Markets in Intangibles: Patent Licensing

The absence of organized trading in intangibles has been a major hindrance to their recognition as assets in financial reports. Economic circumstances, however, change fast and markets in intangibles, particularly in patents and know-how, are operating both off and on-line (Internet). We examine the most active of these markets-the licensing of patents and know-how-which has grown exponentially in recent years, focusing on information-relevance and valuation issues. Our findings indicate that: (a) a significant nonuniformity exists in the reporting of royalty income across firms, (b) royalty income is highly relevant to investors, (c) in addition to being an important source of income, the intensity of patent royalties provides investors with a strong signal concerning the potential of R&D expenditures, and (d) there are systematic positive risk-adjusted future returns to licensing-intensive companies, consistent with either a systematic undervaluation of these companies' shares, or a yet unknown risk-factor associated with patent licensing. The implications of these findings for managers, investors and particularly accounting standard-setters are discussed in the concluding section. The common wisdom is that intangibles are not traded in active markets and hence they cannot be reliably valued and recognized as assets in financial statements. Thus, writes Zvi Griliches, the pioneer R&D researcher (1995, p.77): A piece of equipment is sold and can be resold at a market price. The results of research and development investments are by and large not sold directly… the lack of direct measures of research and development output introduces an inescapable layer of inexactitude and randomness into our formulation. Walter Schuetze, a former SEC Chief Accountant and FASB member, opposes the asset recognition of most innovation-related intangibles because of their non-exchangeability or non-tradability (1993, p. 68): It is the same line of reasoning, that a cost can be an asset, that leads some people to suggest that the FASB should reconsider FASB statement No. 2 and allow for recognition of research and development costs as an asset. Note that in none of the cases is the asset [proposed to be] represented on the balance sheet exchangeable. To be sure, the absence of markets, denying intangibles' owners liquidity and investors comparable valuations weakens the case for recognition of these assets in financial statements. 1 Recent developments, however, call for a reconsideration of the intangibles' marketability issue. A growing number of Internet-based exchanges in technology and know-how have been recently established, providing markets in patents, processes and even non-patented …