Second Quarter 2002 / Issue 27 (originally published by Booz & Company)

Who Profits from Brainpower?

Knowledge assets are essential for competitive advantage today, but they don’t guarantee shareholders above-average returns. Why? Because even though firms may be producing more value than ever from brainpower, not all of that value goes to shareholders. Rather, some portion goes into employees’ pockets — in the form of higher salaries, bonuses, stock options, incentive plans, and discretionary spending. And employees deserve it.

After all, ownership of stock doesn’t mean ownership of all of the company’s assets. Such intangibles as know-how and star power belong to, and are controlled by, individual employees. For example, when the six stars of the successful sitcom Friends recently made joint salary demands, they got what they wanted. AOL Time Warner Inc. (which owns Warner Bros. Television, the show’s producer) and General Electric Company (which owns NBC, the show’s network) may earn higher revenues from advertisers and ancillary products associated with the popular show, but profits don’t necessarily rise, because most of the additional revenues go to paying the television show’s stars.

Similar situations occur in other kinds of businesses with individuals who own other kinds of intangible assets — scientific knowledge, production experience, customer relationships, etc. To be clear, these business “stars” aren’t stealing from the firm; they’re simply exercising their right to a fair portion of the unique value that they generate.

Star employees who are not given their due may be attracted by other opportunities. For example, when Inc. was ramping up its crucial distribution strategy in 1997, Richard Dalzell, then the highly celebrated chief information officer of Wal-Mart Stores Inc., joined Amazon, which offered stock options worth millions of dollars and a salary Wal-Mart could not match. (In 1999, Wal-Mart, renowned for its distribution system, sued Amazon for poaching its talented supply chain master to steal trade secrets, but they later settled the suit.)

The point is, when such intangible assets as an individual’s intellectual capital produce increased revenues, these valuable employees compete with shareholders for those additional dollars. Investors may still earn average returns. But they shouldn’t necessarily expect knowledge-based assets to produce spectacular returns because key employees need to be retained, and that is costly to the bottom line.

But how does management determine how much compensation represents the knowledge workers’ fair share of the value-added? And how can companies gain more control over their knowledge assets?

Never forget that when individuals have highly valued knowledge, it gives them bargaining power. Still, firms can transfer ownership of some knowledge from individuals to the firm. Patents, for instance, give ownership of ideas to the firm. IBM files for thousands of patents every year and earns impressive revenues from them. In this way, companies stake a claim to knowledge assets, from which the firms can earn income for shareholders.

Similarly, enterprise software that encodes business processes or records customer information captures the practices and knowledge held by individual employees for the shareholders’ benefit, even if key “knowledgeholders,” like Wal-Mart’s Mr. Dalzell, leave.

Nevertheless, much of the value of knowledge assets remains inaccessible to investors. Patents reflect advances that are established and fully codified. But patents come from much broader tacit knowledge, which is the engine of breakthroughs, the foundation of the firm’s future value, and the most difficult value to realize because it must be extracted from the brains of employees. IBM’s existing patents bring in revenues, but its future patents depend on the ongoing research and genius of its scientists and engineers. Shareholders cannot expect to capture the full value of future breakthroughs through patents.

A healthy firm with a knowledge-based advantage must compensate all stakeholders, but especially the employees whose intellectual capital creates and sustains that advantage. Shareholders will realize a fair rate of return, but key employees may keep the lion’s share.

Russell W. Coff,
Russell W. Coff is an associate professor of organization and management at Emory University’s Goizueta Business School. His current research explores how firms achieve competitive advantage by leveraging knowledge-based assets.
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