Intangible Capital in M&A

I was thrilled to see this new report by the Hay Group The Silver Bullet of Success: Winners and Losers in the M&A Game. The report is about how intangible capital is critical to the success of M&A. Below are the major points of the paper (quotes in italics) with my comments on each one:

Companies underestimate intangible capital : Executives typically value intangible capital – including culture and customer relationships – at just 30 per cent of market capitalization, not the 75 per cent that analysts expect.

This finding has a very strong correlation with actual market data I have previously cited from Ernst & Young which shows that on average, 70% of the average deal is intangible but only 23% is linked to identified intangibles like customer lists and technologies. That leaves 47% as goodwill. To me, this shows that accountants are creating a dangerous information gap because this goodwill represents real value and investment. It is clear that executives are influenced by and trapped in the mental model provided to them by their accountants.

Buyers risk damaging deal value: By underestimating intangible value, they allocate insufficient resources to protecting it during integration. Just 38 per cent of companies conduct cultural due diligence.

If you cannot identify 47% of the value of a company that you are purchasing (and probably have a similar information gap about your own company), it’s no surprise that mistakes will be made.

Other findings include:

• Management of intangible capital influences integration success: Companies that reviewed intangibles during due diligence are more than twice as likely to consider their merger a success compared with those who did not.
• Poor management of intangible capital has major consequences: Executives struggle with cultural integration, leadership changes, understanding the target company’s customers, governance.
• Dealing with intangible capital is considered to be more challenging in cross-border transactions.
• Two thirds of respondents (66 per cent) believe an increased focus on intangible capital would improve merger success.
• Most business leaders (61 per cent) plan to increase their focus on intangibles but need guidance on how to capture data about intangible capital during M&As.

Hay details a list of intangibles that are relevant to M&A. For example, organizational capital is described in terms of shared values, effective governance, agility, channels of information flows and effectiveness of the organization to deliver on the strategy.

These all describe aspects of effective structural capital. But I recommend taking a step back and first identifying the basic components of organizational capital (aka structural capital) which include core processes, databases, captured knowledge, culture and intellectual property.

This approach is an important first step to understanding an organization’s intangible capital. When we assemble a first-level description of IC, we focus on making an inventory of the “assets” that support revenue generation. These include the employee competencies (human capital), the key external relationships (relational capital) and the processes (organizational capital, as they call it-this is what we call structural capital)-that support a company getting paid/creating value for its customers. This is the perspective we used in our video and paper You Can Grow Like Google.

This is a much better place to start because it is more concrete and makes a more direct connection between the financial and the intangible value of a company. It also helps if you want to link intangibles to financials. Because companies invest in building these intangible assets–looking at that investment is an effective and quick way to understand what is going on in that 70% of the operations that is intangible.

That is not to say that the lists provided by Hay are wrong. I would just clarify them as different types of measures of intangibles. Once you have an inventory, then you can decide how to measure intangible asset effectiveness.  The options are financial measures, non-financial indicators and assessments. Most of the items on the Hay lists are assessment criteria which would be great ways to measure the strength, outlook and risk of the intangible assets identified.

They have the bottom line right. If 70% of the average deal is intangible, then it’s past time for analysis of intangibles to be an integral part of every M&A process. Let’s all get to work on this. A great way to start would be through a conversation at the IC Knowledge Center.