Decoding the Value of Software
Although it may consist of thousands of lines of coded instructions, and be small enough to burn onto a single CD, the software owned by a business might be its most valuable asset, its lifeblood, and a key driver of the value of the organization. Many businesses owe their competitive advantage to the unique software they have developed internally (internal use or operational software) notably in the areas of data processing services, product design/engineering, and manufacturing control. Other businesses exist solely to create software for resale or licensing (software developed for commercialization).
Why Value Software
Valuations of software are typically required as part of the purchase and sale of business assets. The purchase price must be allocated to the net assets acquired, and for the purchaser, there is a tax benefit to recognizing the full fair market value of the software, as it is accorded a high rate of Capital Cost Allowance (CCA).
Other reasons for valuing software include litigation (shareholder disputes, disputes over ownership between employees and shareholders, copyright infringement); financing reasons (e.g. assessing value for collateral or a sale leaseback arrangement), cross border transfer pricing, and tax planning.
New Financial Reporting Standards
New accounting standards were introduced in
Software Value Drivers
Evaluating the software's value drivers is a critical stage in the valuation process. Some of the key determinants of market value are:
- Technology–given the rapid rate of advancement in software, assessments of the innovation level, ease of modification and updating, remaining useful life or obsolescence, and replacement cost are critical. For example, is the software written in an up-to-date, widely used language? Or, is the software less useful than its ideal replacement? Moreover, the valuation must consider the extent to which the intellectual property in the software is legally protected. These considerations must also be tempered with the fact that effectively functioning software (i.e. that which clearly meets the business purpose) does not necessarily become less valuable merely because it isn't written in the latest programming language.
- Richness of functionality–software that is easy to use, maintainable, efficient and widely applicable will command a higher value than a complicated, or cumbersome product. For example, is the software compatible with the most recent version of Windows or other platforms?
- Adaptability–software that is robust and can be easily scaled to handle broader business structures, and be readily interfaced with other software applications will inherently command higher valuations.
- Documentation–the valuator looks at the extent of and quality of the documentation, aimed at both programmers and users. For example, is there a sufficient help utility, or adequate user and developer manuals?
Drivers unique to software produced for commercialization include the strength of the market or demand for the software, the intensity of competition and level of technology or functionality of competing software, the installed base, reputation of the vendor in the user community, and quality of user support service, among others.
The methods for valuing software are the cost approach, the market approach, and the income approach. Because each emphasizes different value drivers, in some cases, it may be appropriate to utilize more than one approach in forming a conclusion.
Under the cost approach, based on the principle of substitution, value is based on the estimated cost of replacing the software with one of similar functionality. There are two types of cost: reproduction cost, which measures value as the cost to recreate an exact copy of the software; and replacement cost, which measures value as the cost to recreate the functionality of the software. The cost approach is typically used in valuing internal use software.
Trended Historical Cost Method
Under the trended historical cost method, actual historical development costs such as programmer personnel costs, are quantified (including allocations of costs of items such as payroll taxes, overhead, and a profit element, and excluding time spent by programmers on maintenance and other tasks not related to development) and then time adjusted or trended to the valuation date by reference to an inflation index. The challenge in applying this reproduction cost method is that in many cases, historical records of development costs are unavailable, or may be co-mingled with operations and maintenance costs.
Software Development Cost Models
Sophisticated models, created by software developers to estimate production time and costs are useful tools for valuators in determining development cost and in assessing program complexity. The main variable for these cost estimation models is the measure of the program's size or functionality, which is often measured as the lines of code in the software, or the number of "function points", a standard measure of complexity used by software developers. The COCOMO II model (COnstructive COst MOdel version II) measures development effort based on program size, which in turn is measured by the number of lines of code. Program complexity is then determined through rigorous consideration of a number of factors and development attributes including various product attributes, platform attributes, personnel attributes, and project attributes.
Cost is also estimated by reference to the cost to reproduce the software's function points. Function points measure the size of a program's functionality from an outside user's point of view i.e. the amount of functionality delivered to the user by the program.
Once the number of function points is determined, the cost to reproduce the function points is estimated, for example, by reference to the delivery rates (hours per function point) achieved on actual comparable development projects contained in databases of actual software development projects such as that of the International Software Benchmarking Standards Group, which contains development data on over 1,200 projects representing over 70 programming languages.
Both of the models described above provide an estimate of the number of person hours required to write the code. The software valuator estimates development cost by multiplying the number of development hours per the model, by a cost per person hour, which may include base salary, benefits, payroll taxes, and an overhead allocation.
Under the market approach, value is determined by comparison to transactions involving similar software packages, and subject to adjustments for differences noted. The difficulty in applying this approach relates to the scarcity of reasonably comparable transactions, particularly when the subject matter is internal use software that has been custom built to unique specifications. More data is available on transactions for the shares of software development companies as opposed to the software itself.
Income approaches measure software value by reference to future earnings, cash flows or cost savings.
Under the discounted cash flow approach, the value of software is determined as the present value of projected future net cash flows (related to revenues less expenses). The cash flows are only projected for the expected remaining life of the software. The valuator must determine an appropriate discount rate reflecting the risk of attaining the projected results, as well as general economic, product and industry specific risks.
Under what is known as the relief from royalty method, the software is valued based on the present value of the costs that would be incurred if the software had to be licensed from an arm's length party. The notional license rates are estimated based on published license rates for similar software, published in intellectual property databases and other sources.
Under any of the above noted approaches, decoding the value of the program is the product of a great degree of valuator subjectivity and understanding of the software and the software industry. Irrespective of the valuation methodology or technique employed, valuators should be prepared to support:
- The valuation methodology or technique selected–that it is reasonable and supportable in the circumstances.
- The assumptions which underlie the technique–that they are reasonable and supportable (i.e. capable of being corroborated by reference to industry or market data).
- The data used as inputs into the valuation models–that it is accurate, complete and capable of independent verification or corroboration, as appropriate.
This article was produced by members of Deloitte’s Valuation Services practice. Working with both public and private companies, Deloitte specializes in the identification and valuation of intangible assets and the valuation of business entities. Deloitte provides specific experience with respect to goodwill impairment and purchase price allocations across a broad range of industries. Our team can also be engaged to provide fairness opinions and formal valuations. We also provide valuations of assets and business interests for taxation purposes, shareholder disputes and matrimonial dissolution.