The Value of Outsourced Software
overview only
Gio Wiederhold
Stanford University and MITRE Corp.
Rajat Mittal
Amar Gupta
University of Arizona
Erich Neuhold
University of Vienna
February 2007
Contact: Infolab.stanford.edu/people/gio.html
February 2007
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Why analyze SW value
•
•
•
Much software is being exported as part of
offshoring (offshore outsourcing)
It is typically property – i.e., protected
Value should be known
1. Essential for outsourcing business models
2. Essential to asses business risk
•
If it is valued too low
3. Loss of income to the creators
4. And loss of tax income on both sides (my sponsor)
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Offshoring
Outsourcing to Enterprises in Foreign countries
Two aspects:
1. Work migration: jobs are moved to
lower-cost countries
2. Support software etc. is moved to enable
similar productivity in those countries
•
Income is generated by
workers +
(intellectual) capital
[Marx?]
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IP is the Link to the workforce
To be effective a worker has to know what has to be done
• That knowledge consists of
1. The technology, mainly software
o
Documentation, prior versions, quality control
2. T he business methods
o
o
•
How technology in the product is marketed
The flow from buyers to improved products and methods
Companies distinguish themselves by proprietary IP
1.
2.
3.
4.
Patents, sometimes Copyrights
Confidential Documents
Knowledge within its people – trade secrets protected by NDAs
Software b---> new quantitative model, mistly ptotected by trade secret
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Current State of Valuing SW
• Software producers care about
 Cost of writing software
 Time to complete products
 Capabilities
• When the value is a concern




Business users
Economists
Lawyers
Promoters
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life
inconsistent
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Value of intangibles is huge
Implicitly estimated by share holders
Example: Value of a company (SAP)
•
Largely intangible – like many modern enterprises
1.
2.
Market value = share price × no. of shares €31.5B 100%
Bookvalue – sum of all tangible assets
€ 6.3B 20%
Equipment, buildings, cash
3.
Intangible value per stock market
€25.2B
80%
Intangible/tangible = 4 x


How much of that value is owned software ? > 50%
If outsourced: risk of loss of much property!
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Export of (I) Property
• Tangible
value based on cost + margin ≈ price
$
• Intangible
Use
€
value based on income potential, ≈ cost
$
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Where
used
Anywhere
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Use
€
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Software IP can be valued
[CACM Sep.2006]
• Future income can be estimated
 Past history if mature, comparable situations
• SW IP value diminution can be modeled
 Based on ratio of original software/improvements
Unit
Income
 Simple
assumptions
Original
contribution
Maintenance
contribution
Time →
 Model has been validated and is available
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IP flow with fair return
IP
balance
Income
Income
Capital
taxes
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Income
Capital
taxes
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IP flow without or poor return
IP
$
imbalance
Income
Capital
Income
Capital
taxes
taxes ?
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Capital flow with a taxhaven
Source
IP
CFH
Tax havens:
Income
Income
Capital
Vanuatu
Cayman islands
Barbados
Bermuda
Capital
taxes
CFC
IP license
Royalties
Fees
Capital
taxes
Hard to do with a tangible
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Knowing the Worth of Software
• Allows rational design decisions, as
o
o
Directing and allocating development efforts
Understand limit to software IP Life
• Allows rational business decisions, as
o
o
o
o
Choice of business model
Degree and method of outsourcing
Where and when to invest
How to assign programming talent
• Improve focus of education in software
o
o
Consider lifetime quality in assignments
Effectiveness of curriculum
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Backup
• What
• Who
• How
• Joke
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Why an Economic Concern
• Software is the driving force for generating
income in many modern enterprises
 Companies that sell software
or hardware with embedded software
 Companies that sell other stuff on the web
 Companies that sell financial services
o
There are no real, tangible piles of money there
 Companies that rely on their supply-chain prowess
 Multi-nationals that coordinate their operations
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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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Intellectual vs Intangible property
1. Intellectual property refers to creations of the mind:
inventions, literary and artistic works, and symbols, names,
images, and designs used in commerce [WIPO].
a.
b.
Industrial property, which includes inventions (patents), trademarks,
industrial designs, and geographic indications of source;
Copyright, includes literary, artistic works, focusing on presentation;
and software, including transformations of representation.
2. "Workforce in place" has much value
but People cannot be considered property anymore
3. Goodwill everthing else – mainly in
Σ1-3 = Intangible contribution to corporate value
• Tangible property including cash is the rest
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Hypothesis
•
Offshoring of jobs is effective because of concurrent
Intellectual Property (IP) transfer
•
•
Much of that IP is corporate property
Transfer of corporate IP is poorly understood
 IP as property is not well defined, hard to measure
 There are many components to IP, coming from
•
o
open source, R&D, marketing, reputation
as
o
Patents, copyright, trade secret (covered by NDAs)
But can't ignore IP, it is a valuable, significant export
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Types of Foreign Destination Entities
• Independent Foreign Contractors
 IFG may serve multiple customers
o
Share trade secrets with competitors
 Owners need contracts to protect the IP
o
IFG
Hard to monitor and enforce
• Owned, Controlled Foreign Corporations
 CFC provides much more control over IP
CFC
 Ownership often in third-party countries
o
Avoids taxation of sales to other countries
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• Sum of future income
o
o
Sales = price * copy count
Maintenance fees if service subscription
• Minus sum of future costs
o
Cost of goods
Cost of marketing
Cost of doing business
Cost of maintenance
o
To account for risk
o
o
o
• Discounted to today
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Independent of cost
Basis for SW value NPV
19
Effect: SW 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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IP sources after creation
• Corrective maintenance
 Feedback through error reporting mechanisms
o
o
o
Inadequate protection from virus etc.
Taking care of missed cases
Complete inadequate tables and dimensions
• Adaptive maintenance
 Staff to monitor externally imposed changes
o
o
Compliance with new standards
Technological advances
• Perfective maintenance
 Feedback through sales & marketing staff
o
Minor features that cannot be charged for
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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
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Growth diminishes IP
For constant unit price
at 1.5 year / version
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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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Fraction of income for SW*
Income in a software company is used for
• Cost of capital
typical
 Dividends and interest
• Routine operations
≈ 5%
-- not requiring IP
 Distribution, administration, management ≈ 45%
• IP Generating Expenses (IGE)
 Research and development, i.e., SW
 Advertising and marketing
≈ 25%
≈ 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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Doonesbury 1/2
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Doonsbury 2/2
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