This document discusses methods for valuing software and similar intangible assets. It begins by explaining that software value is traditionally based on development costs but should also account for future income potential. The document then provides models and examples for calculating software value based on estimated future sales and maintenance income discounted to present value. It stresses that software value depends on assumptions about market size, penetration, pricing, and maintenance over the product lifetime. The goal is to help various stakeholders make informed decisions by understanding a software product's true economic worth.
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2011.06.23 How to Value Software in a Business
1. June 2011
Gio: Value SW
1
How to Value Software(and similar products) part 1
Gio Wiederhold
Stanford University and MITRE Corp.
June 2011
Full versions at infolab.stanford.edu/people/gio.html
and why bother: part 2
2. June 2011
Gio: Value SW
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Current State
•Software producers traditionally care about
–Cost of writing software
–Time to complete products
–Capabilities
•When the value is a concern
–Investors
–Economists
–Lawyers
–Promoters
–Tax advisors
life
inconsistent
3. Why should one care?
•Investors: assess what they will own.
•Investors: know what the result is really worth.
•Designers: make the tight decisions
–if the products is likely valuable, invest more
–if is likely to be worth little, not spend too much
•Computer scientists: know what’s going on
•Tax authorities: Value exports
Other professions have reasonable insights
Architects, hardware manufacturers, . . .
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4. What is the problem?
Create some software and ship it on a CD to a company that sells software.
•Let’s assume they get the exclusive right to the SW.
What should the company pay you?
1.The cost of the CD and mailing it? about $10.-?
2.The cost to write the SW placed on the CD:
5 months at $10,000/month = $50,000.-?
3.Half of their sales that year (~ 50% is cost of selling) :
50% of 10,000 copies at $49.99 = $250,000.-?
4.50% of their $2M lifetime sales = $1,000,000.-?
•Does the creator or seller still have obligations?
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5. June 2011
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Why is value a Concern
•Making decisions about creative tradeoffs
–Elegance versus functionality
–Rapid generation versus maintainability
–Careful specification versus flexibility
•Model of Dealing with customers
Dijkstra model: for self-satisfaction
Engineering model: satisfyformal external specifications
Startup model: see if it sticks to the wall
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Why now
Worrying about economics is a sign of a maturing field
Phases:
1.Get new stuff to work
2.Getting adequate performance
3.Get it to be sufficiently reliable to be useful
4.Get it into routine production
5.Increase capacity
6.Make it safe
7.Make it affordable
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Why me
•Much software is being exported as part of offshoring(offshore outsourcing)
•It is typically property –i.e., protected
•If it is misvalued
1.Loss of income to the creators
2.And loss of taxes to governments
3.Excessive profits kept in tax havens
4.Increased motivation for offshoring
5.Reduced investment for future jobs
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Intangibles
•Product of knowledgeby
•Cost of original >> cost of copies
1.Booksauthors
2.Softwareprogrammers
3.Inventionsengineers
4.Trademarksadvertisers
5.Knowhowmanagers
6.Customer Loyaltylong-term quality
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Valuation of intangibles
•Principle
The sum of all future income
discounted to today (NPV)
Implicitly estimated by share holders
•Example: Value of a company (SAP)
–Largely intangible –like many modern enterprises
1.Market value = share price ×no. of shares €31.5B 100%
2.Bookvalue –sum of all tangible assets €6.3B 20%
Equipment, buildings, cash
3.Intangiblevalue per stock market€25.2B 80%
–How much of it is software ?
Intangible/tangible = 4 x
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Basis for SW value as of today
•Sum of future income
•Sales = price * copy count
•Maintenance fees if service subscription
•Minus sum of future costs
•Cost of goods
•Cost of marketing
•Cost of doing business
•Cost of maintenance
•Discounted to today
•To account for risk
Independent of cost
11. June 2011
Gio: Value SW
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Software has a dynamic life !
Continuously updated
1.Corrective maintenance
bugfixing reduces for good SW
2.Adaptive maintenance
externally mandated
3.Perfective maintenance
satisfy customers' growing
expectations
[IEEE definitions]
Life time
Ratios differ in various settings
100%
80%
60%
40%
20%
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IP sources
•Corrective maintenance
–Feedback through error reporting mechanisms
•Inadequate protection from virus etc.
•Taking care of missed cases
•Complete inadequate tables and dimensions
•Adaptive maintenance
–Staff to monitor externally imposed changes
•Compliance with new standards
•Technological advances
•Perfective maintenance
–Feedback through sales & marketing staff
•Minor features that cannot be charged for
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Effect: SW Size Growth
Rules: Sn+1= 2 to 1.5 ×Sn per year [HennesseyP:90]
Vn+1≤ 1.30% ×Vn[Bernstein:03]
Vn+1= Vn + V1 [Roux:97] [earlier indications]
Deletion of prior code = 5% per year [W:04]
at 1.5 year / version
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Price remember IP =f(income)
•Price stays ≈ fixed over time
like hardware Moore's Law
Because
1.Customers expect to pay same for same functionality
2.Keep new competitors out
3.Enterprise contracts are set at 15% of base price
4.Shrink-wrapped versions can be skipped
•Effect
The income per unit of code reduces by 1/size
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Growth diminishes initial IP
at 1.5 year / version
For constant unit price
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Total income
Total income = price ×volume (year of life)
•Hence must estimate volume, lifetime
Best predictors are Previous comparables
Erlang curve fitting (m=6 to 20, 12 is typical)
and apply common sense limit = Penetration
estimate total possible sales F ×#customers
above F= 50% monopolistic aberration
P
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Sales models
1.Normal curve: simple, no defined start point
2.Erlang: realistic, more complex
both have same parameters: mean and variance
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Gestation period →
Effort →
start
75%
50%
25%
done
Development
Testing
35%→
@27.4% →
Lag delays benefits of R&D investments
Effective lag
~37% →
Research
~14% →
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Software users & IP
Companies that
1.develop & sell software → *
•Basis of IP: income from sales
2.purchase & license software for internal use
•Do not generate IP with software
3.develop software internally for their own use
•Basis of IP: relative SW expense ×all income (Pareto rule)
4.combinations
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Fraction of income for SW*
Income in a software company is used for
•Cost of capital typical
–Dividends and interest≈ 5%
•Routine operations --not requiring IP
–Cost of manufacturing goods sold(COGS) ≈ 5%
–Distribution, administration, management ≈ 40%
•IP Generating Expenses (IGE):
–Research and development, i.e., SW ≈ 25%
–Advertising and marketing≈ 25%
These numbers are available in annual reports or 10Ks
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Discounting to NPV
Standard business procedure
•Net present Value (NPV) of
getting funds 1 year later = F×(1 –discount %)
Standard values are available for many businesses
based on risk (β) of business, typical 15%
Discounting strongly reduces effect of the far future
NPV of $1.-in 9 years at 15% is $0.28
Also means that bad long-term assumptions have less effect
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Example
Software product
Sells for $500/copy
Market size 200 000
Market penetration 25%
Expected sales 50 000 copies
Expected income $25M
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Result of Example
•Selling 50 000 SW units at $500 ≈ $ 1M
not $ 25M
Once its in a spreadsheet, the effect of the many assumptions made can be checked.
When assumptions later prove unwarranted then management can make corrections.
To be wise, don't spend more than ≈ $500 000 to develop the software product.
25. June 2011
Gio: Value SW
25Alternate business model
Consider maintenance and its income
"Service model"
•More assumptions –now include cost
1.Original cost $516 000 (used to estimate 2.)
2.Maintenance cost 15%/year of original cost
3.Maintenance fee 15%/year of original price
4.Lag = Δ(tcost , tincome) = 2 years
5.Stop maintenance when cost > income
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Effect of service model
factor
today
y1
y2
y3
y4
y5
y6
y7
y8
y9
Version
1.0
2.0
3.0
4.0
5.0
6.0
7.0
Org.cost $K
516
Maint.cost
0
77
129
181
232
284
339
387
0
0
Aggregate
0
77
207
387
619
903
1239
1626
not discounted
Disc.(lag)
0
102
171
239
307
376
444
512
0
0
income
0
240
946
1413
1424
1081
661
343
103
21
Net income
0
137
776
1174
1117
705
218
-170
103
211
Contribute
0
119
586
772
639
351
94
-64
32
6
Total
2537
≈ $ 2.5 million but $ 1626 for maintenance
Good time to quit
Reduce income 1/3 each year
Assume designed
for maintenance
typical
Cost of maintenance = 1626/(516+1626)= 61% of total
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Service model
Analysis shows profitability in service model
•To achieve such a beneficial model
1.Management must value maintenance
2.Marketing and sales must provide feedback
3.Education and training must recognize the value of maintenance and maintainability
–Often ignored today
1.Academics don't teach it (3/850 pages [Pressman:01])
2.Companies give maintenance tasks to novices
Experienced programmers should maintain their work
«
28. June 2011
Gio: Value SW
28Knowing what software is worth
•Allows rational design decisions, as
•Limiting development efforts
•Programming investment for maintenance
•Understand limit to Software Life
When cost of maintenance > income
•Allows rational business decisions, as
•Choice of business model
•Where and when to invest
•How to assign programming talent
•Adjustment when assumptions turn out to be wrong
•Improve focus of education in software
•Consider quality, not just quantity in assignments
•Effectiveness of curriculum
29. SW is only a part of intellectual capital
Labor + Property
includes knowledge used in a business
Typical ranges for a creative company
•Total value of a company (~ market value)100%
1.Tangible property (in knowledge-based enterprises) < 20%
2.Workforce–in-place (not property nowadays)~30%
3.Intellectual property (IP)(unique to the company)~50%
•Patents 5% to 20% of the IP
•Software under NDA10% to 70% of the IP
•Copyrights held0% to 5% of the IP
•Trademarks20% to 50% of the IP
IPis the essential component for a modern company to generate income and to grow.
Tang ible
Work force
I P
(
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What happens next?
Outsourcing & Offshoring
1.Moving jobs to jurisdictions that can be exploited for tax avoidance
2.Moving IP to taxhavens
3.Moving revenue to jurisdictions without visibility
A company can live in many places
31. Taxes
Intel-. lectual. Capital .
Public
& Private
Invest- ments
Taxes
Common Knowledge
Inte- gration
Tech- nology
Trade- marks
Intellectual Property (IP)
Know-How of workforce
Profits
Profits
Commodity Products
non-routine
High- value ...products
Earnings Flow
32. Segregation of IP rights from locale
•Tangible value based on cost + margin ≈ price
•Intangible value based on income potential, ≈ cost
Creator
Owner
$
User
€
Creator
Owner
$
User
€
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33. Taxhavens
CFH: Prime taxhaven
no personnel, holds only $ and IP
CFC: Semi taxhaven
operations, personnel, needs IP
CFI: Financial intermediary
no personnel, no long-term $
Are used together to reduce owner’s taxes
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34. Primary Taxhaven CFH
Jurisdiction –country/kanton--where
•Taxes are low or non-existent
fee income only is adequate:
Cayman Islands: 90,000 co’s x $3000 for 55,000 locals.
•Holding companies are easy to set up
delegated to legal firms
•Corporations are minimally controlled
few rules, no public records
•No local workforce needed
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35. Semi Taxhavens CFC
Jurisdiction where
•Competent local workforce
easy immigration for educated
•Taxes are territorial
Profits from external revenue not taxed
•Incentives are provided for investors
Real estate, employee training, R&D support, tax forgiveness for some time,
•Supervision of corporations is modest
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36. Secondary Taxhavens IFC
Jurisdiction where
•Financial interchange is convenient
Banking services under contract
•Taxes are strictly territorial
Profits from external revenue not taxed
•Little supervision of non-local business
Exclusion rules if just an intermediary
•No local workforce expected
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37. June 2011
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Double Irish / Dutch Sandwich
CFH
US Parent Company
CFH
Operational CFC
IFC
Typical arrangement comprises 3 types
In practice dozens of entities
in many different countries
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Interaction among Foreign Entities
1.Controlled Foreign Operations
Operations licensing the IP, routineprofit
2.Taxhaven companies to hold the IP
The IP held there earns most profits
3.Shell companies to allocate of income
Keep income invisible
•Avoids taxation of sales
CFH
CFC
IFC
40. Detail for IP Shifting: Why?
Jobs &IP goes together [Marx], also when Offshoring
IP represents the capital of modern manufacturing
•In order for offshore workers to be productive, the IP they need is offshored as well.
•But rights to IP are segregated
–A holding company (CFH) is established to holds the IP.
–Offshore profits, income above what is needed to operate & pay offshore workers, is credited to the CFH.
The transfer of income is by paying royalties to the CFH.
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41. Summary
IP is poorly understood, but crucial to generating high profits in high-technology
IP can be valued, but is often misvalued
IP is not seen on books, provides opportunities for funny arrangements
IP rights can be segregated to move profits for tax avoidance
Traditional models used by governments fail
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43. Radical Prescription
Do away with Corporate income tax entirely
•Compensate by increased taxes on dividends
–Would encourage investment over paying dividends
•Stop treating a corporation legally as a person
–Now lobbyists can promote nicerules for individuals, that become tax loopholes for corporations
Will now justify corporate objective that the duty of a corporation is to maximize benefits for stockholders
The objectives and morals do differ!
22-Jun-11
43
Loss due to IP Export V4
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45. Intellectual Resources
Private & Public
Intellectual Capital
Rights owned by the business
Intellectual Assets
Available for transfer
Intellectual Property
Legally protectable
Patents
Copyrights
Trade secrets
Trade marks
Contracts covering intellectual capital
46. Tangible Property Simile
1.Company UScohas built and owns building B
2.Sells B to a financial company in Bermuda REc, but actually
UScohas set up that REcas a holding & provides a mortgage
3.Now UScopays REcolease rates for use of B
4.REcopays mortgage & maintenance to keep up B’s value
5.REcoprofits, pays few taxes, profit is consolidated with USco
Intangible property simplifies hiding of funny deals
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B
REc(B)
47. June 2011
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%
100
90
80
70
60
50
40
30
20
10
0
0 1 2 3 4 5 years
Vn
Vn+1
Vn+2
Depreciation
Normal
Erlang
Sales curves used
48. indefinite
PCs cars software intangibles
Typical Life 3years 5 years 12 years 18 years expected .
Maintenance 2%/year 5%/year 15%/year 13.75%/year compounded .
Maintenance costs 6%21%80%most over asset life
Depreciation 33/y. linear20%/ y. linear8%/y. linear12% geometric of investment
Life spanmaintenance /ownerhipcost ratio
depreciation / year
Life span
years
4
2
7
3
1
8
9
6
5
11
12
10
100%
40
0
20
70
30
10
80
90
60
50
Asset Life under maintenance
49. Costs →
Centroid of revenue
time →
Sales lag
Income
Manufacturing& distribution delay
Marketing lag
Marketing
←Costs
Centroid of total development costs .
~60% →
Research,
Design, Simulation
Integrate &Test
Centroid of pre-sales . marketing costs
Income from sales →
Part of CoGSales
Development lag
$
50. Testing
R&D
Lag centroid @
0.33 of period
Lag centroid @
0.42 of period
before done
Av. Effort 50 %
Av. Effort 70%
start
R&D
Testing
start
R&D
Testing
start
Lag centroid @
0.27 of period
Av. Effort 30 %
lim
done
done
done
Growth
limit
Growth
limit
Lag for 3 company situations
51. Accumulating profit in a CFH
•The fraction of profits that can be legitimately transferred to the CFH is the fraction of `Non-routine profits’ equal to the CFH ownership.
Routine profits are those made by a company without IP, typically 5%-10%, but high-tech net profit %s are ~50%
•The IP fraction transferred offshore may just be proportional to the foreign income: Justifiable
•There is no fundamental reason why not all IP cannot be legitimately moved to a tax haven ?
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52. Details 2 “Non Routine-profits”
There is a variety of economists’ approved methods to determine what fraction of profits is due to SW IP.
In general:
1.Start with revenue from sales, say 500,000 copies at $200
2.Subtract cost-of-goods-sold –minimal for SW
3.Subtract other identifiable costs -licenses etc., (none?)
4.Subtract distribution cost if known, or typical % (5-15%)
5.Subtract profit margin for similar goods without IP, say selling open-source software ~5-10%
6.The remainder is due to SW IP and Marketing IP
7.If marketing IP is not in tax haven, split it off (often 50%)
500,000 x $81 = $40.5M of $100M for SW goes to tax haven.
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53. Royalties
Income
Capital
CFC IP consumer
Capital flow with a taxhaven
Foreign taxes
IP license
Tangibles are harder to move than IP
Income
Capital
US taxes
Source IP Creator
CFH
Tax havens:
Vanuatu
Cayman islands Barbados
Isle of Man
Fees
Controlled Foreign
Holding Company
IP
I P
Buy-in
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54. Details 3: Tax avoidance
1.Paying royalties for use of IP is a legitimate expense and deducted from taxable income.
2.There is little or no control on setting of royalties
Setting a correct royalty also requires an IP valuation
Easily set excessively high
3.Royalties are also collected from offshore sites, especially if that reduces taxes too.
•Tax rates in India are similar to the US, Irish rate is still money
•Non-US tax authorities understand IP very poorly
The benefits of globalization are only the jobs, all countries lose out on corporate taxes
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55. Details 4: $ & IP held by CFH grow
•Once the value of the IP transferred Export is paid off, no income from the CFH goes to the Parent company
–Regulations allow payment for IP over multiple years, so that no spikes occur, and tax loss is gradual.
–In formal reports the CFH’s are integrated with the parent company, so that employees nor stockholders know about offshore flows.
•The CFH pays cost of all R&D performed in the Parent and offshore, to assure that the CFH owns the IP.
Parent and offshore employees are unaware of the source of their paycheck
22-Jun-11
55
Loss due to IP Export V4
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56. Details 5: Setting up Tax Havens
•Few companies have the smarts themselves
•A few consulting firms are very active, get high fees
–Convince UScotax VPs that they can reduce taxes
–Formulate and present plans to board of directors
•Members of the board are impressed by saving
•Most board members in high-tech companies are technical
•Discussion and understanding is avoided or minimized
•Risks are glossed over: `It is more likely than not that the IRS will not challenge this transfer … ‘
•Moral issues are completely ignored –not a concern for USco
•Consulting firms operate the mailbox CFH services
•Small companies are at a cost disadvantage
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57. Long term Summary
IP creates profit where it is located, not where it is used
•IP and profits are put into a tax haven by setting up a CFH
•Semi-taxhavens gain jobs, but negligible corporate tax due to sandwich
•Repatriation of $$ from the CFH to the US is avoided.
•Tax avoidance means infrastructure –schools, services, etcsuffer
•IP generating workers (R&D, creative folk) are paid by the CFH.
US and offshore employees are unaware of the source of their paycheck
–The CFH acquires an increasing fraction of the IP
–The CFH is paid an increasing fraction of the income
–The CFH in time can becomes richer than the company.
•It seems best for the company to invest in low-tax countries and create jobs there.
–Job losses in the U.S. increase
•Eventually the CFH can buy the parent company: Inversion.
–Control by stockholders is gone as well
•Few people know what is going on, and those that do, don’t talk.
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58. June 2011
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Example from Business Week 1/421 Oct 2010
nearly irrelevant
59. June 2011
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Example from Business Week 2/4
owns IP
All three are
sub-divisions
of the same
CFcorporation
plus the Dutch sandwich
Ireland
has
territorial
taxation
The US & UK tax worldwide
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Example from Business Week 3/4
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Example from Business Week 4/4
Google only shifted European income for collection in theNetherlandsand allocation to taxhavens.
Other companies have shifted also IP pertaining to US income to taxhavens
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Global philosophical questions
Happiness or contentment
•Personal
More cheap stuff ---a benefit of offshoring
Less employment ---a cost of offshoring
•Global benefits of offshoring --long term
Greater income equality among countries
Similar working conditions within countries
NAFTA or EU -neighboring countries
Friendly countries
World-wide
Taxhavens
•Can a corporation or government be happy?
•Should Corporations be treated as Persons?