This article is written by Nimish Dhagarra, pursuing Diploma in M&A, Institutional Finance and Investment Laws (PE and VC transactions) from LawSikho. The article has been edited by Tanmaya Sharma (Associate, LawSikho) and Smriti Katiyar (Associate, LawSikho).
Table of Contents
Introduction
In the past decade, we have seen the world economy shifting from the physical realm to the digital realm and for the last few years, we have been in a digital overdrive. A new era is unfolding before us where the digital economy is thriving and growing at a fast pace. Since this digital drive, the business has shifted from providing physical goods and services to providing information and digital goods/services. This aspect of business has greatly changed the way we do mergers & acquisitions and has made the procedure of merger & acquisition so flexible and dynamic that it requires a great deal of attention to detail when entering such transactions, at the same time making the procedure smooth and attractive. Businesses all around the world need to understand the importance of intangible assets in their business operation from its ownership to acquisition to its use.
In the present times, a significant part of the value of deals involving mergers & acquisitions is allotted to intangible assets. According to the EY based on annual reports of top 500 listed companies in India by market capitalization from FY 2017 to FY 2020, 31% of the enterprise value of the acquired companies was allocated to ‘identified intangible assets’. [1] Today the success and failure of a company can be determined by how they capitalize their intangible assets, at the same time minimizing the risk associated with them. As businesses now are mostly driven by such assets, it is important for companies to identify-value-protect-use and merges such intangible assets daily, evaluating the future economic benefits that may arise from them. So when a company has an intangible asset, the 5 questions that they need to ask themselves is-
1. What are the intangible assets used in business?
2. What is their value and hence level of risk?
3. Who owns it? Could I sue or can someone sue me?
4. How may it be better exploited?
5. At what level do I need to ensure my intangible assets risk?
What are intangible assets?
According to Indian Accounting Standard Intangible asset is:
“An identifiable non-monetary asset, without physical substance, held for use in the production or supply of goods or services, for rental to others, or for administrative purposes”.
It can include inventions, intellectual property rights, goodwill (brand reputation/brand value/customer loyalty), brand equity, technical know-how, software, data, trade secrets, proprietary technologies, licence etc to name a few. Either a company acquires such assets separately from a third party, develops such assets internally which can be very valuable or acquires them in a business combination. According to Indian Accounting Standards for measuring and recognizing an intangible asset, it should be identified first and control over such assets must be established.
Identification of intangible assets
To identify such assets, it must be distinguished from goodwill as goodwill is a subset of intangible assets, it only arises as a result of business acquisition and represents the difference which the company pays and the fair value in the market. One of the ways to distinguish between intangible assets from goodwill is ‘separability’, that is whether an asset if separated could be sold, rented or exchanged. But this is not a necessary condition as there can be such a situation that does not fulfil such a separability test. Other than this, intangible assets can be determined through contractual or legal rights.
Control of intangible assets
An entity controls an asset if the entity has the power to obtain future economic benefits flowing from the underlying resource and to restrict the access of others to those benefits. The capacity of an entity to control the future economic benefits from an intangible asset would normally stem from legal rights that are enforceable in a court of law. In the absence of legal rights, it is more difficult to demonstrate control. However, the legal enforceability of a right is not a necessary condition for control because an entity may be able to control the future economic benefits in some other way. [2]
Future economic benefit
The future economic benefits flowing from an intangible asset may include revenue from the sale of products or services, cost savings, or other benefits resulting from the use of the asset by the enterprise.
Role of intangible assets in M&A
Competitive advantage
It is a simple equation to understand that having an asset in the market that your competition in the market does not possess, puts you in an advantageous position, at a higher pedal than that of other players in the market. Having a unique intangible asset as a value driver for your company puts the company in such a position in which they have the opportunity to dominate the market share by attracting various stakeholders to invest in your company and increasing the total value of the company in the market.
Tax purpose
For tax amortization, Section 32 of the Income Tax Act,1961 talks about the amortization of intangible assets which can be grouped into a block of assets and can be amortized at a common fixed rate of 25% for tax purposes. The Government of India vides Finance Act 2021, has excluded ‘goodwill of a business or profession’ from the definition of a block of the asset. By virtue of this amendment, goodwill of any nature shall henceforth not be considered as a depreciable asset for the purpose of tax amortisation under the India Income-tax Act. [3]
For business combination
When it comes to a business combination, whether it is a merger or acquisition or amalgamation or a joint venture, the value of intangible assets can be a driving force in determining the main essence of the deal as in present times, as mentioned above intangible assets are allotted most of the value when it comes to the valuation of such a deal. Every player in the market tries to get its hands on such assets to create customer value, increase its value in the market and have a competitive advantage over others. Now it is up to the company whether they acquire such assets separately from a third party or engage in such business combinations.
Licencing and franchising
When it comes to an intangible asset, like any other assets they can be licensed- allowing the other party to acquire rights to use the product or service where the ownership remains with the company or franchising the assets in which the company let the other party enjoy the ownership of the assets in payment of a fee provided such usage will be under the supervision and control of the company.
Preserving the asset value
This is a secondary benefit of having an intangible asset as it indirectly helps the company in preserving the value of all assets in general, in which the company intends to protect such assets to identify and monitor risk related to such assets and motivate them in creating a safeguard mechanism to preserve the value of intangible assets and creating a balance with that of other tangible assets.
Types of intangible assets
Goodwill
It is one of the important subsets of intangible assets. It is treated differently from intangible assets. There is a thin line between the two but both of them have similar characteristics. It is important to note that goodwill only arises when one company acquires the others by paying a premium for the brand value, customer loyalty and brand reputation. So the premium here, the extra money paid by the acquirer above the net value of the company.
After breaking down the word goodwill, it simply means the trust, credibility and reputation that a company builds and earns over a period of time. It is only recorded in the balance sheet after it is acquired in a merger or acquisition.
Intellectual property
One of the most trending and important domains of intangible assets and areas of practice in the corporate sector and business, intellectual property according to the World Intellectual Property Organization “ Intellectual property (IP) refers to creations of the mind, such as inventions; literary and artistic works; designs; and symbols, names and images used in commerce”. [4]
The company that possesses such intangible assets should be aware of the rights and the value of such property. Why? So as to be rewarded for their creation, for growth and encouragement, to get recognition of the protection of the IP so that no unauthorized use of their asset without their consent is being done for profit earning by its competitors. Some common types of intellectual property-
- Patent- A document that protects an invention and creates exclusive rights for the creator of the invention for a limited period.
- Copyrights- These are rights that are concerned with protecting the work of human intellect such as literacy and artistic work.
- Trademark- It is a tool that helps the companies in the protection of brand name, logos and unique designs of the company.
- In India, under the following statutes, IP right protection can be taken-
- The Patent Act, 1970
- The Trade Mark Act, 1999
- The Copyright Act, 1957
- The Design Act, 2000
- The Geographical Indication of Good (Registration and Protection Act) Act 1999
- The Semiconductor Integrated Circuits Layout Design Act, 2000
- The Biological Diversity Act, 2002
- The Protection of Plant Varieties and Farmer’s Right Act, 2001
Brand equity
It refers to the consumer perception of the company. It is the value of the brand that is created by the consumer about the company in the market after interacting with its goods and service. The consumer is willing to pay extra to use the goods and services of the company as it has high brand equity in the market. Depending on the reaction, brand equity can be positive or negative. This concept helps companies in increasing the sales of their goods and services. It is important to note that brand equity is different from goodwill as a company owns the brand and from there it earns goodwill over a period of time.
Licensing and franchising
As mentioned above, these are the agreements between the intangible asset or intellectual property owner and others who are authorised to use such assets for business purposes in exchange for a fee or royalty payment.
Customer list and R&D
Customer list refers to the list of old customers of the company that they have built over a period of time. It carries with it significant future value. It helps in future projects of the company as they have targeted customers which will help them market their products and service.
Research and development is also considered an intangible asset as it is an activity in which the company constantly tries to develop, acquire or use technical knowledge for developing new products and updating the existing ones. They are termed intangible assets due to their economics, which would result in higher sales for the company.
Intangible assets can also be classified based on the below table
| Marketing Related | •Trademarks, trade names, service marks, collective marks and certification marks, •Trade dress (unique colour, shape or package design), •Newspaper mastheads, •Internet domain names, •Non-competition agreements. |
| Customer Related | •Customer lists, •Order or production backlog, •Customer contracts and the related customer relationships, •Non-contractual customer relationships. |
| Artistic Related | • Plays, operas and ballets, •Books, magazines, newspapers and other literary works, •Musical works such as compositions, song lyrics and advertising jingles, •Pictures and photographs, •Video and audiovisual material, including motion pictures or films, music videos and television programmes. |
| Contract Based | •Licensing, royalty and standstill agreements, •Advertising, construction, management, service or supply contracts, •License agreements, •Construction permits, •Franchise agreements, •Operating and broadcasting rights, •Servicing contracts such as mortgage servicing contracts, •Below-market employment contracts that are beneficial from the employer’s perspective, •Use rights such as drilling, water, air, mineral, timber-cutting and route authorities. |
| Technology Based | •Patented technology, •Computer software and mask works, •Unpatented technology, •Databases, including title plants, •Trade secrets such as secret formulas, processes or recipe. |
How to protect intangible assets?
Asset protection is a good corporate governance practice that a company can adopt. Just as a company manages the physical risk associated with tangible assets, in the same way, the risk associated with intangible assets such as infringement of intellectual property, issues related to human capital such as codifying/sharing of knowledge, staff training of handling of intangible assets and brand/reputation issues such as poor employment practice, the conduct of management leading to a leak of information, have to be mitigated and to do that a company needs to build a mechanism for their intangible assets so that they can protect their intangible assets.
Non-Compete Agreement/Non Solicitation agreement
- During and after such merger and acquisition, the company has the intangible assets should make the other party sign a non-compete agreement preventing the other party from creating such assets for themselves that would be in direct competition against the company after the end of the relationship between them. This agreement puts a restriction on the other party, not to compete with the company for a certain period after the ending of their business relationship.
- A non-solicitation agreement should also be signed though it is less restrictive; it prevents the other party from engaging the company’s clients, vendors, suppliers and employees.
Confidentiality agreement
As we know, when such a transaction of merger and acquisition happens, there will be a bundle of brand strategy, technical information and knowledge, trade secrets, customer list/data etc that will be shared, which means there are high chances of leakage of information from both the parties. Hence a confidentiality agreement must be signed between the parties ensuring any proprietary information shared between the parties is protected and should not be used for competitive purposes. Any leak of information will result in the imposition of hefty liability for damages.
Registration of intellectual property
The total value of IP is significantly growing in various countries all over the world. That being said, the cost of IP litigation, dispute and claims are also rising day by day that’s why to recognize, protect and enforce the rights of intellectual property, the companies should register their Intellectual property with the required authorities so that they can protect their IP from such infringement and also at the same time recover the damages incurred due to such infringement.
Internal mechanism for risk evaluation and safeguards
As the companies are dealing with intangible assets daily, many companies have developed proactive guidelines for evaluating the value of such assets, the risk associated with them and the course of action to mitigate such risk. Companies are also forming an internal crisis response team that helps the company protect against cyberattacks, corporate espionage, data privacy/theft etc. HR is also tasked with the responsibility to evaluate the behaviour of the company and use proactive methods to influence adverse behaviours in organizations so that the reputation/ brand value, relationship with all the stakeholders are up to the standard.
Insurance
At the end the companies cannot account for all the events and risks that may be associated with the intangible assets as there are situations that are beyond the control of company management, therefore companies are buying insurance products to address the issue related to the intangible assets and transfer some of the risk or damage out of their balance sheet.
Conclusion
The digital era is unfolding before our eyes and the landscape of merger and acquisition is changing itself, creating opportunities at the same time exposing the companies’ business operations to new risks. With the usage of intangible assets by companies at such a high level, organizations all around the world need to find new ways to protect, and at the same time exploit their intangible assets by implementing such risk management practices and safeguard mechanisms in place so that they are prepared to face the constantly changing landscape of not only merger and acquisition but business in general. This will require companies to constantly engage themselves in finding new ways to deal with the internal and external risk that could impact their intangible assets and in turn compromise their competitive position in the market.
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