The Value Proposition: the price of knowledge

Information is driving the economy of the western world, but we have no reliable method to measure its value. Established accounting methods completely fail to value and manage volatile resources, principally because banks are only interested in the value of a company when wound up. The market valuation of public companies is fashion-led, but much more likely to reflect the value of knowledge than the end of year accounts.

Paul Strassmann has developed an approach to measuring Knowledge Capital which is based on a very simple premise that Knowledge Capital is the result of a stream of past investments in ideas, software and people i.e. good management.

The product of that Knowledge Capital is the Economic Value-Added (EVA) generated by the company. Talk to a venture capitalist and you will find a very similar approach.

If you accept that EVA is the output generated from a pool of Knowledge Capital held within a firm's people, designs, software and processes, how can it be valued? You need to know the interest rate of knowledge so that you can plug it in to the equation, Capital x Interest Rate = EVA. In this case we know EVA so the equation can be rearranged to Knowledge Capital = EVA/Interest Rate.

Establishing the interest rate for knowledge is easier than you might think. Company acquisitions take place all the time and for each one of these transactions a capital sum is exchanged for a company based on its ability to create EVA. When Knowledge Capital is acquired, money has to be raised to make the purchase. The interest rate paid to the bank or venture capitalist is effectively the interest rate for Knowledge Capital. If the purchaser is a cash buyer, the interest rate that the cash was earning while it was on deposit is lost after the sale goes through and this rate is the interest rate for Knowledge Capital.

Two companies with identical EVA can have significantly different Knowledge Capital if the interest rate they pay for acquisitions is different. Share swaps and other ingenious techniques to convince shareholders to move their allegiance to the stronger management team are all mechanisms used by successful companies to decrease their cost of acquisition and thus maximise Knowledge Capital. If a bank or VC likes your business plan and has faith in your management it will lend at a lower rate and your Knowledge Capital will be higher. In this 'winner takes all' economy, your ability to purchase an EVA generating firm at a lower price is an important weapon in your ability to dominate the market.

To conclude this discussion of Strassmann's definition of Knowledge Capital, one word of caution: Knowledge Capital can be lost in a wide variety of ways. Bad management, staff losses, corrupt databases and buggy software can all contribute to loss of Knowledge Capital and the best Business Intelligence software in the world is unlikely to regain any of it!