No you can’t capitalize intangible assets, no you can’t use enterprise valuations, no you can’t, no you can’t, no you can’t!
Until I met Joseph Batty, I had no idea that accountants were like doctors. Like the medical profession, there’s accounting GPs (general practitioners) and brain surgeons. In other words, in the accounting world there are regular accountants, who are basically tax specialists, and a small but growing number of technology specialists schooled in intangibles that actually do what accountants are supposed to do – identify the true assets and liabilities of a company.
According to Batty, not only can you capitalize intangibles according to GAAP (Generally Accepted Accounting Principles), you MUST capitalize them.
Batty does mention, as an aside, that a company is allowed to prepare a set of financial statements for tax purposes, expensing as many costs as are allowable under existing tax law, and then to prepare a separate set of ‘management’ statements which recapitalize these expenses in order to capture the true accounting picture.
But, like the man said, that’s accounting brain surgery.
So, what would be the point of a young technology venture going through all the hassle and expense of doing an intangible asset assessment? Well, for one thing, it could help them escape from Technology Jail.
Let me give you an example. I once consulted to a small tech company that designed and manufactured access control security systems. This company produced relatively low cost security solutions and relied strongly on referrals to market and sell its products.
At the time of my engagement, the company was in the final stages of developing a new ‘premium’ system. The company needed $3 million to launch this new product into the market.
They had been in business a number of years and so – naturally – they went to their bank and asked for a loan. Needless to say they were turned down flat.
After this disappointment, they decided to raise some private finance; for which they we’re prepared to give up 33 per cent of the company’s equity. Our task was to help them raise the money and to prove to a potential investor that $3 million in new money was “worth” 33 per cent of the company.
One look at the company’s books, however, and I could see they were in Technology Jail.
As per usual, their financial statements had been prepared for tax purposes, expensing everything allowable. As a result, although they had decent revenues, they had virtually no assets on the books, no profits and a huge accumulated deficit.
No wonder the bank turned them down!
I knew this wasn’t the whole story, so I called in Batty, who quickly discovered that the company had been steadily re-investing every extra dollar they could get their hand on into R&D and a continuous stream of re-designing for its new products.
Joe reviewed the situation and then assembled the company’s auditors and senior management team. He asked them the simple question, “Do you know what your assets are?
They answered: “Certainly, they’re in our line of products.”
He then asked them: “Why don’t your financial statements show these assets?”
They had no answer.
Batty’s recommended they treat their new product line as an asset. He told them they should re-examine and re-state their financial statements as management statements (while still taking advantage of allowable R&D tax considerations).
After about a week of analysis with their engineering staff, their accounting staff and their external auditors, Batty was able to adopt a series of policies that would change their approach to accounting and capitalize their intangible assets. The results were dramatic:
Batty added $4.5 million worth of assets to their balance sheet, the restated financials showed strong and growing profits for the last five years, and the accumulated deficit was almost written off.
The result? An escape from Technology Jail. The same bank manager who had turned them down a month earlier provided them with a $3 million revolving line of credit to finance their expansion, saving them months of work and a third of the equity in their company.
The sad truth is, this story is typical. Most tech companies and a lot of marginally successful businesses today are undervalued and underperforming because of the toxic combination of income tax laws and inexperienced accountants.
Bottom line is we can and must fix this; Canada’s entrepreneurs cannot compete against fierce global competition playing with one hand tied behind their backs.
Robert McGarvey is an economic historian and former managing director of Merlin Consulting, a London, U.K.-based consulting firm. Robert’s most recent book is Futuromics: A Guide to Thriving in Capitalism’s Third Wave.