbers. That was generated in the height of the stock bubbles, so I’ve never been sure how much is real intangible wealth and how much was market froth. The 30% estimate seems low to me, but it may be one of the closest numbers we have to actual market data. This is an area for further work.

I have one other quibble with the study. I cringe at the hype about intangibles being the “silver bullet” in M&A. Of course, as I acknowledged above, this report is a sales tool for the consulting. Therefore the hype is to be somewhat expected. However, my concern is that sets up intangibles as the fall guy for any failed deal — any executive can simply say the deal failed because “insufficient attention to intangibles”, rather than the fact that the deal might have been a stupid idea in the first place.

A standard problem with intangibles is that some define it as such a broad category that it includes everything — which means for analytical purposes it is nothing. In fairness to the report’s authors, they use the intellectual capital framework of organizational, relationship and human capital, so there is an analytical backstop to their claims. But we should be careful to not over hype intangibles — making them into a meaningless concept.

Overhead and who counts in health care

Here is an interesting tidbit from the New York Time Economix blog — One Reason U.S. Health Care Costs So Much. The blog has a chart by Harvard economics Professor David Cutler:

As the blog puts it:

The takeaway: For every doctor, there are five people performing health care administrative support.

An eye-catching statistic — one sure to be bandied about in debates as evidence of excessive overhead. But misleading at best.

If you look at chart, you also see a large number of nurses. According to the data from the BLS, 43.8% of health care workers are in the service delivery area, which includes nurses, doctors, social workers, paramedics, clinical laboratory technicians, etc. Only 17.7% are in office and administrative support and 4.3% in management/financial.

So yes, there is a 5 to 1 ratio of doctors to support administrative support staff. But doctors are only a small part of the health care delivery system — 3.6% of total employment. There is a huge number of other health care professionals, especially nurses. In fact there is a 5 to 1 ratio of doctors to nurses as well.

There are inefficiencies in the health care system. But this is unclear from the occupation data. The 17.7% office and administrative support is high but not unusually high. 15% of workers in auto dealerships are office and administrative support. The number is 9.6% in computer and electronics production companies. But in computer companies, 16.2% of employment is in management/financial whereas only 4.3% of health care employment is management/financial. By this measure, one of the most efficient operations are food service and drinking places, where only 2.4% of employment is in management/financial while 91.3% are in direct service delivery.

What really troubles me about this posting, however, is the underlying assumption that only the high-end workers — physicians and surgeons — count in the worker to support ratio. I’m sure the author did not mean to down play the role of nurses. But that comment on the 5 to 1 ratio does just that.

Unfortunately, this is an all too common occurrence. We talk about “high-tech” as if only it matters and non-tech activities and innovation are meaningless. That is an attitude we need to resist. In a knowledge economy, all levels of skills and knowledge matter — and all forms of innovation are important.

Update on IPR and Cotton

In an earlier posting, I discussed the US-Brazil cotton dispute, where Brazil was given the right to suspend intellectual property rights in retaliation for US cotton subsidies. From last week’s the New York Times comes this update — U.S. and Brazil Reach Agreement on Cotton Dispute:

Under the preliminary deal, Brazil would hold off on retaliation in exchange for American concessions that include the modification of an export loan program and the establishment of a temporary assistance fund for the Brazilian cotton industry. The broader issues in contention would be deferred until Congress takes up the next farm bill, most likely in 2012.

Some thought the suspension of intellectual property right as inappropriate. Interestingly, at least one free-trader defended this tactic:

“Traditionally, retaliation in trade has been the preserve of the largest developed countries, which have market power,” said Robert Z. Lawrence, a professor of international trade and finance at the Harvard Kennedy School. “But this mechanism — suspending intellectual property protection — gives smaller, developing countries a way to enforce their rights under trade rules.”

February trade in intangibles

BEA’s February’s trade data showed an increase in our deficit increasing by $2.7 billion to $39.7 billion. Imports increased by $3.0 billion while exports rose only $0.3 billion. This month we couldn’t blame the increased deficit on oil imports, as the petroleum trade deficit remained basically the same as in January (see chart below). The real culprit was the stagnation of exports in the face of rising imports. That, unfortunately, sounds more like the “old normal” than the “new normal” we are supposedly headed toward.

That negative trend extended to our trade in intangibles — where the surplus declined slightly. Most of that decline was due to a rise in outgoing royalty payments (imports). Incoming royalty payments also rose, but only slightly. Exports of private services increased and the imports of private services actually decreased slightly.

Our deficit in Advanced Technology Products also increased slightly in February as exports declined faster than imports. The exception was for opto-electronics and weapons where exports and imports both rose. The last monthly surplus in Advanced Technology Products was in June 2002 and the last sustained series of monthly surpluses were in the first half of 2001.

Intangibles trade-Feb10.gif
Intangibles and goods-Feb10.gif
Oil good intangibles-Feb10.gif

Note: we define trade in intangibles as the sum of “royalties and license fees” and “other private services”. The BEA/Census Bureau definitions of those categories are as follows:

Royalties and License Fees – Transactions with foreign residents involving intangible assets and proprietary rights, such as the use of patents, techniques, processes, formulas, designs, know-how, trademarks, copyrights, franchises, and manufacturing rights. The term “royalties” generally refers to payments for the utilization of copyrights or trademarks, and the term “license fees” generally refers to payments for the use of patents or industrial processes.

Other Private Services – Transactions with affiliated foreigners, for which no identification by type is available, and of transactions with unaffiliated foreigners. (The term “affiliated” refers to a direct investment relationship, which exists when a U.S. person has ownership or control, directly or indirectly, of 10 percent or more of a foreign business enterprise’s voting securities or the equivalent, or when a foreign person has a similar interest in a U.S. enterprise.) Transactions with unaffiliated foreigners consist of education services; financial services (includes commissions and other transactions fees associated with the purchase and sale of securities and noninterest income of banks, and excludes investment income); insurance services; telecommunications services (includes transmission services and value-added services); and business, professional, and technical services. Included in the last group are advertising services; computer and data processing services; database and other information services; research, development, and testing services; management, consulting, and public relations services; legal services; construction, engineering, architectural, and mining services; industrial engineering services; installation, maintenance, and repair of equipment; and other services, including medical services and film and tape rentals.

Hong Kong promotes borrowing using Intellectual Capital

In an earlier posting, I mentioned Hong Kong’s new Intellectual Capital Management Consultancy Programme. Run by the Intellectual Property Department, the Innovation and Technology Commission and the Trade and Industry Department, the Consultancy Programme provides a free service to businesses, especially SMEs, to help them understand and manage their intellectual capital (IC). The service works with the company to identify and assess their and create a simple IC report. The service also covers intellectual property policies and procedures.

Last month, they announced a new partnership with Hong Kong banks to use those IC reports in lending decisions. The five Partnering Lending Institutions (PLIs) are the Bank of China (Hong Kong) Limited, Chong Hing Bank Limited, Citi Commercial Bank, Hang Seng Bank Limited, and the Bank of East Asia Limited. As the announcement notes:

The banks will offer more favourable financial and/or service privileges to successful business loan applicants who have prepared their own intellectual capital reports.

This is the first time I know of that banks will systematically recognize the information from IC reports in their lending decisions. While the banks will still require the standard documentation and conduct the normal credit assessment, this could be a major breakthrough in how intellectual capital and intangible assets are handled on a routine basis. Our earlier report (Maximizing Intellectual Property and Intangible Assets: Case Studies in Intangible Asset Finance ) described how some financial institutions utilize intellectual property in the financing decision. But those were essentially hand crafted deals. The Hong Kong program has the potential to create the much needed standardization in the process.

Something we need to keep an eye on — and learn from.

Banking on transparency — Not!

Here is the latest way that companies — in this case specifically the big banks — can legally cook the books. From the Wall Street Journal:

Major banks have masked their risk levels in the past five quarters by temporarily lowering their debt just before reporting it to the public, according to data from the Federal Reserve Bank of New York.
A group of 18 banks–which includes Goldman Sachs Group Inc., Morgan Stanley, J.P. Morgan Chase & Co., Bank of America Corp. and Citigroup Inc.–understated the debt levels used to fund securities trades by lowering them an average of 42% at the end of each of the past five quarterly periods, the data show. The banks, which publicly release debt data each quarter, then boosted the debt levels in the middle of successive quarters.

Why does this not surprise me? It is becoming clearer and clearer that even in the post-Enron SOX era, playing accounting games (or as the bank spokesperson called it “managing the balance sheet”) is still a standard practice.

Of course it is. Why shouldn’t it be when the balance sheet is almost a meaningless piece of paper that does not include a companies’ most important assets. I’m speaking, of course, of that huge portion of the value of a company that is made up of intangible assets.

There are a lot of reasons for these accounting games. Chief among them is the quite understandable attempt by management to paint the best possible picture for investors — especially those with a millisecond investment horizon. These are also the same investors who really don’t care about a company’s intangibles assets – because intangibles are the basis for the future of the company and these investors’ definition of the future does not go beyond today.

There is some hope, however. Companies are finding that communicating with investors about their intangibles assets can pay off.

But much more needs to be done to push this trend along. What we need is a three pronged approach:
  • Policies to promote a longer term investment horizon and discourage short-termism.
  • Greater disclosure of important information – especially on intangible assets.
  • A crack down on game-playing through stricter regulations and better enforcement.

The currently pending legislation on financial reform may be a good place to start with some of this. But the changes do beyond the scope of that bill – and includes tax changes and accounting changes. Once the financial reform bills are passed, there will be a tendency to forget about the issue. We must avoid that temptation and continue to press for broader changes which will help bring of financial and accounting system into the 21st Century.

Learning from China

There was an interesting story in today’s New York Times entitled China Again Hopes to Drive U.S. Rail Construction:

Nearly 150 years after American railroads brought in thousands of Chinese laborers to build rail lines across the West, China is poised once again to play a role in American rail construction. But this time, it would be an entirely different role: supplying the technology, equipment and engineers to build high-speed rail lines.

Specifically, Chinese companies have signed an agreement with California and GE to build the system using Chinese technology and Chinese banks would finance it.

This raises the question if the United States is smart enough to learn from the Chinese — both on technology and economic policy. The US has not been in the high-speed rail industry for years. The fact that GE is a partner in this may make it possible to get back in the game. As the story points out:

The railways ministry has concluded a framework agreement to license its technology to G.E., which is a world leader in diesel locomotives but has little experience with the electric locomotives needed for high speeds.
According to G.E., the agreement calls for at least 80 percent of the components of any locomotives and system control gear to come from American suppliers, and labor-intensive final assembly would be done in the United States for the American market. China would license its technology and supply engineers as well as up to 20 percent of the components.

This sound similar to the type of agreements that US companies sign in China. The Chinese have successfully used this policy of importing technology for decades. As a recent “Schumpeter” column in the Economist notes:

The [ruling Communist] party regards foreign investment as a mechanism for acquiring foreign know-how rather than just jobs and capital; hence the insistence on joint ventures.

In other words, the Chinese have based their economic policy on fostering their intangibles assets – not simply neo-classical theories of consumer welfare.

So, can we do the same? The conditions set down in the deal are important: technology transfer to US companies; use of US labor; and use of US suppliers. They need to be looked at very carefully before the deal is signed. Are they really structured in a way to promote the growth of an American-based industry in this field? Or are they structured in a way that simply give the US the low value-added part of the project – with no future benefit? In addition, any other potential supplier mentioned in the story — Japan, Germany, South Korea, Spain, France and Italy — should be subject to the same analysis: who will give us the best deal for building up the industrial and technological base here at home.

The US has the opportunity to act strategically in its technology policy — the way China and other countries have been doing for years. Let’s hope the policymakers in California and elsewhere are smart enough to recognize the opportunity.

Innovative Financing for Innovation

As the U.S. economy evolves, intangible asset investments are becoming vital to economic growth and sustainability. But, as our new paper “Intangible Assets: Innovative Financing for Innovation” outlines, intangible assets can also be the source of financial capital. As industry has invested capital in research and development (R&D) to create new technology and advance other creative activities, a niche market of firms specializing in intangibles-based financing is springing up. Some intangible assets–traditional IP consisting of patents, trademarks, and copyrights–have been used in sale, leasing, equity, equity-debt, debt, and sale-leaseback transactions to finance the next round of innovation.

The paper outlines a number of public policy actions that can be taken to foster the use of intangible asset financing. These include streamlining the technology transfer process, developing underwriting standards to cover the use of intangible assets as collateral and making financial statements more transparent with respect to intangible assets.

The deals that have been done demonstrate that IP and other intangibles are viable assets to secure capital. Unlike other “exotic” financing vehicles, however, intangible-asset financial products are built on some of the most basic financing mechanisms. Far from exotic, they use traditional techniques in new ways to help companies innovate and grow. As the paper shows, there is plenty of opportunity to harness the power of intangibles.

The paper is a summary of our two reports: Intangible Asset Monetization: The Promise and the Reality and Maximizing Intellectual Property and Intangible Assets: Case Studies in Intangible Asset Finance.

Published in the Winter issue of Issues in Science and Technology, the paper is also available on the Issues website.