CHAPTER 3:
INTELLECTUAL CAPITAL
‘What’s new? Simply this: Because knowledge has become the single most important factor of production, managing intellectual assets has become the single most important task of business.’40
Most people are aware that, for most organizations, the value of their tangible assets – land and buildings, plant and machinery, cash and so on – is different from the value of their intangible assets – the ones not carried on their books. The value of the intangible assets is usually taken, in simple terms, as being equal to the difference between the net book value of the business and its current market capitalization.
Although company valuation is a complex exercise, way beyond the scope of this book, it’s probably fair to say that, in broad terms, the current value of a company (its market capitalization) is derived from a computation of its expected future earnings (however defined, but often free cash flow) discounted (by one of a number of possible methods and taking a range of risk factors into account) back to the present – or, simplistically, the present value of future earnings.
Those earnings are made possible by the organization’s assets, both tangible and intangible. In the manufacturing economy, an organization’s key asset was its productive capability: its machinery, logistical support and distribution equipment, and its stocks of raw materials and finished goods. The value of its intangible assets was, in comparison, relatively small.
Knowledge assets
In the last fifteen years, however, the apparent value of these intangible assets has grown (in some cases, admittedly, because of the Internet bubble’s overvaluation of their shares) and now, in many cases, their value exceeds that of their tangible assets – sometimes considerably. In the information age, an organization’s key asset is its intellectual capital: its human resources, retained knowledge and intangible assets. Every organization with a long term desire to survive and succeed in its chosen market has to focus on preserving, protecting, developing, and applying its knowledge assets – its ‘intellectual capital’ - for the benefit of its shareholders.
Thomas Stewart, who brought the intellectual capital concept to a broad business audience during the 1990s, defines an asset as ‘something that transforms raw material into something more valuable’, and comments that intellectual capital is ‘knowledge that transforms raw materials and makes them more valuable.’ Even the ‘raw materials’ themselves are more likely, in today’s economy, to be intangible than tangible.
‘Knowledge assets determine success or failure, but you will search in vain to find them in a company’s books. There is no tested body of knowledge about how to identify, acquire, and exploit intellectual capital. Instead, it usually fends for itself – undefined, unaudited, unreported, almost certainly underused.’41
It has long been common, for instance, to talk of a consultancy business as one ‘where the assets walk out of the office at the end of the day.’ (Bizarrely for the knowledge economy, that’s sometimes given as a good reason not to acquire a consultancy business.) The value of the business is substantially dependent on the knowledge, skills and contacts of its consultants, yet this core component of its value is not reflected on its balance sheet.
41 The Wealth of Knowledge: Intellectual Capital and the Twenty-First Century Organization, Thomas A Stewart, 2002
‘Core competence’ is also seen as key to a business’s success: focus on your core competence and all will be well (well, sort of), but there is no financial valuation of that core competence. In other words, the financial net book (or tangible) value of a business may have little relevance to its market capitalization. The value of the knowledge assets, however, are almost certainly contained in the computation of its expected future earnings and, therefore, in the current market capitalization of the business.
Tangible relevance
In the information economy, the structure of an organization’s asset structure and market capitalization is (or should be) closely related to its business model, strategy and objectives. ‘Tangible relevance’ quantifies the extent to which tangible assets contribute (or are relevant) to its market value; intangible relevance identifies the extent to which this is composed of intellectual assets. The following table compares the tangible and intangible relevance in the market capitalizations of two significant businesses:
The relevance of Glaxo Smithkline’s (a pharmaceutical company) tangible assets to its overall valuation is only 11 percent. Nearly 90 percent of its valuation relates to its intellectual capital. Even a major retail business, like Tesco, has intangible assets that are more relevant to its overall valuation than are its physical ones.
Comparing organizations on the basis of the tangible and intangible relevance of their market capitalizations is a rudimentary method of assessing the extent to which they are leveraging their intellectual assets; organizations, like property companies, that traditionally have a high tangible relevance might be expected to have a different ratio than, for instance, an intellectual property company. However, a business strategy aimed at increasing intangible relevance might lead to the development of new business models that improve shareholder returns; within any individual sector, the company that has the highest intangible relevance is likely to be the company to beat – or back.
And so an organization’s intellectual capital can be defined, simplistically, as ‘an intangible asset that is usually not included on an organization’s balance sheet and which is approximately42 equal in value to the difference between the market capitalization of a company and its tangible (or net asset or book) value.’ This definition is a pragmatic one; there is no generally accepted accounting for intellectual capital. There are many suggestions, proposals and models but no one, generally accepted, consistently auditable standard.
Guideline for Directors: you’re better off concentrating your energies on finding ways of driving up your market capitalization by increasing its intangible relevance than you are philosophizing about how to value intellectual assets on your balance sheet.
Structure of intellectual capital
In de-facto terms, intellectual capital is made up of human, structural and market capital. Simplistically:
• Human capital is made up of the individual competences of the employees in a firm, of its team capabilities and of their knowledge (including their skills, expertise, experience, and contacts), both implicit (or tacit: people’s know-how) and explicit (ie it can be documented, in which case it become a datum, a piece of information, for someone else).
42 ‘Approximately’ is an important part of this definition. There are sometimes circumstances in which the market may under- or over-value a company; that is not unusual.
• Structural capital is made up of the organization’s ‘hard’ intangible assets (patents, copyrights and other intellectual property, software, databases, documents, methodologies), its standards, attitudes and values, objectives (particularly strategic) and processes.
• Market capital is made up of corporate and product branding (including reputation and public perception), supply-chain and partner relationships, especially customer relationships and market momentum.
There is a high-level of interdependence between all these components and it is important to understand that they all fundamentally depend on information, knowledge and information technology. Clearly, given a high intangible relevance percentage, more time, effort and money should be committed to protecting, managing and enhancing the intangible, intellectual assets of the organization than the tangible ones.
The Balanced Scorecard emerged in the late 1990s to provide an ‘integrated set of measurements that link current customer, internal process, employee, and system performance to long-term financial success.’43 It ‘translates mission and strategy into objectives and measures, organized into four different perspectives: financial, customer, internal business process and learning and growth.’ There is clearly a correlation between the three non-financial perspectives and the make-up of intellectual capital.
The make-up of the Balanced Scorecard suggests that three quarters of the board and business’s time and effort should be focused on those aspects of the business that are directly involved with leveraging the organization’s intellectual capital. From a board perspective, intellectual assets should be at the heart of the organization’s competitive strategy.
43 The Balanced Scorecard: Translating Strategy Into Action, Robert S Kaplan and David P Norton, 1996
Guideline for Directors: correlate the specific measures used in your Balanced Scorecard with your most valuable intellectual assets. If your most valuable intellectual assets are not critical to your business strategy, you have a disposal opportunity – or a re-modeling one.
The role of IT governance
The role of IT governance was defined (in chapter one) as ‘ensuring that the organization’s IT supports and enables the achievement of its strategies and objectives.’ IT governance is, in other words, fundamental to leveraging the organization’s intellectual assets; the board is responsible for determining how it will leverage the organization’s intellectual assets and, as part of that process, for determining the role that IT has to play in enabling that strategy.
Guideline for Directors: within your overall business strategy, you need to identify how you deploy your organization’s intellectual assets for competitive advantage, how to increase them, and how to protect them. This is a board responsibility.
While this book doesn’t consider any of the important governance questions around intellectual capital (such as: In what ways do our intellectual assets give us competitive advantage? What is the relationship between our business model, strategy and goals and our intellectual assets? How could we (and should we?) change the ration of tangible to intangible assets on the balance sheet?), it does look (in chapter six) at the keys to a successful translation of business strategy into IT action.
Every organization is an intellectual construct; it is a (usually unique) structure of capital assets (financial, physical, and intellectual) that are deployed to achieve a particular strategic goal. The precise information and communication needs of that structure determine the ICT infrastructure that will be appropriate for the organization. The ICT hardware and software that an organization deploys should, in other words, be decided in the light of its business model, the structural relationship between its physical and intellectual assets, its financial resources and investment return objectives, and its information and communications strategies.
Guideline for Directors: IT can only generate value for the business if the business is clear about what it requires from IT. IT is infrastructure and it may be a commodity; those responsible for its day-to-day management can only deliver something that is valued by the business if the business is clear about what it values. Vision and leadership are at the heart of governance, whether of the corporation or of IT. You can’t abdicate IT leadership to the IT department and expect a great result. Well, you can, but…
The rest of this chapter will look at some of the issues involved in increasing the value of information assets and for protecting them.
Beyond knowledge management
In the late 1990s, knowledge management (KM) was promoted as the big, new thing that would transform organizations. Largely driven by IT and consultancy vendors, KM proved not to be the silver bullet that transformed companies into agile, 21st Century winners. But, in much the same way that BPR turned out to contain some elements of business common sense, so does KM.
KM was promoted as critical to the successful leveraging of intellectual assets. That doesn’t mean it actually is. Without knowing, objectively and clearly, what the purpose of a knowledge management project is, the likelihood is that such a project will not deliver any discernable value; in fact, it is more likely to fuel the view that IT projects are expensive, painful methods of destroying value.
KM is a term that, today, includes a wide range of disciplines and activities: business intelligence, business integration, communication and collaboration, content management, data mining, data warehousing, e-learning, e-mail, enterprise portals, groupware, intranets, instant messaging, process automation, strategic planning (!), virtual workspaces and web boards are all terms that are likely to be found in the KM context.
Guideline for Directors: most of KM offerings are solutions looking for a need; if your business strategy doesn’t need one of them, don’t have it. By all means, ensure that you keep aware of the options that new technologies might give you but, unless you have a clearly articulated business reason – with realistic return on investment objectives - for pursuing one of them, don’t.
Knowledge management is thought of as having two aspects: creating infrastructures that enable knowledge sharing and capturing implicit knowledge and making it explicit. The first objective is achievable, the second makes no sense.
Collaborative technology - in the form of e-mail, groupware, web boards, instant messaging, Voice over IP and related technologies can help facilitate the sharing of knowledge; neither technology nor the IT department, though, can make people use the technology or actually share their knowledge (knowledge, after all, is power and power is rarely shared for long). In other words, deploying a knowledge management programme because it seems a good idea, or allowing it to be developed and deployed by the IT team on its own, are not wise.
Guidelines for Directors:
• If, strategically, you have determined that there is a knowledge management element to a business goal, then you also need to determine how you will measure that element’s contribution and what you are prepared to invest in order to realize the benefits that you’ve identified. A KM project should be subject to the same governance and change management (including internal communication) processes as any other IT-related project.
• Any large scale KM initiative should start small; once a small number of people are enthusiastically sharing knowledge and the business benefits are clearly demonstrable, it will be much easier to get buy-in elsewhere in the organization.
• Under no conditions should you let KM solutions drive your KM strategy; KM vendors are selling ‘solutions’ to problems you may not have and, just like snake oil salesmen, should be treated with caution. Once you have determined your needs, then you can concentrate on finding those KM vendors who are interested in meeting them. Of course, this is a good way to purchase any technology.
• Avoid incentivizing people to take part in the KM project; if the project doesn’t deliver the sort of benefits that have employees taking part willingly, it’s almost certainly a waste of time and will die as soon as the incentives cease.
• KM projects should not be led by anyone from the IT department. KM projects, like all IT-related projects, are business projects; IT has a role to play, but only to facilitate and enable business managers to achieve business goals faster, more simply and more cost-effectively.
• Refuse to countenance any programs that claim to make tacit knowledge explicit. ‘Tacit’ is defined as ‘unspoken; silent, noiseless, wordless.’44 ‘Tacit’ knowledge is more akin to instinct, experience and judgment than to information; once a judgment is extruded (made explicit) it simply becomes more information to which someone else can apply judgment. We’re already suffering from information overload; don’t join those organizations who are adding to this deluge. Concentrate on supporting and training the people who apply judgment to information, and whose ‘wetware’ (the stuff between people’s ears) turns that information into something that has business value.
Protecting intellectual assets
Intellectual assets, like all assets, need protection. You can almost define an asset in terms of whether (and how much) someone else wants it: if no one else wants it, it probably isn’t an asset. If lots of people want it, it’s probably an asset, and a valuable one. There are three categories of intellectual assets: human, structural and market. This book does not include guidance on protecting the human assets.
This is not to say that human assets aren’t probably your most valuable assets, just that they’re beyond the scope of IT governance.
The first step in asset protection is always to identify and value your assets. Sometimes called an Intellectual Property Statement, every organization needs to have a complete list of its intellectual assets – broken down into the three classes of intellectual capital.
A cornerstone of protecting market capital is protecting reputation: brands, relationships, and so on. While IT governance has a role to play here (helping avoid damage to the corporate reputation by ensuring compliance with relevant regulation, particularly around privacy, data protection and corporate governance, securing relevant databases, and ensuring that web activity reflects the letter and spirit of the corporate branding guidelines, including dealing with any issues around URL/domain name management and cyber-squatting), it is a small role. Poor service delivery, inadequate product quality, poor staffing decisions, and ethical failings: these all have the capacity to do the market capital of an organization much more damage.
IT governance does however have an important role to play in protecting the key structural intellectual assets, the assets that can be given a defined, legal form: patents, copyrights and other intellectual property, software, databases, documents, and methodologies. ‘Intellectual property’ (or ‘IP’) is the catch-all term usually given to these structural intellectual assets, and the four important legal components of IP are copyright, designs, patents and trademarks. The brief description below of each asset type should not deter you from taking appropriate legal advice from an IP professional; the law is complex and it is not an area in which you should take any risks.
Guideline for Directors: All ‘hard’ intellectual assets now have an electronic or IT aspect that should be protected and/or exploited; you should ensure that this perspective is in your IP strategy from the outset. This is particularly important if you are trading in markets (and, if you are trading on the Internet, you have de facto exposures in every geographic market place irrespective of whether or not you are trading in them) in which the standard of IP protection is lower than in the West.
Copyright
Copyright is an ‘unregistered right’; copyright comes into existence the moment that something is created and ‘fixed’ in a format and on a medium that demonstrates its existence: paper, music, software, etc. Copyright does not protect ideas; it only protects specific expressions of those ideas. While some patent offices recommend that any such material should be marked with the copyright symbol (©) to warn against copying it, this is not absolutely legally necessary.
Design
A registered design (the ‘outward shape and appearance of a product’) is a 25 year ‘monopoly right for the appearance of the whole or a part of a product resulting from the features of, in particular, the lines, contours, colors, shape, texture, or materials of the product or its ornamentation.’45 A design, to qualify for registration, must be both new and have ‘individual character.’ Registering a design provides its owner with the exclusive right to make, use or trade any product to which the design has been applied, and also gives the owner the right to take legal action against anyone who might be infringing the design.
Patent
Patents cover products or processes that possess or contain new functional or technical aspects. Patents are therefore concerned with how things work, what they do, how they do it, what they are made of or how they are made. The vast majority of patents are for incremental improvements in known technology.
A patent for an invention is granted by a government to an inventor, giving the inventor the right for a limited period to stop others from making, using or selling the invention without the inventor’s
permission. When a patent is granted, the invention becomes formally identified as the property of the inventor, which - like any other form of property or business asset - can be bought, sold, rented or hired. Patents are territorial rights; UK Patent will only give the holder rights within the United Kingdom and rights to stop others from importing the patented products into the United Kingdom.
About 125 countries are signatories to the Patent Cooperation Treaty (PCT). Under the PCT one can file a single international patent application with a PCT Receiving Office in one language and in accordance with one set of rules to seek simultaneous patent protection in a number of PCT contracting states. The United Kingdom and most other Western European countries are also parties to the European Patent Convention (EPC). A patent application filed under this convention will be, if granted, effective in each country listed on the application.
When granted, the European patent provides protection in the same way as a number of separate national patents, becoming subject to the national law of each country. One can therefore obtain a patent valid in the United Kingdom by filing a European application and making the United Kingdom a designated country
Trademark
A trademark is, in effect, a badge; any distinctive sign that a trader uses to distinguish goods or services from those of competitors could be a trademark. A trademark can be registered and, therefore, protected if it is distinctive (for the goods or services to which it is applied), and is neither deceptive nor illegal/immoral. Trademark protection is primarily on a national level, although it is possible to register a trademark in Europe or through an international Protocol administered by the World Intellectual Property Association (www.wipo.org) in Geneva. Domain names are not trademarks and have to be dealt with separately. They are, though, just as important.
Copyright Designs and Patents Act 1988 (‘CDPA’)
All countries have a patents office and that is where anyone exploring the subject should start. In the UK, the Internet starting point for organizations that want detailed advice on intellectual property is www.intellectual-property.gov.uk . The principal legislation on copyright can be found in the Copyright Designs and Patents Act 1988. It has been amended a number of times and there is no official consolidation of it. A list of the most important pieces of legislation that have amended the 1988 Act and some other information about the legislation can be obtained from the UK Patent Office (www.patent.gov.uk). This is a complex and difficult area for any organization that deals in intellectual property and appropriate professional advice should be taken from a firm that specializes in this area.
Third party intellectual property rights (IPR)
Organizations deal with all sorts of third party material, some of which may contain IPR, in the form of copyright, design rights, or trademarks. Copyright infringement can lead to legal action, even involving criminal proceedings, if there has been a clear breach of IPR-protection legislation. Organizations should, therefore, adopt appropriate controls to avoid this happening.
Software copyright
A most important issue in dealing with copyright is for the organization to ensure that it is not infringing the copyright of the suppliers of the software that it is using. Different software packages are licenced on different bases and the organization needs to be clear how each of its software packages is licensed and that it has paid for the correct number of licences.
Guideline for Directors: organizations need to maintain an up to date register of software licences, which lists all the licences that they own, as well as the purchase dates and, where appropriate, the disposal dates. Only licensed and formally approved software should be allowed on the organization’s computers and the use of illegally obtained or unlicensed software should lead to disciplinary action.
The Federation against Software Theft (‘FAST’) was set up in 1984 by the British Computer Society’s Copyright Committee. It was the first software copyright organization. It offers organizations advice, assistance and training on compliance with software law; it also offers an audit certificate that recognizes that the organization concerned is properly managing its software.
‘Software is covered by the laws of copyright and using software outside the terms of its licence can constitute either a civil and/or a criminal breach of copyright law. Many people are surprised to find that they can still be found guilty of copyright infringement even if they did not copy or distribute software for the purpose of direct commercial gain. Officers of a company are responsible for ensuring that their organization complies with the law. Ignorance is no defence. Even if a manager is totally unaware that software theft is occurring within his or her organization, that does not absolve the company from legal proceedings. In the recent past, those sued by software publishers have been forced to pay all the legal fees that have been incurred; pay damages to the copyright holder; remove all their illegal software and buy new, legal copies.’46
Anyone in the UK who decides to ‘blow the whistle’ on his/her employer for software infringement will (according to FAST) be protected:
‘The Public Interest Disclosure Act (the ‘Whistle Blowers Act’) includes three basic requirements:
• The employee believes that their employer is committing a criminal offence or breach of civil law. Under-licensing falls within both these categories. The illegal use of software in a business, or a manager turning a blind eye to misuse, are both criminal offences. Software infringement such as buying one copy and using many is a civil infringement.
• The employee must believe that the disclosure is ‘substantially’ true, act in good faith and not make any personal gain. The Act has regard to the identity of the person to whom the disclosure is made. A complaint to FAST would be reasonable, whereas
employees seeking a fee from a newspaper may not be on such safe ground.
• Was it reasonable in all the circumstances? For instance, could the employee have brought the matter to the attention of the company first without suffering detriment?’47
The implications of this should be clear for all organizations that are not already committed to complying with the existing software legislation.
Guideline for Directors: put systems in place to ensure that your organization complies with relevant anti-copyright legislation. There is a very real risk that non-compliance will be exposed to FAST or a similar organization, perhaps by a disgruntled current or former employee or competitor, with damaging consequences.
There are similar private organizations, which are funded by the major software manufacturers to combat illegal use of software. They target organizations which they think may be using illegal software (which includes having more users of an off-the-shelf package than there are licences). There is no legal requirement to comply with their demands and it is appropriate to take legal advice before responding to any demands that are made.
Conclusion
Intellectual capital is at the heart of the modern organization. It represents a substantial part of its market value but usually does not appear on its balance sheet. Methods of valuing and accounting for intellectual capital are emergent but nothing is established. Successful organizations have been exploiting their intellectual assets for a long time; all boards need to ensure that their business strategies include both the exploitation and protection of these assets.
The protection and exploitation of these assets depends, in large part, on the organization’s ICT infrastructure. That infrastructure has to be appropriate to the organization’s intellectual model and the
board is fundamentally responsible for clarifying and articulating that model in a way that enables them to provide leadership to the IT department. Deployment of ICT solutions should be driven entirely by the desire to solve problems set by the business – not problems unearthed by the vendors.