Ownership in question

In Capitalism without Capital Jonathan Haskel and Stian Westlake show how intangible assets – things such as patents, brand loyalty, proprietorial software or good business processes – are becoming increasingly important. This changes how companies should be financed.

One feature of such intangibles, they say, is that they are sunk costs. If a company gets into trouble it can quite easily sell its physical assets such as shops or land. Intangible assets, however, aren’t so sellable. Yes, there are markets in patents and even goodwill, but because these are harder to value, the distressed seller might not recover his investment.

Intangibles, therefore, are lousy collateral. Whereas a bank will lend you money to buy land or machinery, it will be less keen to lend to someone wanting to hire researchers or software writers.

This helps explain why companies have for years been building up cash piles; because they cannot borrow so easily, intangible-intensive companies try to become self-financing.

But what about those companies that need cash but aren’t yet generating it? If debt finance is impractical, shouldn’t they tap stock markets instead?

Not necessarily. These too are problematic for intangible-intensive companies.

One reason for this, say Haskel and Westlake, is that markets often demand short-term results which such companies cannot provide in their early stages. This is because of another feature of intangibles – their scalability. If you’ve developed a great drug or phone app or platform such as Facebook or Twitter you can easily sell it to millions of extra customers at little cost. The problem is that it might take years and millions of pounds to do the initial development. During this time, stock market investors might lose faith and be loath to provide the extra funding needed. It’s no accident that most of the growth in Facebook and Twitter came before they were listed on the stock market.

A second problem is that dispersed shareholders have little incentive (or ability!) to acquire in-depth knowledge of a company. Managers therefore have an incentive to placate them by cutting investment in intangibles: shareholders can see current profits but cannot so clearly see potentially great R&D. Alex Edmans at the University of Pennsylvania has found evidence for this. He shows that companies that score highly in surveys of employee satisfaction subsequently on average see their share prices rise, which implies that equity investors under-rate the importance of workers’ goodwill. “The stock market does not fully value intangibles,” concludes Professor Edmans.

All this has a devastating implication, pointed out by the University of Chicago’s Luigi Zingales. It is, he said, “unclear whether control should reside in the hands of shareholders, because the pursuit of shareholders’ value maximisation may lead to inefficient actions”. Or as Maynard Keynes wrote over 80 years ago, “when the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done”. 

In light of all this, one fact becomes unsurprising – that the number of companies listed on the UK and US markets has dropped sharply in recent years, and those that are quoted tend to be older, bigger and more profitable than listed companies were years ago.

You might think there’s a solution to these defects in debt and stock market finance – private equity or venture capital.

You’d be half right.

This can have great benefits for intangible-dependent companies. Good venture capitalists can use their experience gained from past investments to mentor new start-ups. And their networks allow them to better exploit another feature of intangibles – the synergies between them – by bringing together ideas and entrepreneurs.

One big fact is consistent with all this – that performance of venture capitalists persists. To a greater extent than for equity fund managers, good performance leads to more good performance. This implies that the best venture capitalists do bring useful skills to their companies.

Venture capital and private equity, however, are not panaceas say Haskel and Westlake. For one thing, fund managers’ skill isn’t scalable; they have only a limited span of expertise and control.

Also, venture capital works best when funding can be added in phases, such as during different stages of drug trials, as the chances of success become less uncertain. It’s not so useful when huge sums are needed at once.

Worse still, there’s another feature of intangibles that private equity cannot so easily overcome – spillovers. Intangible investments by one company benefit others. For example, great products can be reverse-engineered and copied: how many smartphones now look like an iPhone? And workers can take lessons learned in one company out of the building. In fact, Silicon Valley was pretty much created by former employees of one man, William Shockley. This means that, as Yale University’s William Nordhaus has said, producers get only a “minuscule fraction” of the benefits of innovation. This in turn means that the private sector will under-supply such investments, which means there might be a case for state financing of them.

None of this means that listed equity finance will become wholly redundant. It works well for companies where investment opportunities are abundant without the need for close scrutiny of managers – such as for resources companies during commodity booms.

It does, though, have two implications.

One is that it raises the question: who should own companies? Ownership matters because it confers residual control rights – the right to decide how to use an asset in ways not specified by laws or contracts. As the Nobel laureate Oliver Hart has pointed out, efficiency requires that these rights should be help by the people best able to maximise assets’ value. Such people won’t necessarily be dispersed shareholders, and in fact they increasingly are not.

Secondly, an economy in which intangibles are increasingly important will be one in which listed stocks are only a fraction of all investment opportunities and probably not the best ones. There’s a good case, therefore, for investors to consider private equity and venture capital funds.