Intangible Assets Remain Key to Valuation Amid Tightening Capital

Editor's note:Tyler Capson is the managing director of intangible asset consulting, valuation, and corporate financial advisory firmEverEdge Global. The views expressed in this article are those of the author alone.

Although capital once flowed freely to startups, 2022 may be the year investors begin to scrutinize more closely. Executive teams may face greater pressure to justify their valuations, and by giving intangible assets the attention they deserve, they can do so more effectively. Rigorous scrutiny of intangible assets will enable them to credibly defend higher valuations and explain to investors the difference between reality and hype.

The Rise of Intangible Assets

What are intangible assets? Simply put, they are assets you cannot touch and that may not appear on your balance sheet. Yet, for almost all companies today (except pure real estate investments), these assets are the primary drivers of company performance.

Think of the data and algorithms that power Google and Facebook, the secret formula of Coca-Cola, the brands of Apple and Nike, the patents held by IBM and Intel, and the employee culture at Southwest Airlines. These assets are unlikely to be recorded on income statements or balance sheets, but they drive strategic decisions.

The rise in importance of intangible assets represents a major but still underappreciated shift in the economy. With capital so cheap today, physical assets no longer differentiate companies as they once did. Buying or investing in a factory does not, by itself, distinguish a company from its competitors. What truly sets them apart are intangible assets: Which company has better supplier relationships? Who can leverage their customer data to predict purchasing trends and insights? Who has better pricing strategies, systems and processes that operate more safely and efficiently, a better workplace culture, and better software code?

These assets are increasingly the most important ones. According to one analysis, in 1975, intangible assets accounted for 17% of the enterprise value of S&P 500 companies; today, that figure is 90%.

If intangible assets are so important, why haven't they entered mainstream accounting? One reason is that our financial reporting system was developed during the industrial age, when physical assets (inventory, property, plant, and equipment) drove the most value and capital was scarcer. Reporting standards for intangible assets have not kept pace with their importance.

Intangible assets are also difficult to value, and they are so diverse and varied that treating them as a single category can seem unwieldy and impractical. Depending on the context, different people call them different things. Lawyers may view them as intellectual property (IP), accountants as "goodwill," CEOs and entrepreneurs as "competitive advantage." Warren Buffett has called them "moats."

Identify, Value, and Defend

Whatever they are called, ignoring them is a mistake, even for early-stage companies. Startups often focus so much on getting their product or service to market and achieving growth that they fail to take the time to identify the intangible assets most critical to their growth.

By failing to go through this process to understand where true value lies, startups often fail to protect these assets, making their companies more vulnerable to competitive threats, thereby slowing or hindering growth. We have seen technology companies outsource software development to third parties to meet deadlines, without any protections or safeguards. They put their most valuable intangible asset—software code—at risk of theft, with devastating effects on market share and margins.

We have also seen companies spend hundreds of thousands of dollars on branding before obtaining trademark protection, effectively promoting a brand they do not own, thus wasting money. Sometimes, executives misjudge their competitive advantage. A low-cost eyewear supplier might believe its competitive advantage lies in price. But what truly drives that low cost? Is it an efficient manufacturing process? Or a special relationship with suppliers? Knowing the answer is crucial.

One way to find out is to assign value to all intangible assets. Intangible asset valuation should use traditional quantitative methods while also analyzing context and qualitative factors. These factors are the primary drivers of intangible asset value.

There is a big difference between believing an asset has value and proving it. Executives who can do the latter can attract more capital. It is one thing to show potential investors the value of an existing relationship with a partner willing to provide distribution channels to sell your products and services; it is another for a founder to say "Google will love our technology."

Companies that invest in developing intangible assets and building frameworks to reduce risk are more likely to achieve higher valuations in the medium to long term. This may include investing in company culture, leading to a more efficient workforce with lower turnover and reduced recruitment and training costs.

This process also allows executives to consider various options. If the assets developed by a startup are key to another company's success, they may have significant value. This could mean the startup can leverage its intangible assets by licensing or selling them to a third party capable of reaching large-scale markets, entering an entirely new market, and operating at a vastly different scale.

Valuing intangible assets also helps companies prepare for unexpected situations. If an acquirer seeks a partnership or makes an offer for the entire company, understanding and being able to clearly articulate the value of intangible assets helps to secure and defend a higher valuation. Lacking such valuation can give buyers and other parties an unfair advantage.

Here are some questions we recommend executives ask themselves:

• What are our intangible assets?
• How do these assets bring economic and strategic value to our business?
• How much are these assets worth?
• Does our company valuation adequately capture and articulate the full value of intangible assets?
• How can we unlock additional value from intangible assets—are they more valuable in our hands or in someone else's?
• What is our intangible asset strategy—are we actively managing these assets?
• Does our team understand the importance of these assets?
• What are our key intangible asset risks?
• What is our strategy to manage and mitigate these risks?
• What systems and processes do we have to manage and mitigate these risks?

Throughout my career, I have encountered many "spreadsheet billionaires." They tap on their keyboards and convince themselves that their company's sales will grow exponentially. My advice is always the same: conduct a rigorous accounting of your company's assets and develop a plan to protect them. Otherwise, you will forever remain in a fantasy world.