Acquired vs Internally Generated Intangibles: The buy vs build divide and valuation impact

Why Your Most Valuable Asset Isn't on Your Balance Sheet

For a founder in a deeptech, biotech, or SaaS startup, your most valuable asset is often invisible on the balance sheet. The intellectual property your team develops, from source code to drug compounds, is the core of your company's value. Yet, when you review your financials in QuickBooks or Xero, that value is typically missing. This is not an accounting error; it's a fundamental principle of how intangible assets are treated. The rules create a sharp distinction between the IP you build and the IP you buy.

Understanding the accounting for purchased vs. developed intellectual property is not just for accountants. This knowledge directly impacts your reported profitability, your ability to pass investor due diligence, and your eligibility for critical R&D tax credits. This guide breaks down the rules in a practical way for early-stage founders.

The Core Problem: A Tale of Two Assets

Imagine your team spends six months and $500,000 in salaries developing a proprietary algorithm, the engine of your entire SaaS platform. Where is that half-million-dollar asset on your balance sheet? The short answer is, it probably is not there. Instead, it is likely buried in your profit and loss statement as an operating expense.

Now, imagine you acquired a smaller company specifically for its $500,000 patent. That asset would appear on your balance sheet. This discrepancy confuses many founders. It feels counterintuitive that the IP you create is treated as a current-period cost, while the IP you purchase is treated as a long-term asset. This isn’t a mistake in your bookkeeping; it’s a core principle of accounting standards. Navigating these rules correctly is essential for accurate financial reporting and securing investment.

The Guiding Principle of Intangible Asset Accounting Rules: Verifiable Value

The entire system for the accounting for intellectual property is built on a single idea: verifiable value. Accounting standards like US GAAP and IFRS prioritize objective, verifiable numbers. When you acquire an intangible asset from a third party, the transaction itself creates that objective evidence. The price paid in an arm's-length negotiation is considered its fair market value, a reliable figure that can be recorded and audited.

Internally generated IP is different. While you know your team’s work is valuable, putting a precise, objective dollar figure on it is extremely difficult. How much of that $500,000 in salary was productive R&D versus time spent on dead ends? At what exact moment did an idea transform into a viable asset with future economic benefit? To avoid balance sheets filled with subjective and potentially inflated asset values, the default rule is to expense costs related to internal IP creation as they are incurred. This conservative approach ensures the P&L reflects the actual cash spent on research activities, even if the balance sheet does not capture the full value of your innovation.

Initial Recognition: Accounting for Purchased vs. Developed Intellectual Property

How an intangible asset first appears in your financial records depends entirely on its origin. The accounting for purchased vs. developed intellectual property diverges significantly from the moment of creation or acquisition.

When You Buy IP (Acquired Intangibles)

If you purchase a patent, a customer list, or a software platform, the accounting is straightforward. Acquired intangibles are recorded on the balance sheet at fair market value, which is typically the purchase price. This transaction creates a new asset account on your balance sheet, such as “Patents” or “Acquired Technology.”

This principle also applies when you acquire an entire company. The purchase price is first allocated to all tangible and identifiable intangible assets, like technology, brand names, and customer relationships. Any purchase price left over after this allocation becomes Goodwill. Goodwill represents the premium you paid for things you cannot separately identify, like the team's expertise, operational synergies, or market position. It is a placeholder for the future value you expect to gain from the combined entity.

When You Build IP (Internally Generated Intangibles)

This is where things get more complex for SaaS, biotech, and deeptech startups. The default is to expense all costs related to internal R&D as they are incurred. However, there are important exceptions, particularly for recognizing software development costs.

For US companies following US GAAP, software development costs can be capitalized only after 'technological feasibility' has been established, as defined by ASC 730. This is a specific milestone, usually met once you have a detailed program design or a working model. Costs incurred before this point are R&D and must be expensed. Costs incurred after, such as coding and testing, can be capitalized. In reality, most pre-seed to Series B startups lack the rigorous time-tracking systems to cleanly separate these costs. As a result, they often expense everything for simplicity and to be conservative.

In the UK and other regions following IFRS, the rules are slightly different. IFRS also requires expensing costs in the “research” phase. However, it mandates capitalizing costs during the “development” phase if certain criteria are met. These criteria include demonstrating technical feasibility and having the clear intent and ability to complete and use or sell the asset.

Post-Recognition: The Amortization of Intangibles vs. Ongoing Expenses

Once an asset is on your balance sheet, its journey continues to impact your financials over time. This is another key difference in the accounting for purchased vs. developed intellectual property.

Acquired Assets: The Slow Burn of Amortization

An asset on your balance sheet is expensed over its useful life through a process called amortization. If you buy a patent for $500,000 with a 10-year useful life, you would typically record a $50,000 amortization expense on your P&L each year. This reflects the gradual consumption of the asset’s value.

The result is a smoother expense profile. Instead of a single $500,000 hit to your profit, the cost is spread out. Acquired intangible assets also require periodic impairment testing. You must regularly assess if the asset is still worth its value on the balance sheet. If a competing technology renders your acquired patent worthless, you must write down its value, taking an immediate expense on the P&L.

Internally Generated Assets: The One-Time Expense

For internally generated IP where costs were expensed as incurred, there is no asset on the balance sheet to amortize. The financial impact was fully realized on the P&L in the period the costs were paid. This leads to lower reported profits and EBITDA during heavy R&D phases but simplifies accounting in later years. There is no amortization schedule to manage and no impairment testing required.

To see the P&L and EBITDA impact, consider two $500,000 scenarios. A $500,000 acquired patent with a 10-year life creates a $50,000 amortization expense each year. In contrast, $500,000 of expensed internal R&D creates a $500,000 R&D expense in Year 1 and $0 in subsequent years. Because amortization is added back to calculate EBITDA, the acquired asset does not reduce EBITDA. The expensed R&D, however, reduces Year 1 EBITDA by the full $500,000, making it appear much lower.

The Founder's Bottom Line: How This Impacts EBITDA, Diligence, and Tax

These intangible assets accounting rules have direct, practical consequences for your startup’s valuation, fundraising, and cash flow.

EBITDA, Covenants, and Valuation

As the comparison shows, expensing R&D directly reduces EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), a key metric in valuations. In practice, sophisticated investors perform “EBITDA normalization.” They understand that high R&D spend in a growing tech company temporarily suppresses profitability and will often adjust for it. However, having clean, accurate books that follow the rules builds credibility and streamlines due diligence.

Investor Insight: Reading the R&D Line
Investors scrutinize this line. They do not just look at the total R&D expense; they analyze its efficiency. They want to see a clear connection between R&D spending and progress in product development, user growth, or achieving technical milestones. A high R&D expense without corresponding progress is a red flag, suggesting inefficient spending or a lack of focus. Clear tracking in your accounting system helps you tell this story effectively.

Due Diligence Landmines

Investors and acquirers will dig into your financials. Overlooking scheduled amortization and impairment testing on purchased IP inflates balance sheet values and can derail investor due diligence or violate debt covenants. If an investor discovers that an asset listed at $1M is effectively worthless, it undermines trust in your entire financial reporting. They will want to see that you have a process for managing the full lifecycle of your recorded assets.

R&D Tax Credits

For R&D-heavy startups in the US and UK, R&D tax credits are a vital source of non-dilutive funding. To claim these credits, you must have meticulous records of your qualified research expenditures, primarily salaries and contractor costs. By expensing R&D costs properly and tracking them in dedicated accounts in QuickBooks or Xero, you create the necessary paper trail to support your claim and maximize your cash return from the government.

Practical Takeaways for Founders

As a founder without a full-time CFO, you do not need to be an accounting expert, but you do need to manage this area correctly. Here are the key actions to take:

1. Segregate R&D Costs Now. In your QuickBooks or Xero Chart of Accounts, create specific expense accounts for R&D. Consider sub-accounts for salaries, contractor fees, and software dedicated to research activities. This is the foundation for both accurate reporting and claiming R&D tax credits.
2. Understand Capitalization Thresholds. If you are a software company, discuss the specific criteria for “technological feasibility” under US GAAP or the “development phase” under IFRS with your accountant. Determine if and when you should start capitalizing costs. For most early-stage startups, the answer will be to continue expensing, but it’s a vital question to ask as you scale.
3. Document All Acquired Intangibles. If you buy a patent, customer list, or another business, ensure the purchase agreement clearly itemizes the assets and their values. This documentation is critical for recording them correctly on your balance sheet and setting up the amortization schedule.
4. Implement an Amortization and Impairment Schedule. For any acquired intangibles on your books, work with your accountant to establish a formal amortization schedule. Set an annual calendar reminder to discuss impairment testing to ensure your balance sheet remains accurate. This proactive step prevents major write-downs and diligence issues down the road.

The distinction between building and buying intellectual property has tangible effects on your startup's financial story. Getting it right builds a foundation of trust with investors, maximizes your access to tax incentives, and gives you a clearer view of your company's performance. Continue learning at the hub: Capex, Depreciation, and Intangibles.

Frequently Asked Questions

Q: In simple terms, what is “technological feasibility”?
A: Under US GAAP, technological feasibility is the point where a software project is proven to work. It is typically established after you have a detailed program design or a functional working model. Before this point, costs are R&D expenses. After this point, certain costs like coding and testing can be capitalized.

Q: Why is goodwill considered an intangible asset?
A: Goodwill is the premium paid when acquiring a company over the fair value of its identifiable assets. It represents non-physical assets you cannot separately value, like brand reputation, a talented workforce, or market position. It is recorded on the balance sheet as an intangible asset and tested for impairment.

Q: Can a startup switch from expensing R&D to capitalizing it?
A: Yes, but it requires a change in accounting policy and rigorous tracking. As your startup matures and establishes formal processes to identify when software meets capitalization criteria under GAAP or IFRS, you can begin capitalizing costs. This change should be discussed with your accountant and applied consistently going forward.

Q: Does capitalizing software development costs increase a startup's valuation?
A: Not directly. While capitalizing costs increases reported assets and EBITDA, sophisticated investors understand the underlying economics. They perform "EBITDA normalization" to compare companies on a level playing field. Following the correct accounting rules builds credibility, which indirectly supports a healthy valuation, rather than artificially inflating metrics.