The “From the Editor” section has this to say about trust:

The public’s trust in business leaders has never been weaker. According to the Edelman Trust Barometer, released in January, trust in U.S. business dropped from 58% to 38% in one year…. If companies can’t address this problem, an economic turnaround may be delayed indefinitely: Banks won’t lend money; innovation will slow to a crawl; trade across borders will fall even more rapidly; governments will overregulate the private sector; unemployment numbers will continue to rise; and consumers won’t open their wallets for anything they consider nonessential. A complex modern economy simply can’t function unless people believe that its institutions are fundamentally sound.

I highly recommend reading the article “Rethinking Trust” by Roderick M. Kramer. While other articles in this issue offer platitudinous suggestions (i.e., “organizations should be more transparent” and support a “culture of candor”), Mr. Kramer roots his analysis in the biological realities of brain chemistry and human instinct. This perspective makes the author’s subsequent rules for “tempering trust” more valuable and actionable. In fact, Mr. Kramer’s 7 rules bear a lot of (uncorroborated) similarity to my “Laws of Relation.” My only caution with Mr. Kramer’s rules of trust in this article is that they are meant for interpersonal forms of trust, and not always applicable to institutional trust.

I’m hoping the Harvard Business Review’s “Spotlight on Trust” can generate a lot more discussion on this important issue.

The hook was a decision by the US Court of Appeals for the Federal Circuit in Washington DC. Instead of automatically granting a patent for a business practice, the court decided there would be a specific testing procedure to determine how patentable is the process in question.

As the story put it, this is “a nearly complete reversal” of a judgment of 1998, which started the stampede for patenting business practices.
All I can say is, About damn time! Here’s the link to my extremely cranky New York Times column on this very same subject, written in 1999.

So here’s the goofy bit: The reporter wrote,

The decision is great for open source advocates. But it could mean a permanent change in the value of intangible assets, which comprise approximately 70 per cent of the average high-tech company’s market capitalisation. With the world’s economy sliding downhill at an increasing pace each day, this decision could cost US companies billions of dollars.

Oh, please. First of all, patents comprise only a fraction of that “70 percent” value for intangibles, and business practice patents are only a fraction of those.

And second, those patents should never have been granted in the first place, and everybody knew it. During the dot-boom before the dot-bomb, anybody could do pretty much anything they wanted for the ka-ching, and that was one of the most ridiculous of them.

But I’ll give the reporter credit. Even if the patent/intangible thing was a little off, he found a nameless Silicon Valley executive who saw “a silver lining” to the decision: Companies will save a lot of money on legal fees (I’d say legal departments) by not needing to ceaselessly file, license and defend patents so basic that the bureaucracy to maintain them equals or exceeds the money they bring in the door.

Patents are gumming up the works in more places than the software industry, and I’ll be writing more about this in the next few weeks, in the context of biomedical and environmental research in particular. In the meantime, I wouldn’t worry too much about the software industry in this regard. Some companies will probably even find some upside in all the downturn.

Back then, Lee Jeong-bae, a senior consultant at South Korea’s LG Economic Research Institute, said he thought he knew why Korean firms have failed to produce such iconic devices as Apple’s iPod and Motorola’s RAZR, despite their technological expertise: he said they lack “T-shaped” people — people who have an area of deep interest or expertise (the vertical part of the T), but also have empathy for and ability in other areas.

“To create innovative products, we have to secure insights not only into the products but also into their business opportunities by having an observant and empathetic view of the world. Only T-shaped people, who have well-rounded personalities and broad interests, can obtain such viewpoints. Sophisticated engineers who do not understand the market and customers will never devise [the products] which have a shot at becoming a grand slam.”

As ridiculous as this statement now seems (especially to those of us whose retirement funds have been decimated) I’d argue that the statement holds true—even in a grizzly market. Yes, good bankers do know how to manage risk—their own risk. Which is why the best investment bankers view a recession more like a sabbatical, while the rest of us have to figure out how to keep food on the table. And even as the government is coming to the rescue, the Fed won’t be doing the risk management part: they’re paying bankers to figure out how to get out of the mess they’ve created. Talk about a win-win!

Not that these guys aren’t suffering. Here’s a bit of anecdotal evidence of how bad things have gotten:

This is a finance guy making a ton of money and he was trying to decide whether he should sell the country home in Connecticut, the apartment here in the city or the 8,000-square-foot dream home in Oregon that he just finished…  (from “End of an Era on Wall Street: Goodbye to All That“)

A dilemma for sure, but global financial crises demand desperate measures.

Markets Transfer Risk, Not Trust

The foundation of modern financial markets is seeped in the mathematics of probability. Over the years, rules and regulations have been piled on to promote competition and reduce overall risks. The results are compelling. And something in the human psyche tells us that since these guys are so much better at managing their own risk—and they obviously are, since they have several luxury houses at their disposal—then maybe we should trust them to manage our risk too. A market allows us to transfer our assets to someone who can navigate a risky terrain better than we might ourselves.

But risk management in itself doesn’t guarantee collaborative outcomes—that is, outcomes in which gains and losses are shared proportionally—nor does risk management inexorably produce social trust.

Clearly, the current crisis is as much about a breakdown in social trust and a loss of social capital as it is about debt ratios and credit freezes. We’ve already seen how even an injection of more than a trillion dollars won’t allay lenders’ anxieties. If you’re not an actuary, the reason is obvious: anxiety isn’t a risk equation, it’s a human emotion. Anxiety is symptomatic of a collapse of trust.

The problem with words like “anxiety” and “trust” of course is that they’re mystical to the mathematical mind. How’s a actuary to calculate the value of trust futures? or social trust default swaps?

Restoring Social Trust

What the world needs now is a renewed social trust. Until recently, social trust seemed like an intangible commodity with a will of its own; it couldn’t be systematically cultivated, measured, forecasted, or valued. But a growing canon of research into successful resolutions of social dilemmas demonstrates that collaborative arrangements are more likely to emerge when certain conditions are met. It’s time to develop mechanisms that foster pro-social behaviors by supporting natural processes of recognition, reciprocity, and community awareness. Most of the fundamental research is available to build such a system, so it’s more a matter of applying these ideas to real world relations, institutions, and markets.

Laws of Relation Revisited: Codifying Pathways to Trust

A few years ago, I challenged the software industry to take ideas about trust from various branches of science (such as game theory, social science, evolutionary biology, and psychology) and produce a system that greatly improved the likelihood of collaborative outcomes and improvement in social trust. The system could then be applied to trust-related problems on the Internet, such as spam, identity theft, and credit fraud. If such a “trust leavening” could be invented, it might even be applicable to a wider range of problems, including stronger trust in financial markets.

To design a trust system, there needs to be some workable theory on trust that explains how it’s created, how it’s maintained, and how it’s used. The theory needs to be intellectually accessible to a wide range of professionals. Just to get the conversation started, I offered three “Laws of Relation” (which are really more like postulates at this point). They are:

Law of Relational Symmetry

The party in control of the terms of a relationship controls the relationship and, in the absence of symmetrical countervailing controls, will eventually exploit the other participants.

Law of Relational Risk

Contribution to the relationship that is not met proportionally by the other participants is a loss to the contributor.

Law of Relational Projection

Any party with more than an informational interest in a relationship is a participant in the relationship.

As it turns out, financial markets illustrate these laws rather well.

The first law says that exploitation will occur in asymmetrical relations. Who controls the playing field in financial markets? The SEC? The Fed? It seems in many cases, the large investment banks who continually added exotic financial instruments, pushed for rule changes, and lobbied for reduction in government oversight. The prevailing belief in Washington was that these are smart guys who know how to manage risk. As it turns out, they were easily the smartest guys in the room and they were exceptional at managing their own risk, but not motivated at all to think of market risk. The average investor has almost no say in matters regarding market rules, so the relation was systematically slanted in favor of the rule makers.

The Law of Relational Risk predicts that collaborative outcomes are more likely when all parties experience a loss proportionally. The losses on Wall Street have been catastrophic, but not for everyone. Many of the people directly involved in creating this mess won’t suffer from the crisis the way some of the shareholders or general public will.

And the Law of Relational Projection distinguishes participants from on-lookers. One thing that has been a surprise to everyone is how interrelated and interdependent we’ve all become. Interdependency can be a vital pro-collaborative element to relations (per the Law of Relational Risk). In fact, it’s our agreement on a shared conflict, our mutually assured financial destruction–that has formed the basis for cooperation in congress and among world banks. But the strategy only works well when these relations are explicit. Instead, as our home loans have been sold, resold, hedged, and bet on through derivatives of derivatives, it’s no longer clear to anyone who is a participant and who’s a bystander. So what’s happened is that people who were believed to be bystanders have brought the house down with little or no accountability.

Designing Pro-Collaborative Systems
Few of society’s existing institutions are set up to support collaborative outcomes, and so exploitation is inexorable. With an informed understanding of elements that promote collaboration and trust, we can greatly improve our institutions, including financial institutions. I’ll continue to present my ideas on how to do this in follow-on posts, but I hope that professionals from a wide range of disciplines will contribute their ideas as well.

Unfortunately I was not able to quote either Mary or Henrik Martin, the CEO of Intellectual Capital Sweden, in the article, despite the fact that they both gave me terrific interviews, in order to avoid the appearance of conflict of interest: I’ve been talking to both of them about becoming a licensee/practitioner of the IC Rating method, which I think is one of the most sensible intangibles rating systems I’ve seen so far.

It is not surprising that the organizers of the conference turned to two accountants to explain the “state of the art” of intangibles in the firm. It was a natural decision. We rely on accountants to provide objective information about our organizations. Who better to help us understand this new “asset” class that makes up 80% of the valuation of the average company and fuels competitive advantage?

But the problem is that accountants have not been able to answer this question. Accounting was designed 500 years ago to track the movement of tangible goods. The system worked well throughout the industrial revolution because it provided a way to keep track of the full value chain of a tangible business—from construction of a factory to purchase of raw materials, creation and sale of finished goods, and collection of accounts receivable.

The value chain of an intangibles-intensive business, however, is much less visible in traditional financial statements. The intangible assets used to create services and knowledge are not on the balance sheet. So the first time a service may hit the financials is as revenue. Costs related to the delivery of a service or creation of a knowledge product are not tracked directly. They hit the income statement as operating expenses. So the cost of building intangibles is mixed in with the cost of operating both the tangible and intangible sides of the business.

At the National Academies, Baruch Lev asserted that the best way to develop standards for intangibles reporting would be to work industry by industry to develop models of what he calls the “structured input-output information on performance of the major drivers of enterprise value.” He supplies two examples of this kind of value chain analysis for the pharma/biotech and telecom/internet industries.

Lev’s argument mirrors those of many others when confronted with the challenge of capturing intangibles in accounting—“we need to understand intangible values before we can account for them.” I think that this argument misses the point. Companies (and their accountants) are not in the business of “valuing” assets.

Think about it. When a company builds a new manufacturing plant, the analysis is not around the value of the plant. It is about the expected cost and return. No one around the table says, “this plant will have a great re-sale value.” The important questions are about how to use the plant to create revenues and profits for the company. The accountants book all the investments and expenses at cost.

Treatment of intangibles should be the same. Managers, accountants, boards of directors and investors should not ask the value of intangibles but, rather, the accumulated cost and expected return. This argument was made very effectively in a Melbourne Institute Working Paper, Measuring Intangible Investment, by L. C. Hunter, Elizabeth Webster and Anne Wyatt.

I stood up at the National Academies conference and asked a question about this. I’m not sure the panel had thought about the issues in this way before so I would like to pose it again and, hopefully, open a conversation about where to go from here:

Aren’t we ignoring a hugely important set of information that is already in every accounting system: the cost of the investments that companies make every year in their intangibles?

Corporations around the world pay to hire people and train them. They pay to develop business processes, implement software (sometimes five times the cost of the software license itself) and perform R&D. They invest in their brands and customer relationships.

If we use macroeconomic data as a guide, the annual investment in intangibles now surpasses tangible investments in the U.S. But, with the exception of R&D, spending on intangibles is not broken out. It passes through the income statement where it is mixed in with true operating expenses.

Couldn’t/shouldn’t every company prepare a report of these intangible investments? It would detail out all the “expenses” that are in the current year’s financial statements that are actually “investments” in the company’s future that are expected to provide value beyond the current year? Accountants are used to this distinction between current costs and future investments; they would just be applying that distinction to create a supplementary report.

The income statement would not be changed. GAAP would be respected. But a company’s stakeholders would have a better view into the long term thinking and investing of its management:

• How are they preparing their people for the future?
• What are their key processes and how are they building them?
• What is their investment in innovation and research?
• How much do they invest in their brand and customer relationships?
• Are they investing in key partnerships?

I would call this something like the “Intellectual Capital Expenditure Report.” It would provide critical information that should be available to managers, boards of directors and investors. Once you get this data over a series of years, you could begin to look at the relationship between spending on intangibles today and increases in revenues and profits in future years. You could also create industry consortia that collect and provide benchmarking data to their members.

I think that having good information on the cost of intangible investments would be a boon for managers and investors alike. Do you agree? How can we get this going? I hope to hear from you by email or through comments on this entry.

However, it is worth reading the analysis that led them to this conclusion. Their examination of the largest 150 companies in the world showed that after growing at 3% from 1970 to 1994, their total market capitalization grew at 11% per year through 2004, even taking into account the bursting of the internet bubble in 2001. They then separate the companies into two groups: “labor-intensive” and “thinking intensive,” looking at net income per employee. It probably won’t surprise you that the thinking intensive companies had much higher income per employee. (Note that this data is in the Introduction to the book which is available as a free download)

The authors go on to state that “almost all of today’s companies…were built primarily to mobilize their labor and capital assets—not the intangible assets that enable profits per employee to rise to levels never seen before.” And further that this model leads to “massive, unnecessary, unproductive complexity.” They also imply that many of the companies that have succeeded at this game have done so more by intuition and luck than by deliberate strategies.

The authors’ focus on complexity reflects their focus in their data and in their suggestions on the largest companies in the world. But that does not reduce the value of their recommendation that organizational design and innovation be a primary focus of business leaders in the coming years. Unlike Gary Hamel and Bill Breen, who made the same recommendation in their recent book The Future of Management but stopped short of suggesting how to accomplish this, Bryan and Joyce explore in great detail what they call “ideas” for the reader’s consideration:

• Backbone Line Structure
• One-Company governance
• Dynamic management
• Formal networks
• Talent marketplaces
• Knowledge marketplaces
• Motivating economic behaviors
• Role-specific performance measurement
• Organizational design as strategy

I found that many of the recommendations would only be relevant to the mega-corporation. No surprise as that’s McKinsey’s market. Not every company has the same complexity of challenges that need complex solutions. Nevertheless, this is a valuable contribution to the field of intangibles.

There were two panel discussions on the role of government around intangibles. Many of the presentations were rich with data, and I recommend them to those interested in the macroeconomic aspects of intangibles.

Douglas Lippoldt, Organization for Economic Cooperation and Development (OECD) made a clear case for governments and organizations like the OECD to focus on intellectual assets as:

• They are central to value creation, economic growth and competitiveness in a modern economy.
• Continued shortfalls in measurement and understanding of intangibles has implications for decision making
• IA relationship to innovation, as inputs and outputs needs to be understood
• There are significant possibilities to leverage these assets for acceleration in development

R&D was the focus of presentations by John Jankowski, Science Resources Statistics Division of the National Science Foundation, and Steve Landefeld, Bureau of Economic Analysis at the Department of Commerce. Landefield explained the significant shift in how research and development gets done today versus the way it was done in the 1950-70s. Today, more research is done at the corporate level (although not just in large companies) while less basic research is done at the corporate level; basic research has moved to academia. The focus of R&D today is much more on IT, services and is global. These changes speak to the need for new approaches to measurement of R&D, an effort that is currently underway.

Ahmed Bounfour, Paris-Sud University, gave a dense overview of activities in different regions of the world (other than North America). Nir Kossovsky, Steel City Re, explained the role of reputational risk in the value of intangibles.

Kenan Jarboe, Athena Alliance, presented a detailed estimate of the U.S. government’s spending on intangibles of $204 billion in 2006. Of this, $122 billion was in R&D. The remainder was in development of human, reputational and organizational capital. Jarboe also outlines the beginning of an intangibles policy agenda including expanding definition of investment tax credits from capital to intangible assets. He also identified many measures which will help support the growth of markets for intangibles, such as registries of security interest in intangibles.

All in all, The National Academies conference on Intangible Assets was a great start to what I hope will be a new chapter in the U.S. focus on the resources that will make or break our collective future. But there is still much work to do. Stay tuned here for lots more ideas and information.

This was the discussion of the day closest to my experience and practice so I was especially interested in these presentations.

I recommend the discussions by Laurie Bassi, McBassi & Company, and James Malackowski, Ocean Tomo, whose companies are encouraging market development for intangibles. McBassi offered data on the value of investment in human capital. Malackowski’s firm made its name by developing public auctions of patents and is now developing investment units tied to licensing rights. The work of companies like this will provide an important validation to markets and managers of the value of intangibles in business.

Baruch Lev of New York University’s Stern School, reported that “shares of intangibles-intensive companies are systematically undervalued, causing excessive cost of capital as well as suboptimal investment and growth.” Lev rejects the value of many intangibles indicators and advocates “structured input-output information on performance of the major drivers of enterprise value.” The challenge to this is, as Lev admits, that this type of analysis would need to be done industry by industry and, as such, would take years to develop.

Ron Bossio, Financial Accounting Standards Board (FASB), explained that FASB’s priorities are around international convergence and joint projects with the IASB and completion of codification of US GAAP. As previously reported late in 2007, FASB will not work directly on the issue of intangibles. He ended the discussion with the prediction that the challenge of intangibles disclosure will not be solved for the foreseeable future.

I asked Lev, Bossio and the others on the panel about cost. In my own work, I keep coming back to cost and I am beginning to see it as the potential answer to this dilemma. Companies are already spending millions on intangibles. Accountants know how to count costs — they are counting the cost (I would call it investment) in intangibles and putting most of it on the income statement. Why don’t we start creating management reports about intangibles spending and use the information for greater transparency and learning? Our economy has already changed. We are already in an intangibles-heavy economy. We cannot afford to ignore a powerful information source in the form of annual investment data in intangibles.

The discussion of the challenges and approaches to macroeconomic measurement of intangibles was greatly strengthened by the presentations of perspectives from not only the U.S., from Carol Corrado, The Conference Board and Brent Moulton, Bureau of Economic Analysis, but also from Jonathan Haskel from Queen Mary College, University of London, and Kyoji Fukao of Hitotsuboshi University and RIETI. I recommend the individual presentations for more detail but thought I would highlight a couple points that struck me.

Corrado pointed out that many of the expenditures in intangibles are co-investments in IT. This emphasizes the role of technology as a catalyst for change in organizations as well as a tool for accomplishing that change. Process improvement, increased employee competencies, improved customer service, are all inter-related. This comment was also interesting in light of Wladawsky-Berger’s presentation based on his experience at IBM on the role of intangibles in business.

Using the approaches developed by Corrado, Hulten and Sichel in 2006 on Intangible Capital and Economic Growth, it appears the intangibles investment in the UK and Japan is much lower than in the U.S. But then Fukao dug into the numbers. He pointed out that one component of the calculation of investment in organizational structure is the CEO’s time commitment to corporate strategy. Data shows that, in the U.S., CEOs spend 20% of their time on strategy (versus 9% in Japan). Further, CEOs in the U.S. earn about 10 times more than their counterparts in Japan. So 20% of U.S. CEO compensation will far outreach 9% of Japanese CEO time.

Another difference in the calculations was in the differing role of formal versus on-the-job training. The U.S. tends to use formal training for employees. Japan relies more heavily on informal training. So the U.S. calculation under-counts Japan’s investment of 9% of the average worker’s time in on-the-job training.

These two factors lead to higher calculation of the U.S. investment in intangibles — but I was left wondering whether the U.S. calculation is valid. … Another demonstration of the challenges ahead on measurement of intangibles.