Putting a value on innovation: the CFO perspective
The growing importance of innovation requires new ways to value the R&D asset and project portfolio. Novel tools offer the right combination of actual costs, risks, and business case forecasting for the CFO to do this. This leads to improved decision-making about innovation as investment.
CEO’s and CTO’s agree with this view
In a recent global survey of 246 CEOs, PwC found that 97% of CEOs see innovation as a top priority for their business [“Unleashing the power of innovation”, PwC,2013]. Their main challenge is how to maintain growth? In other words, does our the company have the right innovation capabilities? In line with this shift, new management and controlling practices are required that capture the essence of innovation. In this post, we look at the practical valuation implications of this shift.
In 2002, the Paris-based organization EIRMA (European Industrial Research Management Association) started a best practice study looking at R&D Effectiveness amongst its members (here). These make up the organizations that make up represent the majority of the CTO’s of the European industry. This study identified the need to look at R&D expenses as inputs in a value creation process, with the ultimate outcome being new business. The participants in this study concluded that looking at R&D spent, as an investment in future business, trumps the view where R&D is seen as a cost of current business.
Innovation as an investment portfolio
The “innovation as an investment” view, while conceptually appealing, is not without complications. The main management tool to assess an investment is the business case, where the investment is linked to its future financial benefits (such as additional profits, cost savings and hence cash flows). The long time horizons, the typical uncertainties around new business, and the intangible nature of the assets make an innovation’s business case tough to forecast and to manage.
Let us first have a look at the latter: the intangible nature of the assets involved. These include a wide range of organizational routines, brand awareness, knowledge (both tacit and explicit), as well as more specific assets such as computer programs and databases, patents, and other Intellectual Property Rights (IPRs). Like any other, innovation assets can be valued with three different valuation techniques each with their own merits and drawbacks, as listed in this table:
|Cost-based||The asset is valued at the historical costs of acquiring or developing the asset||Based on historical, factual data|
|Price-based||The price of the asset on a market for such assets||Based on economic and accounting principle of fair market value|
|Value-based||The expected future value derived from the asset||Value aligns with importance|
Table “Overview of the typical innovation asset valuation approaches”.
Value, risk, and open innovation
By definition, innovation is about newness, so it contains inherent uncertainties. Technological uncertainty is about whether the idea can really be turned into a working product or service, which may or may not generate value in use: the commercial uncertainty. The right indicators need to be used to assess their value where individual projects have these uncertainties. More importantly, the hedging of risk at the portfolio level is an important executive management responsibility.
One way of reducing risk is widening the search for innovation input and commercialization beyond the company boundaries. This “Open Innovation” approach creates a transparent view of the innovation funnel and adoption implies that value can be more easily assessed for intermediate assets. In open innovation, agreeing on the value of innovation assets such as patents and other IPR is critical to business. The multitude of choices to use individual patents and their bundles offensively (from exclusive exploitation via sales or licensing to cross-licensing and pooling) and defensively (in protecting freedom to operate, increasing entry barriers for competitors, to downright litigation) makes a value-based assessment of the portfolio necessary to compare all decision options.
Accounting standards also require this business case
The financial reporting landscape is also driving the adoption of this concept for R&D valuation. The International Accounting Standard (IAS) covers the accounting rules for innovation assets in IAS 38, which “requires an entity to recognize an intangible asset, whether purchased or self-created (at cost) if, and only if [IAS 38.21] it is probable that the future economic benefits that are attributable to the asset will flow to the entity and the cost of the asset can be measured reliably. This probability of future economic benefits must be based on reasonable and supportable assumptions about conditions that will exist over the life of the asset. [IAS 38.22] The probability recognition criterion is always considered to be satisfied for intangible assets that are acquired separately or in a business combination. [IAS 38.33].
A further key requirement is to expense the research stage related costs, as opposed to the development costs, which are defined to be incurred after proof of technical and commercial feasibility. This is where the accounting rules fully align with the management need for building the business case around each innovation.
A good valuation approach
Summarizing the ingredients of a good R&D valuation approach:
- Allocation of time and costs incurred to individual research and development projects and assets (activity-based costing);
- Having a business case that forecasts the expected value for these resulting intangible assets of each project (over the right future time period);
- Explicit tracking of the technological and commercial risks for each project and across the portfolio;
- Progressive updates of the above data as an input for explicit decisions about the project portfolio.
(This post is a summary of an article by Jac Goorden in the French controlling magazine Finance & Gestion, february 2014).