2011.06.23 how to value software in a business

June 2011 Gio: Value SW 1

How to Value Software(and similar products) part 1

Gio WiederholdStanford University and MITRE Corp.

June 2011

Full versions at infolab.stanford.edu/people/gio.html

and why bother: part 2


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

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, . . .


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?



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: satisfy formal external specifications

Startup model: see if it sticks to the wall


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


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


Intangibles

• Product of knowledge by

• Cost of original >> cost of copies

1. Books authors

2. Software programmers

3. Inventions engineers

4. Trademarks advertisers

5. Knowhow managers

6. Customer Loyalty long-term quality


Valuation of intangibles

• PrincipleThe 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. Intangible value per stock market €25.2B 80%

– How much of it is software ?

Intangible/tangible = 4 x


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 Indep

endent of cost


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%


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


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


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

• EffectThe income per unit of code reduces by 1/size


Growth diminishes initial IP

at 1.5 year / version

For constant unit price


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


Sales models

1.Normal curve: simple, no defined start point

2.Erlang: realistic, more complex

both have same parameters: mean and variance


Gestation period →

Eff

ort

→

start 75% 50% 25% done

Development

Testing

35%→

@27.4% →

Lag delays benefits of R&D investments

Effective lag

~37% →

Research

~14% →


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


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


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


Example

Software product

Sells for $500/copy

Market size 200 000

Market penetration 25%

Expected sales 50 000 copies

Expected income $25M


Combining it allfactor 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

unit price $500 500 500 500 500 500 500 500 500 500

Rel.size 1.00 1.67 2.33 3.00 3.67 4.33 5.00 5.67 6.33 7.00

New grth 0.00 0.67 1.33 2.00 2.67 3.33 4.00 4.67 5.33 6.00

replaced 0.00 0.05 0.08 0.12 0.15 0.18 0.22 0.25 0.28 0.32

old left 1.00 0.95 0.92 0.88 0.85 0.82 0.78 0.75 0.72 0.68

Fraction 100% 57% 39% 29% 23% 19% 16% 13% 11% 10%

Annual $K 0 1911 7569 11306 11395 8644 2646 1370 1241 503

Rev, $K 0 956 3785 5652 5698 4322 2646 1370 621 252

SWIP25% 0 239 946 1413 1424 1081 661 343 155 63

Due old 0 136 371 416 320 204 104 45 18 6

Disct 15% 1.00 0.87 0.76 0.66 0.57 0.50 0.43 0.38 0.33 0.28

Contribute 0 118 281 274 189 101 45 17 6 2

Total 1032 ≈ $ 1 million


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.


Alternate 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 (t cost , t income) = 2 years

5. Stop maintenance when cost > income


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 quitReduce income 1/3

each year

Assume designed

for maintenance

typicalCost of maintenance = 1626/(516+1626) = 61% of total


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

«


Knowing 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

SW is only a part of intellectual capital

Labor + Property

includes knowledge used in a businessTypical 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 NDA 10% to 70% of the IP

• Copyrights held 0% to 5% of the IP

• Trademarks 20% to 50% of the IP

IP is the essential component for a modern company to generate income and to grow.

Tang

ible

Wor

k

forc

e

I

P

(



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

Taxes

Intel- . lectual . Capital .

Public

& Private

Invest-ments

Taxes

Common KnowledgeInte-

gration

Tech-nology

Trade-marksIntellectual

Property (IP)

Know-How of workforce

Profits

Profits

Commodity Products

non-routine

High-value

...products

Earnings Flow

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

€


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


Primary Taxhaven CFH

Jurisdiction – country/kanton -- where

• Taxes are low or non-existentfee income only is adequate:

Cayman Islands: 90,000 co’s x $3000 for 55,000 locals.

• Holding companies are easy to set updelegated to legal firms

• Corporations are minimally controlledfew rules, no public records

• No local workforce needed


Semi Taxhavens CFC

Jurisdiction where

• Competent local workforceeasy immigration for educated

• Taxes are territorialProfits from external revenue not taxed

• Incentives are provided for investorsReal estate, employee training, R&D support,

tax forgiveness for some time,

• Supervision of corporations is modestJune 2011 Gio: Value SW 35

Secondary Taxhavens IFC

Jurisdiction where

• Financial interchange is convenientBanking services under contract

• Taxes are strictly territorialProfits from external revenue not taxed

• Little supervision of non-local businessExclusion rules if just an intermediary

• No local workforce expected



Double Irish / Dutch Sandwich

37

CFHUS Parent Company

CFH

Operational CFCIFC

Typical arrangement comprises 3 types

In practice dozens of entities

in many different countries


Interaction among Foreign Entities

1. Controlled Foreign Operations

Operations licensing the IP, routine profit

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


Effect for US, 2005-2010

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.


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


Questions? Arguments?


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 nice rules 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 43Loss due to IP Export V4June 2011 Gio: Value SW 43

Intellectual ResourcesPrivate & Public

Intellectual CapitalRights owned by the business

Intellectual AssetsAvailable for transfer

Intellectual PropertyLegally protectable

Patents

Copyrights

Trade secrets

Trade marks

Contracts covering intellectual capital

Intellectual PropertyLegally protectable

Patents

Copyrights

Trade secrets

Trade marks

Contracts covering intellectual capital

Tangible Property Simile

1. Company USco has built and owns building B

2. Sells B to a financial company in Bermuda REc, but actually

USco has set up that REc as a holding & provides a mortgage

3. Now USco pays REco lease rates for use of B

4. REco pays mortgage & maintenance to keep up B’s value

5. REco profits, pays few taxes, profit is consolidated with USco

Intangible property simplifies hiding of funny deals


B REc(B)


%

100

90

80

70

60

50

40

30

20

10

0

0 1 2 3 4 5 years

VnVn+1 Vn+2

Depreciation

Normal

Erlang

Sales curves used

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. linear 20%/ y. linear 8%/y. linear 12% geometric of investment

Lif

e s

pan

main

ten

an

ce

/o

wn

erh

ipc

ost

rati

o

de

pre

cia

tio

n / y

ear

Lif

e s

pan

years

4

2

7

3

1

8

9

6

5

11

12

10100%

40

0

20

70

30

10

80

90

60

50

Asset Life under maintenance

Costs

→

Centroid of

revenue

time →

Sales lag

Income

Manufacturing & distribution delay

Marketing lag Marketing

←C

osts

Centroid of total development

costs .

~60%→ Research,

Design, Simulation

Integrate &Test

Centroid of pre-sales . marketing costs

Incom

e fr

om

sale

s →

Part of CoGSales

Development lag

$

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

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 ?


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.


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:

VanuatuCayman islands BarbadosIsle of Man

Fees

Controlled ForeignHolding Company

IP I P

Buy-in


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 royaltiesSetting 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


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 55Loss due to IP Export V4June 2011 Gio: Value SW 55

Details 5: Setting up Tax Havens

• Few companies have the smarts themselves

• A few consulting firms are very active, get high fees– Convince USco tax 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


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, etc suffer• 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.



Example from Business Week 1/421 Oct 2010

nearly irrelevant


Example from Business Week 2/4

owns IP

All three are sub-divisions

of the same CF corporation

plus the Dutch sandwich

Ireland

hasterritorial

taxation

The US & UK tax

worldwide



Google only shifted

European income for

collection in the

Netherlands and

allocation to taxhavens.

Other companies have shifted

also IP pertaining to US income to

taxhavens


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 countriesWorld-wide Taxhavens

• Can a corporation or government be happy?

• Should Corporations be treated as Persons?