This extract is the concluding portion of the article The hidden roots of value carried last week.
The roots of value
Perhaps the best way to appreciate the role of Intellectual Capital is metaphorical. If we picture a company as a living organism say a tree, then what is described in organisation charts, annual reports, quarterly statements, company brochures, and other documents is the trunk, branches and leaves. The smart investor scrutinises this tree in search of ripe fruit to harvest.
But to assume that this is the entire tree because it represents everything immediately visible is obviously a mistake. Half the mass or more of that tree is underground in the root system. And wh-ereas the flavour of the fruit and the colour of the leaves provides evidence of how healthy that tree is right now, understanding what is going on in the roots is a far more effective way to learn how healthy that tree will be in the years to come. The rot or parasite just now appearing thirty feet underground may well kill that tree that today looks in the prime of health.
That is what makes Intellectual Capital -- the study of the roots of a company's value, the measurement of the hidden dynamic factors that underlie the visible company of buildings and products -- so valuable.
What are these factors? According to research conducted by the Swedish insurance and financial services company Skandia, these factors typicaly take two forms:
1. Human capital: The combined knowledge, skill, innovativeness, and ability of the company's individual employees to meet the task at hand. It also includes the company's values, culture, and philosophy. Human capital cannot be owned by the company.
2. Structural capital: The hardware, software, databases, organizational structure, patents, trademarks and everything else of organisational capability that supports those employees's productivity -- in a word, everything left at the office when the employees go home. Structural capital also includes customer capital, the relationships developed with key customers. Unlike human capital, structural capital can be owned and thereby traded.
It is easy to see why Intellecutal Capital does not fit within traditional accounting models. In particular, Intellectual Capital values activities, such as customer loyalty or employee competence building, that may not impact the bottom line of a company for years. And it devalues near-term success that does not position the company for the future.
Intellectual Capital may be a new theory, but in practise it has been around for years as a form of common sense. It has always lurked in that multiple between a company's market value and its book value. But until recently, it was assumed that this difference was entirely a subjective fa-ctor, driven by gossip, insider information about upcoming poroducts, and a gut feeling about a company's prospects, that co-uld never be empirically measured. Mor-eover, it was also assumed that any such gap was a temporary aberration, a nonempirical added value that would, in due time, manifest itself in some form -- increased revenues, reduced overhead, improved productivity or market share -- that could be measured by traditional means.
But recent business history has shown neither to be true. The core of the so-cal-led knowledge economy is huge investme-nt flows into human capital as well as information technology. And, stunningly, neither of these appear as positive values in traditional accounting. Rather, it is often just the opposite. Yet, these investments are the key tools of the new value creation.
Somehow, if only by hunches and intuitions, the market is putting a value on invisible assets. And some of these qualitative assets seem to hover in the ether almost indefinitely, converting to line items on the balance sheet years after the market has accounted for them.
The recognition of this new business reality is forcing a new balance to emerge, in which the past is balanced by the future and the financial by the nonfinancial -- Intellectual Capital.
The case for establishing a new way to measure institutional value is powerful. If Intellectual Capital represents the buried root mass of the visible tree, or, to use an-other familiar image, the giant iceberg hi-dden beneath the tiny islet above the surface if it indeed accounts for two th-irds or more of the real worth of compan-ies, then we are faced not just with an inequity in the investment community but a true crisis that extends across the economy.
Given the frenzied pace of technological change and the almost instantaneous speed of modern telecommunications, we are flying blindly in a hurricane depending on instruments that measure the wrong things. (Some of the latest theories about Intellectual Capital even suggest that it is related to chaos theory or to complex adaptive -- that is, living -- systems).
Obviously this imbalance cannot continue. The sheer wastefulness of resources flowing to the wrong places at the wrong time is dangerous enough. But an even greater risk is that the same indicators that fail to show the economy surging upward are also likely to miss when those underlying forces start trending down. We are in enormous danger of losing our direction and flying straight into the ground without even knowing we are heading toward disaster. This alone should chill the soul of every investor, manager, or politician... and it should be more than incentive to search for effective ways to measure and nurture Intellectual Capital.
Not that this search will be easy. By its very definition, subjective information cannot be strictly codified. And this fuzziness courts abuse. Says Herwick, "Whenever money is involved, people will abuse the process." In particular, he doubts any company will make projections about future intangibles unless they are legally "held harmless and blameless." But that itself may open the door to wild and patently false predictions.
So, says Herwick, in an attempt to protect the individual investor, we may ironically create a system that allows for greater abuse.
He isn't alone. Davidow, too, fears the scenario of a company president standing up to announce that 'the company factory has burned down, we've lost all of our significant customers, but thanks to an as-yet unproven scientific breakthrough, we are today announcing major profits. Ken Hagerty, who, as director of the Coalition for American Equity Expansion, led the US electronics industry in its battle against government plans for a values based stock option accounting plan, is equally concerned. "How can you put a value on risk taking?" he asks. It sounds like the same approach all over again, operating from the same flawed judgement base -- and it could lead to the same outcry.
These concerns, coming from industry veterans, cannot be ignored. But neither should they stop the movement toward identifying and measuring Intellectual Capital. The need is simply too great, and the current lack of consensus too costly, to turn back. Certainly the current accounting system has hardly had an uncheckered history. Rather, it has reached an acceptable balance between the thousands of companies that use the system properly and the handful that take advantage of its soft spots -- a balance made more acceptable because of the punitive enforcement powers of the SEC. The same, we believe, can be done with Intellectual Capital reporting. The most obvious potential abuses can be checked from the start, the more subtle ones countered by a growing body of statutes and case law.
It is comforting that one individual who believes Intellectual Capital disclosure can and must be done is Steven M H Wallman, one of the two current commissioners of the Securities and Exchange Commission. What seems clear to me is that (an accounting entry of ) zero is the wrong answer, he says. So the question is: how do you appropriately report Intellectual Capital?
Wallman admits to sharing the others fears.Not only, he says, is there the danger of fraud surronding the measurement of Intellecutual Capital, but perhaps even worse, the risk that honest companies will produce these numbers in good faith, then be sued for misrepresentation when the predictions don't pan out.
At the same time, Wallman says, "Disclosure is good for everybody because it reduces risk - and that makes the cost of capital lower for companies, lowers the returns demanded by investors, and in turn benefits everyone else from employers to supliers." Even accounting firms, he adds, might find the new reporting systems represent an opportunity to market more of their services. "If we can just come up with the right balance, says Wallman, every- body wins.
Pioneering efforts
In July 1994, a pioneering group from industry, academia, and policy research met in Mill Valley near San Francisco to strart the search for this right balance. The gathering began with simple questions:
Does the existing management language value knowledge as an essential resource for creating value and wealth? What are the meaningful predictors of a company's future prosperity? How shall we value and measure Intellectual Capital?
At the heart of this group's work was the belief that most, if not all, of a company's Intellectual Capital could be visualised in some way. In particular, the right empirical indicators could be identified and measured, and the right presentational format found, such that Intellectual Capital could be put on the same strong, objective, and comparative base as financial capital.
The work of this group obviously struck a vast and hidden reservoir of need. By October 1994, Fortune magazine carried a cover story on the subject, entitled, Your Company's Most Valuable Asset: Intellectual Capital, that served as a wake up call to enterprises everywhere that the age of Intelectual Capital had begun.
Tom Stewart, author of the article, observed the emerging Intellectual Capital research efforts and came to his own conclusions:
Two quick points. First, knowledge may be intangible, but that doesn't mean it can't be measured. Markets do it. Wall Street prices high-tech stocks at a higher premium to book value that it does stock in industries whose technology is mature. It also reacts, generally with high prices, to announcements of increased R&D spending. Labour markets price knowledge too - for most people, income correlates better with IQ than with the ability to do push ups.
Second, this isn't just an exercise. The guardians of accounting standards are correct to worry about putting unproven and idiosyncratic data into corporate reports. But the data are vital.
The real breakthrough in Intellectual Capital research came in May 1995 when Skandia, the largest insurance and financial services company in Scandinavia, after several years of internal pioneering work, released the world's first public Intellectual Capital annual report, as a supplement to the financial report.
Skandia had been investigating Intellec-tual Capital for four years under the leadership of this book's coauthor, Leif Edvinsson. Edvin-sson, with the world's first title of corporate director of Intellectual Capital was also organiser of that pioneering group that had met in Mill Valley. Beginning in 1991, Edvinsson had set out with a team of accounting and finance specialists to develop for Skandia's fast growing assurance and financial services unit, Skandia AFS, the first ever organisational struture - a new accounting taxonomy they called it - for presenting human capital, stuctural capital, and the other components of Intellectual Capital.
At the heart of the Skandia IC model was the idea that the true value of company's performance lies in its ability to create sustainable value by pursuing a business vision and its resulting strategy. From this strategy one could determine certain success factors that must be maximised. These success factors could in turn be grouped into four distinct areas of focus :
* Financial
* Customer
* Process
* Renewal and development as well as one commonly shared fifth area:
* Human
Finally, within each of these five areas of focus, one could identify numerous key indicators to measure performance.
Combined, these five factors created a new holistic and dynamic reporting model, which Skandia called the Navigator.
In the words of Skandia's then-CEO, Bjorn Wolrath:
Measurement of Intellectual Capital and a balanced reporting represent an important milestone in the shift from the industrial Era into the Knowledge Economy...This broadened, balanced type of accounting and reporting results in a more systematic description of the company's ability and potential to transform Intellectual Capital into financial capital.
The indicators the Navigator tracked ranged from the commonsensical - fund asets, income per employee, marketing expense per customer - to the unexpected - telephone accessibility, days spent visiting customers, information technology literacy, even laptop computers per employee.
The Skandia 1994 IC Annual Report was a landmark in the story of the standardisation of the Intellectual Captial model. But it wasn't the only emerging event. Dow Chemical, for example, created the position of director of intellectual assets, who set out to create an IC report for that company. Hughes Aircraft also set up an Intellectual Capital program called the Knowledge Highway.
The Canadian Imperial Bank of Commerce, North America's seventh largest bank, formed its leadership development program around Intellectual Capital then used those skills to institute a loan programme to finance knowledge based companies using Intellectual Capital valuations as the key criteria. In South Korea, steel giant Posco started its own IC department.
Ernst & Young, the accounting giant, established seminar programmes for its clients about Intellectual Capital entitled "New Values and Measurements for the Knowledge Era" and "The Knowledge Advantage." Arthur Andersen developed a collection of Knowledge Assessment Tools for use by its clients. And at several of the large corporations, patent and trademark managers also turned to Intellectual Capital to refine the value extraction of idle intellectual property.
Clearly a movement had begun. Its first phase culminated in a symposium in April 1996 in Washington, D.C. on Intellectual Capital, sponsored by that arbiter of the old accounting model itself, the Securities and Exchange Commission. At that meeting, Commissioner Wallman predicted that Intellectual Capital, and the Skandia supplement approach in particular, would one day become the heart of the modern corporate annual report - to which today's financial statements would be added as appendices.
He further advised companies to begin experimenting with the disclosure of hidden assets through published supplements.
In just a few years, Intellectual Capital had jumped from an idea to a working concept to the brink of becoming a new corporate disclosure standard. In the words of knowledge - business theorist Charles Savage and entrepreneur Charles Armstrong:
In the short space of about three years, we already see an evolution in thinking, from identifying the components of Intellectual Capital to an understanding of the dynamic interaction between these components.
Clearly Intellectual Capital is an idea whose time has come. Common sense is about to be put into common practice.
Implementing the theories
This book is written to be the core text of Intellectual Capital's second era, that of application and capitalisation.
Application because for the rest of this decade andbeyond hundreds of thousands of companies, large and small, thorugh out the world will adopt Intellectual Capital as a way of measuring, visualising, an representing the true value of their businesses.
They will do so because Intellectual Capital accounting unquely recognises what counts in the modern economy of fastmoving, knowledge intensive virtual corporations.
n Strong and enduring business relationships within networked partnerships.
n The enduring loyalty of customers
n The role of key employees, upon whose knowledge and competencies the company's future rests.
n The commitment of the company and its employees to learn and renew over time.
n And most of all, the character and values of a company, a crucial tool for investors and executives when looking at mergers, acquisitions, alliances personnel hiring, and partnering.
The Skandia Navigator, and the value scheme of IC-components that underlies it, is but the first systematic attempt to uncover these factors and to establish the key indicators for establishing their metrics. There will be others. With trial and error the best of these indicators will emerge as general IC reporting standards...
The rise of Intellectual Capital is inevitable, given the irresistible historical and technological forces, not to mention the investment flows, that are sweeping across the modern world and driving us toward a knowledge economy. Intellect-ual Capital will come to dominate the way we value our institutions because it alone captures the dynamics of organisational sustainability and value creation. It alone recognises that a modern enterprise changes so fast that all it has left to dep-end on is the talents and dedication of its people and the quality, of the tools they use.
But most of all, Intellectual Capital is inevitable because it alone, of any model for measuring corporate peformance, pierces the surface and uncovers true value. In doing so, it restores both common sense and fairness to economics.
...you are hearing the first drumbeats of a radical rethinking of the way businesses and institutions see themselves - and how others see them as well. Step lively now and you will be in the vanguard of this movement, better prepared and more experienced than your competitors. Or wait, until it washes over you and tosses you forward, struggling to keep from being dashed and drowned.
But make no mistake, whetever path you choose, Intellectual Capital is our future.
Excerpted from Intellectual Capital by Leif Edvinsson and Michael S Malone.
(Published by Harper Business, a division of Harper-Collins Publishers).
