Download Diversifying the Alberta Economy Capitalizing

Diversifying the Alberta Economy
1st of 3 white papers
Capitalizing Intangible Assets
Contact :the authors
Robert McGarvey
[email protected]
780.433.5086
Joe Batty
[email protected]
604-824-5713
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Executive Summary
Alberta’s economy is facing its most trying circumstances since the 1930s. With oil prices collapsing, major
projects delayed or cancelled and capital disappearing from major sectors of the economy, there is a
compelling urgency to find ways to diversify the Alberta economy and, in the process, reduce our overdependency on the volatile oil and gas industry.
Of course, governments have been promising Albertans a more diversified economy for decades. We believe
past diversification attempts have failed because governments have either been too deeply involved in
diversification (picking winners, owning businesses outright) or too distant (simply leaving diversification to the
‘market’). Both of these strategies have failed to achieve any significant progress.
We believe the heart of the problem is structural and that diversification of the Alberta economy needs to begin
with fundamental reforms:
1. Adapt to the new economy: The economy has changed in the past 50 years, while Alberta’s banks and
other financial institutions have not. Many of Alberta’s most exciting growth opportunities are
technology-based; that is, they are underpinned by patented inventions, copyright software and
services. However, Alberta’s financial infrastructure has not adapted to these new assets, undermining
the free flow of capital. As a result, various sectors of the Alberta economy, including the technology
sector, are undercapitalized and therefore underperforming in the market.
[This paper outlines the growing importance of intangible assets and presents a methodology to help technology
companies overcome this deficiency.]
2. Reform Alberta’s capital markets: Capital markets are out of sync with the new economic reality.
Unfortunately, there is an overwhelming bias in Alberta’s capital markets, funneling investment toward
unproductive stock market speculation. Approximately $2 billion a month in managed investments
(RRSPs, TSFAs, pension and mutual funds) leaves Alberta to be invested on Bay or Wall streets. Capital
market reforms could redirect some part of this capital to local businesses, allowing Albertans to make
direct investments in investment ready opportunities that help diversify the Alberta economy.
[Our second white paper will investigate ways to reform capital markets to encourage more direct investment in
Alberta.]
3. Managing change: Diversifying Alberta’s economy means doing things differently, capitalizing
intangible assets and opening new sources of capital for Alberta businesses. But these new approaches
also need to be augmented by informed leadership and competent management. The third white paper
in our series outlines some of the most common management challenges in technology companies and
other SMEs (small to medium sized businesses) and addresses the means of preparing them for
investment. The key objectives of management in this role are to prepare the opportunities for
commercial success, in other words, get them market ready and investment ready, properly structured
to receive an investment and to deliver a return on investment.
[Our third white paper will outline a pathway for launching new and exciting businesses in Alberta, creating entire
new industries and diversifying the economy.]
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The Alberta Economy is Changing
Like many other western developed economies, Alberta’s is being buffeted by deep trends in global capitalism.
In the last few decades, the global economy has been radically transformed by the meteoric rise of China (and
other emerging economies) abroad and an almost invisible asset revolution at home.
The scale of the changes is written in the numbers. Since the late 1950s, in the U.S. and other western
economies, intangibles (services and intellectual forms of property, such as patents, copyright materials,
software and network applications) have increased in economic importance. Today, intangibles have displaced
the more familiar tangible
assets as the primary
engine of growth in all
developed economies.
Studies conducted by the
World Bank suggest that
these new sources of value
now contribute more than
three-quarters of GDP.
While this newer intangible
economy is growing,
industrial-type
manufacturing is in
decline. Consider that
between 1995 and 2002
developed economies in
the West lost 22 million
industrial jobs. In the last
decade, the United States
economy alone lost close
to 25 per cent (four million)
of its domestic manufacturing jobs. Yet, despite the shrinking of their industrial work forces, the output in these
countries as a measure of GDP increased by half.
Investment in Research and Development is Growing
As a consequence of these underlying
trends, technology (research and
development) is playing an increasingly
important part of Alberta’s economic
future. Gross domestic expenditures on
research and development (GERD) in
Alberta amounted to $3.6 billion in 2013
and will top $4.0 billion in the near future.
Industry in Alberta invested the lion’s
share ($2.05 billion) of Alberta’s R&D
spending. Suncor, for instance, invested
$1.2 billion in a dry tailings technology
that is expected to reduce the
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environmental impact of oils sands development. Other operators, including Shell, Syncrude and Canadian
Natural Resources, are financing university R&D or conducting in-house research developing new methods of
heavy oil and/or bitumen extraction. These new technologies will reduce their costs dramatically and eliminate
unsightly environmental problems that have plagued the industry.
In 2013, federal and provincial governments also invested heavily in R&D; together they contributed $829
million in grants, mostly to universities in Alberta conducting primary research. The result, in areas of
excellence like bio-refining, (space age) materials, nanotechnology, clean tech, biotechnology and health care,
is very impressive. World-class innovation is being generated in Alberta and has been for decades.
A significant proportion of this innovation eventually finds its way into small to medium sized enterprises
(SMEs) that attempt to commercialize this innovation.
The Starvation Zone
Regrettably R&D development, as valuable as it is, will not diversify Alberta’s economy. Alberta’s innovation is
stymied because Alberta’s innovators are unable to gain access to the capital and other (human capital and
institutional) resources they need to realize their potential.
While there are plenty of resources (grants, facilities, related expertise) available for conducting the primary
R&D through university and related funding channels, once a technology is out in the market the support and
financing options diminish significantly. The problem is, very few of the thousands of technology rich startups
that exist today are able to escape the Starvation Zone and become successful commercial businesses in
Alberta.
What is the Starvation Zone? It is the financial black hole that technology meets when it emerges from the
laboratory. Banks, for example, are NOT equipped to finance (pre-revenue) start-up ventures and don't (or
won't) recognize the collateral value of intangible assets. As a result, low-cost bank financing channels are
closed to these companies, limiting their growth potential.
Venture capital or VC (SME’s alternative financing option) is expensive and very scarce in Alberta; regrettably,
VC business models can address only a small fraction of the market and are specifically designed for rapid ROI
(return on investment). As a result of these limitations, even when they invest VCs are not designed to help
technology companies achieve their full potential.
VCs finance only those companies with very high return potential. Despite choosing only a handful of winners,
the VC success ratio is very low; only one success in six or seven ventures. VCs are further limited in the capital
sums they can invest; it’s very seldom enough to realize the full global potential of the venture.
Regrettably, as a result, a technology success in Alberta most often involves the sale of a world-class
technology to a U.S., Chinese or South Korean venture firm at pennies in the dollar. This represents a direct loss
of opportunity for Alberta-based innovators and a missed opportunity for economic diversification.
So, what do we do to solve this problem?
Identify and Capitalize Intangible Assets
The first step in overcoming this problem involves adapting to the new economic reality. Governments,
corporate leaders, bankers and other financiers have much to gain by recognizing and capitalizing new classes
of intangible assets derived from intellectual property.
What is intellectual property?
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Intellectual property is knowledge, specialized skills and other (often digital) value drivers in trademarks,
patents, copyrighted materials, contracts and/or communities-of-practice (another name for commercial
networks). Unlike the more traditional assets, such as land, industrial equipment or inventory, intellectual forms
of property are not physical, manufactured items. Therefore, to quantify them as assets a process needs to be
undertaken. [Informal protocols are emerging in the handling of intangibles. As they mature they’ll evolve into
formal, recognized processes.]
For example, if University of Alberta researchers develop a new approach to solving the oil sands tailings
problem or develops a new cancer drug, they’ll take the underlying innovation and then document it, codifying
it formally. If the innovation is text-based or computer code, then it’s automatically protected by copyright; if it
is new technology, then the inventors will attempt to have the innovation patented (generally) or protected as a
trade secret. After this process is completed, the individuals or corporations involved will have acquired an ownable form of intellectual property.
If that intellectual property (IP) has (monetary) commercial value, the researchers will have something more
than IP; they will have ownership of Intellectual Capital (IC). If this IC is then transferred into a startup
(technology) company, and if the IC is handled appropriately from an accounting perspective, it can become
that most coveted form of property, an Intellectual Asset (IA).
Why Assets Matter
Assets matter in business for two critical reasons. One, an asset is something an individual or business owns and
from which they can expect future economic benefit. They are the fuel that drives productivity and cash flow.
Two, assets are a form of captured value. If they’re handled and accounted for properly, then they can be
valued and used for collateralizing a bank loan or as security for an equity investment.
A collateral grade asset provides financiers, bankers, investors or joint venture partners with a kind of
insurance. For instance, if a bank lends money for a mortgage then the loan is secured against the asset value of
the house. Why is this important? Because in the case of default the asset (house) can be repossessed by the
bank and sold to another buyer, helping the bank recover its loan principal. This insurance takes significant risk
out of investment decision-making, allowing the free flow of capital into (in this case) the housing sector.
Consider that it’s often easier to get a $30,000 car loan than to get a business loan. Why is this the case? An
individual can get financing approval to buy a new car these days by securing the auto loan against the asset
value of the car. If the purchaser can’t make his or her monthly car payments, then the finance company can
recover its costs by repossessing the asset.
Traditionally, bankable collateral grade assets have been what economists call capital grade; that is they are
tangible. They’re (generally) physical manufactured items that have a long accounting and business history.
Today, however, the asset foundations of our economy are becoming more intangible. Major accounting
standards boards are redefining what an asset is and are offering new guidelines on how to account for
intangibles.
The International Accounting Standards Board (IASB) defines an asset broadly: an asset is a resource that is
controlled by the enterprise as a result of past events (for example, purchase or self-creation) and from which future
economic benefits (inflows of cash or other assets) are expected.
The board defines an intangible asset (IAS 38) as: An identifiable non-monetary asset without physical substance.
The IASB goes on to set the parameters of acceptance: Thus, the three critical attributes of an intangible asset
are: [IAS 38.8], the asset must meet the GAAP standard of Identifiability. In addition, the company must
demonstrate its control (power to obtain benefits from the asset) and there must be an expectation of future
economic benefits (such as revenues or reduced costs in future).
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Despite the fact that intangible assets are clearly playing key roles up and down the economy, they remain
difficult to manage, require new skills to identify and are accompanied by a host of unfamiliar risk factors which
complicates the handling of these assets from a corporate prospective. More importantly, because of Canadian
tax law and traditional accounting practices, most intangibles are written off for tax purposes and therefore do
not appear on the company’s balance sheet.
Despite these procedural difficulties, the secret to diversifying Alberta’s economy lies in redirecting capital to
under-performing sectors of our economy. Accomplishing this means recognizing that the economy has
changed and adapting our business practices, accounting standards and banking protocols to identify and
capitalize these new forms of value as quickly and as accurately as we can.
Strengthening your Technology Balance Sheet
The first step in creating a more successful technology sector, for example, is to identify and capitalize the
billions of dollars of (presently invisible) intangible assets in Alberta companies. Doing so would formally
quantify the value of a technology company’s assets, strengthening their balance sheets and make them more
attractive to banks and other debt and equity financiers.
The Government of Alberta could materially improve the success rates of technology SMEs by supporting
educational programs to inform corporate managers and other related professionals of the importance of
intangibles and work with the Government of Canada to remove various impediments to the capitalization of
intangible assets.
Stronger balance sheets are NOT an end in themselves, but need to form part of a coordinated effort to
increase the flow of capital to this vital sector of the economy.
The Importance of Stronger Balance Sheets
Technology commercialization represents a critical element in any Alberta diversification strategy. Like all
sectors in our economy, technology needs its own nutrient-rich commercial biosphere. This protective
environment wants, first of all, the raw material of innovation but it also needs access to vital nutrients
including expertise in commercialization, production, global marketing, sales and finance in order to create the
conditions for life.
Clearly, we have many of the ingredients for this biosphere already. Alberta is rich in innovation and has
expertise of all sorts, including business development specialists, technology incubators and related support
services. What it lacks is access to finance.
Formal treatment of the (presently invisible) intangible assets on technology balance sheets would strengthen
many company’s financial metrics; perhaps help quantify leverage-able collateral.
This additional asset strength can be translated into financial strength by reducing debt-to-asset ratios,
providing new internally generated collateral, increasing leverage opportunities with banks, bond markets and
other debt and equity financiers.
While IP capitalization is not sufficient in and of itself, it is a necessary first step in ‘oxygenating’ the technology
biosphere. Doing so in tandem with capital market reforms (subject of our next white paper) would help
achieve the goal of diversifying Alberta’s economy.
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Case study
Capitalizing IP: San Jose, California
A few years ago, Joe and I experienced, first hand, the impact of non-traditional assets on SMEs ability to
finance their growth.
One of our clients was an Access Security systems manufacturer, headquartered near San Francisco. There are
giant global companies that dominate the market for office security systems; our client wasn’t one of those. It
was a smallish technology player selling into the western U.S. market. It produced relatively cost-effective
security solutions and relied strongly on its close personal relationships to market and sell its products.
Here is the chronology of events:
 The company was a 9-year-old company that had developed a cost-effective line of Access Control
security systems and other technology related corporate security applications.
 Their original product line had a competitive cost advantage. The company had reached (annual) gross
sales of approximately US$14 million.
 At the time of our engagement, the company was in the final stages of developing a new suite of
security systems and products to take the company to the next level.
 Presuming the company could finance its product development and had the marketing resources it
needed, it expected to be able to double the sales within two years and would make these new sales
more profitable.
 The company estimated it needed an additional investment of $3 million to initiate the new
manufacturing plan and the more aggressive marketing strategy.
After an initial assessment by the strategists, Beckett Advisors decided to call in (intangible accounting
specialist) Joe Batty to see if the company had alternatives to an equity investment. And, sure enough, Joe was
able to assist. The initial accounting assessment:

The company gross sales had grown steadily over the nine-year period from less than $500,000 in Year
1 to slightly more that $14 million in Year 9.
 According to the books, the company had shown losses in years 1 through 8 and showed a profit in Year
9 of approximately $200,000.
 Accumulated deficits for the nine years were more than $5 million.
 The company had limited assets and limited liabilities.
After Joe interviewed the company management, he discovered they had been steadily reinvesting every extra
dollar that was available into R&D, a continuous stream of redesigned and new products.
He asked the simple question, “Do you know what your assets are?
They answered: “Certainly, it is our line of products.”
He then asked: “Why don’t your financial statements show these assets?”
We recommended that they treat their product line as assets, re-examine their procedures for engineering,
manufacturing, and then capitalize the costs associated with the development of these assets.
After about a week of analysis with their engineering staff, their accounting staff and the external accountant,
Batty recommended a series of policies that would lead to a change in the company’s approach to accounting.
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The external accountant agreed to allow the company to restate its last five years of financial statements and
show the product line as intangible assets on these statements. This change was dramatic:


Stronger Balance Sheet: The company’s IP added $4.5 million worth of assets on the balance sheet.
Improved Income Statement: Financial statements showed strong and growing profits for the last 5
years.
 Recent Performance: Year 8 showed a profit of approximately $1 million and Year 9 showed a profit of
more than $1.5 million.
 The accumulated debt was almost written off.
The Result: the same bank manager who refused the company’s initial loan application based on its weak
balance sheet approved a $3-million line of credit based on the revised financial statements.
About the authors
Robert McGarvey: Robert is a consultant economist, geologist and co-founder of the
Genuine Wealth Institute of Edmonton. Over the course of his career, he has held a
variety of senior management positions. Robert began his career as a petroleum
geologist in the oil industry in Calgary, Canada, and went on to become the Managing
Director of Merlin Consulting, a London, U.K.-based consulting firm. Since returning
from the United Kingdom, McGarvey has been the President of Negawatt
International Inc., a Canadian electronics group and Head of Strategy for Beckett
Advisors, a consulting group based in Los Angeles, California.
Robert is a columnist with Troy Media and has been an Executive Committee Member
of the U.K.-based Economic Research Council (ERC) since 1991 (www.ercouncil.org).
Founded in 1943 in London, the ERC investigates economic and political change and
studies their impact on global business.
Joe Batty: Joe is an accountant and associate member of the Genuine Wealth Institute
with a specialty in new asset management. He has a long history in financial management
and is a leading authority on structuring and financing knowledge rich companies.
Joe has held many corporate directorships and senior management positions, including a
three-year tenure as CEO of a Canadian electronics group. During his tenure as VP of
Finance at NAIT (Northern Alberta Institute of Technology), Joe's interest and
involvement in new products and technologies led to his spearheading a technology
transfer liaison program between NAIT professional staff and industry. Two decades
later, the Liaison Program remains a vital source of innovation for Canadian companies.
With more than 40 years of experience in finance and accounting, Joe demonstrates a
proven track record of helping business – large and small – set up financial systems in support of their strategic
goals and objectives. The work Joe has done over the years has made him an authority on the identification,
evaluation, valuation and (where appropriate) capitalization of “Intangible Assets”. His specialty is unique. Every
financial manager today needs to know and understand these principles: The success of their businesses
depends on it.