In the last decades we have seen a strong trend from tangible assets towards intangible assets as the primary source of value creation in the economy. Data from the US consulting company Ocean Tomo from 2015 shows that tangible assets represented 87% of the value of the S&P 500 in 1975, and intangible assets only 13%. For 2015, they show the opposite – intangible assets represented 87% of value and tangible assets only 13%. This fundamental transformation from an economy built on tangible assets towards an economy of intangible assets has a profound impact on how companies are financed. Currently, only equity financing is adapted to fund the growth of businesses based on intangible assets as equity financing does not require tangible assets as security. Yet equity is scarce, expensive and dilutes the entrepreneurs. New forms of financing are required.
To illustrate the assertation, consider comparing the six most valuable companies (measured by market cap) in 2006 with those in 2016. In 2006 the most valuable companies were Exxon Mobile, General Electric, Microsoft, Citigroup, BP and Royal Dutch Shell. In 2016 this list looks entirely different as it consists of Apple, Alphabet Holding, Microsoft, Amazon, Exxon Mobile and Facebook. Today, the most valuable companies are not anymore companies with heavy balance sheets such as Energy, Financial Services and Industrial companies but asset-light, tech-driven companies whose value stems from immaterial assets.
This point becomes transparent once we compare the difference between market capitalization and capital employed of these companies. This difference is called “Market Value-added” or “MVA” or “Value-creation” if you wish.
MVA = Market Capitalization minus Capital Employed
The bigger this difference, the more value is created in excess of the tangible assets on the balance sheet. Thus, it is a good indicator for the value of immaterial assets. For asset-heavy companies on the list of 2006 the market cap was only 1-2x the capital employed. For instance, for ExxonMobile this factor was 1.7x. This has changed dramatically for the corporations on the list of 2016. The market cap of Apple, for instance, is more than 20x its capital employed, for Alphabet Holding this factor is 7x, for Microsoft 8x and for Amazon 9x. The most valuable companies do not rely on heavy balance sheets anymore.
The same transformation holds true for the new SMEs that are emerging. Driven by digitization and new business models, companies need much less tangible assets. New business models allow for a separation between the ownership of assets and the usage of assets. Consider Software as a Service (“SaaS”) business models based on Cloud Computing. Earlier companies were forced to buy hardware, such as capital intensive data centers or other IT infrastructure as well as software licenses. Both are fixed costs and they are capital intensive. Today, they get access to the best infrastructure and software by simply paying a monthly fee for the usage of the infrastructure or service, thus transforming fixed costs into variable costs and strongly reducing their capital employed. Such business models also start to emerge in the machine building industry, something that can be called “machining as a service”. Machine builders, instead of selling the machine to their customers, continue to own the machines and simply provide the machining as a service to their customers against a fee. Today you can start a production business without owning the production assets.
Banks lend against tangible assets
Being light on assets puts SMEs, however, into trouble when it comes to getting financing for their growth. As their balance sheets are extremely light they cannot provide tangible securities to banks. Yet, the whole business model of banks is to lend against tangible assets. This is bad news for both the banks and for companies in general and for SMEs in particular. As tangible assets account for a steadily decreasing share of our economy banks need to fight harder to get a piece of this shrinking pie. Banks have a fundamental problem in their lending model. For SMEs this means that it is extremely hard to get bank financing as their business models build on intangible assets. This is the real reason for the SME funding gap.
As a result entrepreneurs face a dilemma. Currently, the only source of external funding that is adapted to an economy of intangible assets is equity financing. Yet, equity is scarce, expensive and leads to dilution of ownership. This leads to a situation where entrepreneurs either do not want to use external financing (which slows down their growth) or they use external equity financing (if available at all) which dilutes their ownership and reduces their incentives. Both outcomes are bad for the entrepreneur and also bad for the economy. In order to resolve this dilemma new forms of financing are required which adapt to a new economy of immaterial assets.
I will discuss how such financing models could work in my next blog.