UndervaluedIntellectual Property in Offshoring
Gio Wiederhold
Computer Science Department
Gates Computer Science Bldg. 4A, room 436
Stanford University, StanfordCA94305-9040
Tel: 1-650 725-8363; Fax: 1-650 725-2588
Email:
AmarGupta
EllerCollege of Management, University of Arizona
McClelland Hall, Room 202ETucson, AZ 85721 USA
Tel. 1-520-626-9842, Fax. 1-520-621-8105
Email:
DavidBransonSmith
EllerCollege of Management, University of Arizona
Tucson, AZ 85719 USA
Tel: 1-520-275-6111
Email:
September 24, 2008
Executive Summary
Businesses engaging in outsourcing of professional service activities to organizations in foreign countries have focused primarily on the issues of cost and the number of jobs affected, with less consideration of the issue of transfer of intellectual property (IP) that frequently accompanies such offshoring arrangements. We show that the importance of such IP is significant and important to understand risks of loss, obligations of taxation, and above all, its contribution to the profit-making potential of an enterprise. The IP involved in an offshore transfer should be valued according to the type of transfer transaction that is being considered. More specifically we focus on software, an important and often poorly valued component of such transfers.
The value of real and intangible assets to a business sense is due to these assets driving the profitability of a company. We do not provide here a legal view, nor an accounting view of value, but focus on business-oriented issues. While the importance of intangibles in knowledge-oriented businesses is well established, legal and accounting definitions have not kept pace. For instance, the book value of a company as presented formally virtually ignores IP, and hence provides little quantitative guidance to the stockholders who are concerned about the future profitability of the enterprise.
Transfersof IP occursin some form in nearly every service-basedoffshoring arrangement, and as relationships with offshore entities grow, new IP is transferred is transferred in both directions: from the entity sponsoring the work to the entity performing the work, and vice versa.Such transfers have significant long-term effects on the balance of IP generation versus IP consumption. More complex scenarios are common: the IP is transferred to a third, hosting, locale, and users of the IP pay royalties for the use of that IP.
After a general introduction that directs the focus to the need to value IP, and technology-bases IP in particular we introduce methods that can be used for valuing such IP. Multiple competing valuation methodologies are highlighted.
The specific discussion addresses a commonly offshored service – software development – as a proxy for many types of IP, focusing on some of the special attributes of software that makes it difficult to value. It presents the factors that determine software IP valuation, as well as the relationships of IP residing in software to the business models used for outsourcing.
Given that information, we the revisit the issue, why so
many companies involved in the creation and use of software are unaware of the value they are exporting.
The valueof the IP associated with these transfersshould therefore be calculatedjust as in the case of any other long-term project– based on the future usefulness and the income-generating ability. However, the value of transferred IP that is rarely ascertained, especially in cases of intra-company transfers, due to:
- Confusingregulations and multiple legal jurisdictions with disparate objectives governing the offshoring of professional service activities;
- Underdeveloped/ambiguous IP valuation techniques promulgated by regulation;
- Nascent tax regulations governing professional service and IP transfer pricing; and
- Offshoring being traditionally perceived as a transfer of labor rather than as a transfer of IP
The cumulative effect of these factors is potentially unreliable estimates of the cost and risks of outsourcing. Since the amount of IP that is transferred abroad is large, its value should play a significant role in decisions related to offshoring. This problem is exacerbated with offshoring becoming a viable option for smaller companies and with the proliferation of global sourcing[1].
This article explores a commonly offshored service – software development – as a proxy for many types of IP, focusing on some of the special attributes of software that makes it difficult to value.Itpresents the factors that determine software IP valuation, as well as the relationships of IP residing in software to the business models used for outsourcing. Multiple competing valuation methodologies are highlighted.
1
Overview:
Intellectual Property In Modern Enterprises
Technology-Based IP – Software
Computing the Value of Software
Principles of IP Valuation
Assigning Value to Software
Valuation Methods
Post-Offshoring Diminution of Software Value
Diminution of Software IP Value in Offshoring Arrangements
Measuring Diminution
Basic Software Value Considerations
When is Software Property?
Why are IP Values Currently Underestimated?
Why Should Companies Consider IP Value?
Types of Intellectual Property Inherent to Offshoring Arrangements
Relationship between Offshoring and Software Transfer
Contracted Operations
Owned Operations
Location of the IP
Government Interest in Software Valuation: Taxation of IP Flows
Conclusions
Intellectual Property in Modern Enterprises
Intangibles of a business are all assets that are neither physical nor financialobjects[2]. In modern, knowledge–based enterprises these intangibles are the primary business drivers. Owners and stockholders recognize this fact. In 1982, intangibles contributed about 40% of firms’ value, but by 2002, 75%of the market value of all US firms is attributable directly to intangibles, while tangible assets accounted for only the remaining 25%[3]. Just like tangibles, intangibles must be continuously maintained and renewed, but at a rate that is roughly twice the rate of tangible assets[4]. Understanding, and hence management of intangibles is hindered by the lack of consistent metrics and the complexity of the paths from intangibles to profitability.
Intangiblesare considered Intellectual Property (IP) when they are owned in some sense. An important intangible that is excluded from IP assessments is thegeneral knowledge that workers possess, but enterprise knowledge that is covered by Non-Disclosure Agreements (NDAs) can be considered IP. Innovative results of employees work should increase the IP of a business. That IP becomes a mechanism for capturing market share, increasing revenue margins, and a bargaining chip for access to complementary technologies –which in turn supports the first two objectives[5].IP is also leveraged in acquiring financing for new ventures. Strategic IP management – the ability to exploit a company’s IP to its fullest extent – is becoming increasingly important. Since IP is easy to replicate and transfer it must be protected. IP that covered by patents and copyright is at identifiable and easier to manage, but then also visible to competitors. To keep IP away from prying eyes,business and process documentation, as well as software is protected as trade secrets. Unless an obligation to publish code exists, trade secret protection is common for code. Open-source software is excluded from our definition of IP, but its integration and exploitation within larger systems can add considerable value.
IP can be exploited by transfer to new settings, open up new international markets, and leveraged by its use in low labor cost countries3. Without transfer of IP many offshoring[6] projects would not be feasible; even a simple service project as a call center derives its value to a large extent to the IP that that is being provided [7]. In more complex arrangements, say cross-border development and licensing of softwarethe need to manage a company’s IP becomes crucial. In those cases concerns about allocation, security, and taxation abound.
While offshoring of jobs now permeates the economies of developing countries, but the effect of providing IP created originally by offshoring sponsors to offshore service companies may greatly exceed the effect of job transfers to those offshore service companies [8].
However, IP can flow to any place where profits can be accumulated. If royalties for the use of IP are paid to the locales where the IP resides from the locales where the IP is used to create products, then issues become more complex. Preventing loss of IP must focus on the country where it IP is being used, but the eventual loss of profits is felt in the country where the IP formally resides. We expand on that issue later. For our discussion, the difference between nearshoring and global offshoring is of little concern, since the protection of IP remains a concern as soon as the IP has moved from the sponsor to sites where laws, regulations, taxation, and attitudes concerning intellectual property differ. The operational benefits of being close remain valuable.
As smaller companies gain access to offshoring practices, and as communications technology makes offshoring attractive for complex projects in large companies, IP is being transferred across borders more often than ever before in history. The issues surrounding IP are thus becoming a broader concern to business decision makers.Recently,nearly 60% of companies stated that their primary criterion when opting to forego outsourcing arrangements was related to IP issues; half of those companies stated that greater assurance of IP security would fundamentally alter their decision[9].
Why Assign Value to IP?
While the overriding reason for being able to assign a value to corporate intellectual property is the need to understand one’s business in quantitative terms, there are also specific situations where valuations of IP are required. Assigning a value to IP is crucial when setting pricesfor IP, when determining royalty rates for shared IP, toobtain financing, and when attempting to optimize use and maintenance of IP to the firm’s utmost advantage. When offshoring, and thus exposing IP to an increased risk, the potential of loss cannot be quantified unless a value is attached to the IP being transferred. If the offshore entity operates at arms-length, then a transfer price must be established as well, since such a transfer is regarded as an export[10]. Figure 1 indicates the participants, the similarities, and the distinctions when exporting tangible versus intangible property.
Figure 1: Distinctions when exporting tangible versus intangible property
Companies are not the only organizations concerned with IP valuation; governments in many countries are losing billionsof dollars of taxes due to inadequatetransfer pricing estimates in offshore parent-subsidiary relationships. Pricing audits, based on the approval of new U.S. Treasury transfer pricing regulations for services and IP, oblige business decision makers to properly value IP[11].
The role of Technology-Based IP
For accounting purposes, the Financial Accounting Standards Board (FASB) defines technology-based IP as patented technology, trade secrets, databases, mask works, software, and unpatented technology.By focusing on technology we ignore the value of the reputation of a company, its general trademarks, and the management contribution, in part because these elements are even harder to allocate than technology that is being transferred. We also ignore the value of existing customer loyalty. If the sales rights to foreign territories are included in an offshoring transfer customer loyalty can add significant value, which can be estimated from regional sales data.
Overall, despite massive levels of investment in software and information technology (IT) assets, alignment of technology assets with business functions remains a notoriously difficult task[12]. The ubiquitous use of software IP and the extent to which it drives the profits of many of today’s corporations notwithstanding, the value-generating capabilities of software and other intangibles are easily overlooked, and attention is focused on expensing and thus minimizing these items[13].
When the return-on-investment is used as a metric, the reduction of spending generating benefits on IP investments (the denominator) is easier to calculate than the benefits generated by IP investments (the numerator)[14]. The reason for this mismatch is that U.S. accounting regulations disallow the capitalization of costs related to internally-developed intangible assets, allowing only for capitalization of certain development costs related to software to be marketed. This effectively expenses any and all costs attributable to software to be used in house, and allows for the capitalization of the costs attributable to marketable software only during the period of time between when that software is deemed ’technologically feasible’ (i.e., the nature of the costs having moved from being purely research to development of a process for which a new product can be feasibly produced) and the release of the concerned software product to customers. The term “technological feasibility” is ambiguous and depends on management’s philosophy and judgment. Therefore, it is relatively easy for maximization of expensing of software development costs to occur, contributing to the inability to view software as a value-creating asset[15].
Technology-Based IP in offshoring
While many types of IP are transferred across country borders in offshoring arrangements we focus now on technology-based IP. Since software is essentially codified knowledge, much technology-based IPfalls within the broad definition of software. Examples for immediate use are:user guides; proprietary binary software for use in the host operation, embedded databases, documentation on problem resolution based on prior experience, trademark registration and patents for embedded concepts. If the software is to be the basis for further development more material is required:design specifications, source codes, process descriptions guiding further development; and instructions transmitted under confidence that provide an understanding not obvious from primary material. If the host also resells the products in the foreign geographical area, then the rights to use established trademarks, literature that describes the products for the customers, business methods that make sales of the product effective, and instructions on exploiting these business methods are all part of the software.
Offshored software IP is commonly used in applications such as: call centers, offshored production or operational settings, software maintenance[16],software adaptation to international standards, software localizationto specific languages and regions, software creation, and web services.
The contribution of software to IP
The role of IP is to generate income at a level that exceeds reimbursement from labor expended, use of commodity products, and the margins expected in routine business operations. Computer software can generate profit by being replicated and sold as productsto external parties, and by leveraging internal business processes. Product software comprises operating systems, compilers, database systems, common desktop productivity tools, applications for creative artists, games, and a myriad of other applications. Internal-use software can be used to design products, manage inventory and supply chains, handle finances and payroll, support provide sales and call centers, and provide feedback from the field to correct and improve products[17].Companies that develop and market software or products that embody software to external customers see the effects of their investment in IP directly, but it is hard to find an enterprise that does not have some proprietary items of software IP.
Principles of IP Valuation
Valuation is the process of establishing a fair price for a good or service. When tangible goods are transferred to a host for their use, a price for the good is usually already established, leading both parties and regulators to know about what value is being transferred. For software, off-the-shelf marketable packages have similar characteristics. But a master software disk, containing software to be replicated, cannot be valued by a unit price. Its value will largely depend on the future sales of its contents. The contents represents IP to be valued.
Intangibles must be valued by its contribution to the income of a business. More specifically, the value of IP is estimated by a forecast of income from its future use. If a product has a marketing history, it ongoing sales in a foreign region can be estimated. This applies to direct sales of software as well as to the software that is embedded in so many of our seemingly tangible products.
For internal use software the income from business operations has to be allocated to the software versus other costs of doing business. Assuming optimal allocation of software versus personnel resources the allocation of income can be made based on long-term expense ratios. (ref for a pareto argument)
Assigning Value to Software
Software can be used in two distinct ways: as a saleable product, the income generated from which depends on the sales or leasing (licensing) revenue; or, as an internal-use item, the benefits from which are derived from improved business processes (and are thus harder to directly measure).
To be fair, the valuation of software IP remains difficult and subjective. Software is easy to reproduce at a cost that is negligible; each incremental sale garners much more profit than is commensurate with the incremental cost of production. The value of IP is therefore very independent of any cost or effort expended to create it. Case in point: while a thousand lines of code that generate a report that nobody reads have little value, a few brilliant lines of code can drive most of the profitability of a company. Due to the difference in value that can be assigned to software, a distinction between which entity owns what part of an item of software IP in an offshoring arrangement must be made, and the value to each firm must be considered independent of the value of the finished product and of the benefit to each location. In situations involving IFCs, cannibalization (reuse for contracts with different clients) of software IP can occur, and value can diminish for clients of a particular vendor; these clients would have benefited more had the IP been used specifically in their favor[18]. CFCs, on the other hand, have well defined marketing domains, typically mandated in geographic terms and therefore lessen the risk of separate assignment of value amongst a large number of firms or of IP cannibalization. Additionally, any changes that occur in the case of CFCs are easily identified if the client and vendor are owned by the same parent. The value of such IP is generally determined when it is consumed, i.e., used to generate income[19].
For a marketable software supplier employing the use of a CFC, some of the ongoing costs will be incurred at the sponsor site and some at the host. To compute the required cost-sharing payments for alternatives 2 and 3 of Figure 1, all the research and development costs applicable to the creation of the software are aggregated and then allocated according to revenues in the home and CFC geographical areas. Any costs exceeding the revenue apportionment are then reimbursed from the other side. This arrangement becomes complex when IP has been contributed by multiple entities, since IP is also generated by brand and product marketing, which will have different life spans than those of the technological components. No amount of marketing can overcome poor quality, so we focus here solely on the software component.