How to Value Software
(and similar products) part 1
and why bother: part 2
Gio Wiederhold
Stanford University and MITRE Corp.
June 2011
Full versions at
infolab.stanford.edu/people/gio.html
June 2011
Gio: Value SW
1
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
June 2011
life
inconsistent
Gio: Value SW
2
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, . . .
June 2011
Gio: Value SW
3
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?
June 2011
Gio: Value SW
4
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
June 2011
Gio: Value SW
5
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
June 2011
Gio: Value SW
6
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.
2.
3.
4.
5.
June 2011
Loss of income to the creators
And loss of taxes
to governments
Excessive profits
kept in tax havens
Increased motivation for offshoring
Reduced investment for future jobs
Gio: Value SW
7
Intangibles
•
•
Product of knowledge
Cost of original >> cost of copies
1.
2.
3.
4.
5.
6.
June 2011
Books
Software
Inventions
Trademarks
Knowhow
Customer Loyalty
Gio: Value SW
by
authors
programmers
engineers
advertisers
managers
long-term quality
8
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
2. Bookvalue – sum of all tangible assets
€ 6.3B
100%
20%
Equipment, buildings, cash
3. Intangible value per stock market
€25.2B
80%
Intangible/tangible = 4 x
–
June 2011
How much of it is software ?
Gio: Value SW
9
• 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
June 2011
Gio: Value SW
Independent of cost
Basis for SW value as of today
10
Software has a dynamic life !
Continuously updated
1. Corrective maintenance
bugfixing reduces for good SW
2. Adaptive maintenance
Life time
100%
80%
60%
externally mandated
3. Perfective maintenance
satisfy customers' growing
expectations
20%
Ratios differ in various settings
[IEEE definitions]
June 2011
40%
Gio: Value SW
11
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
June 2011
Gio: Value SW
12
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
June 2011
Gio: Value SW
13
Price remember IP =f(income)
•
Price stays ≈ fixed over time
like hardware Moore's Law
Because
1.
2.
3.
4.
•
Customers expect to pay same for same functionality
Keep new competitors out
Enterprise contracts are set at 15% of base price
Shrink-wrapped versions can be skipped
Effect
The income per unit of code reduces by 1/size
June 2011
Gio: Value SW
14
Growth diminishes initial IP
For constant unit price
at 1.5 year / version
June 2011
Gio: Value SW
15
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
June 2011
Gio: Value SW
16
Sales models
1. Normal curve: simple, no defined start point
2. Erlang: realistic, more complex
both have same parameters: mean and variance
June 2011
Gio: Value SW
17
Lag delays benefits of R&D investments
Effective lag
Effort →
~37% →
@27.4%
→
~14% →
Testing
Development
Research
35%→
start
June 2011
75%
50%
Gestation period →
Gio: Value SW
25%
done
18
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
June 2011
Gio: Value SW
19
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
– Advertising and marketing
≈ 25%
≈ 25%
These numbers are available in annual reports or 10Ks
June 2011
Gio: Value SW
20
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
June 2011
Gio: Value SW
21
Example
Software product
 Sells for $500/copy
 Market size 200 000
 Market penetration 25%
 Expected sales 50 000 copies
 Expected income $25M
June 2011
Gio: Value SW
22
Combining it all
factor
Version
today
y1
1.0
y2
2.0
y3
y4
3.0
500
y5
4.0
unit price
$500
500
500
500
Rel.size
1.00
1.67
2.33
3.00
3.67
New grth
0.00
0.67
1.33
2.00
replaced
0.00
0.05
0.08
old left
1.00
0.95
Fraction
100%
57%
y6
y7
5.0
500
y8
y9
6.0
7.0
500
500
500
500
4.33
5.00
5.67
6.33
7.00
2.67
3.33
4.00
4.67
5.33
6.00
0.12
0.15
0.18
0.22
0.25
0.28
0.32
0.92
0.88
0.85
0.82
0.78
0.75
0.72
0.68
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
SWIP 25%
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
Contribute
0
Total
June 2011
0.87
118
0.76
281
0.66
274
0.57
189
0.50
101
0.43
45
0.38
17
0.33
6
0.28
2
1 032 ≈ $ 1 million
Gio: Value SW
23
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.
June 2011
Gio: Value SW
24
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
June 2011
Gio: Value SW
25
Effect of service model
factor
today
Version
1.0
Org.cost $K
516
Maint.cost
y1
y2
y3
2.0
y4
3.0
y5
4.0
y6
y7
5.0
y8
6.0
y9
7.0
0
77
129
181
232
284
339
387
0
77
207
387
619
903
1239
1626
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
-64
32
6
Aggregate
Total
351
2 537 ≈ $ 2.5 million
Assume designed
for maintenance
94
0
not discounted
but $ 1626 for maintenance
Good time to quit
Cost of maintenance = 1626/(516+1626) = 61% of total
June 2011
0
Gio: Value SW
Reduce income 1/3
each year
typical
26
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
June 2011
Gio: Value SW
27
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
June 2011
Gio: Value SW
28
(
SW is only a part of intellectual capital
Labor + Property
includes knowledge used in a business
I
P
Typical ranges for a creative company
• Total value of a company (~ market value)
1.
2.
3.
100%
Tangible property (in knowledge-based enterprises)
< 20%
Workforce–in-place (not property nowadays) ~30%
Intellectual property (IP) (unique to the company)
~50%
•
•
•
•
Patents
Software under NDA
Copyrights held
Trademarks
5% to 20% of the IP
10% to 70% of the IP
0% to 5% of the IP
20% to 50% of the IP
IP is the essential component for a modern
company to generate income and to grow.
June 2011
Gio: Value SW
Wor
k
forc
e
Tang
ible
29
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
June 2011
Gio: Value SW
30
Earnings Flow
Taxes
Profits
Public
&
Private
Investments
Commodity
Products
Common Knowledge
InteKnow-How gration HighIntel- of. workforce
Tradevalue
lectual
.
marks ...products
Intellectual
Capital .
Property (IP) Technology
Taxes
Profits
non-routine
Segregation of IP rights from locale
• Tangible
value based on cost + margin ≈ price
Creator
€
$
• Intangible
value based on income potential, ≈ cost
Creator
User
Owner
€
$
June 2011
User
Owner
Gio: Value SW
32
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
June 2011
Gio: Value SW
33
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
June 2011
Gio: Value SW
34
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
June 2011
Gio: Value SW
35
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
June 2011
Gio: Value SW
36
Double Irish / Dutch Sandwich
Typical arrangement comprises 3 types
CFH
US Parent Company
CFH
IFC
Operational CFC
In practice dozens of entities
in many different countries
June 2011
Gio: Value SW
37
Interaction among Foreign Entities
1. Controlled Foreign Operations
CFC
 Operations licensing the IP, routine profit
2. Taxhaven companies to hold the IP
 The IP held there earns most profits
CFH
3. Shell companies to allocate of income
Keep income invisible
• Avoids taxation of sales
IFC
June 2011
Gio: Value SW
38
Effect for US, 2005-2010
June 2011
Gio: Value SW
39
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.
June 2011
Gio: Value SW
40
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
June 2011
Gio: Value SW
41
Questions? Arguments?
June 2011
Gio: Value SW
42
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
June 2011
Loss Gio:
due toValue
IP Export
SWV4
43 43
June 2011
Gio: Value SW
44
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
Tangible Property Simile
1.
2.
Company USco has built and owns building B
Sells B to a financial company in Bermuda REc, but actually
B
REc(B)
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
June 2011
Gio: Value SW
46
Sales curves used
%
Depreciation
Normal
Erlang
100
90
80
70
Vn
60
Vn+1
Vn+2
50
40
30
20
10
0
0
June 2011
1
2
3
Gio: Value SW
4
5
years 
47
Asset Life under maintenance
years
12
Life span
9
90
8
80
7
70
6
60
5
50
40
4
3
30
2
20
1
10
PCs
cars
software
Typical Life
3years
5 years
12 years
Maintenance 2%/year
5%/year
15%/year
Maintenance costs 6%
21%
80%
Depreciation 33/y. linear 20%/ y. linear
8%/y. linear
intangibles
depreciation / year
100%
10
Life span maintenance /ownerhip
cost ratio
indefinite
11
0
18 years
expected
.
13.75%/year compounded .
most
over asset life
12% geometric of investment
Income
Development lag
Centroid of total
development
costs .
Research,
Design, Simulation
←
Centroid
of
revenue
Integrate
&Test
Sales lag
~60%
→
Marketing lag
Costs
Costs →
$
Marketing
Part of
CoGSales
Centroid of pre-sales
. marketing costs
time →
Income from sales →
Manufacturing &
distribution delay
Lag for 3 company situations
Growth
limit
Av. Effort 30 %
Lag centroid @
0.27 of period
Testing
R&D
start
done
Av. Effort 50 %
Testing
Lag centroid @
0.33 of period
R&D
done
start
Av. Effort 70%
Lag centroid @
0.42 of period
before done
lim
Testing
Growth
limit
start
R&D
done
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 ?
June 2011
Gio: Value SW
51
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.
2.
3.
4.
5.
Start with revenue from sales, say 500,000 copies at $200
Subtract cost-of-goods-sold – minimal for SW
Subtract other identifiable costs - licenses etc., (none?)
Subtract distribution cost if known, or typical % (5-15%)
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.
June 2011
Gio: Value SW
52
Capital flow with a taxhaven
Controlled Foreign
Holding Company
Source
IP Creator
Income
Capital
CFH
I PIP
IP license
Buy-in
Tax havens:
Vanuatu
Cayman islands
Barbados
Isle of Man
US
Fees
taxes
Tangibles are harder to move than IP
June 2011
CFC
IP consumer
Gio: Value SW
Income
Royalties
Capital
Foreign
taxes
53
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
June 2011
Gio: Value SW
54
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
June 2011
Loss due to IP Export V4
55
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
June 2011
Gio: Value SW
56
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.
June 2011
Gio: Value SW
57
Example from Business Week 1/4
21 Oct 2010
nearly irrelevant
June 2011
Gio: Value SW
58
Example from Business Week
2/4
plus the Dutch sandwich
Ireland
has
territorial
taxation
The US
& UK
tax
All three are
sub-divisions
of the same
CF corporation
June 2011
owns IP
worldwide
Gio: Value SW
59
Example from Business Week 3/4
June 2011
Gio: Value SW
60
Example from Business Week 4/4
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
June 2011
Gio: Value SW
61
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?
June 2011
Gio: Value SW
62