Software valuation

Software valuation

Nowadays software systems support a wide range of processes in business organizations.

This massive use of software systems often requires considerable investments and costs.

Many investments in software are known to be troublesome. Often, they do not deliver software according to expectations and consequently do not realize expected benefits. Furthermore, software is an intangible product, and its value cannot be observed in a straightforward manner. Therefore, methods that can estimate the economic value of software systems may help IT executives better understand the value of IT investments. Take as an example the current accounting practice of capitalizing software assets.

Financial considerations

  • Creating custom software requires very specific skills, which may not be available in-house, so bringing in personnel to design, build and maintain such as a system is a significant financial decision for your business.

  • Employment of a full team of IT professionals becomes a fixed cost that must be factored into your budget, meaning the channeling of revenue for its upkeep, while outsourcing can relieve this burden.

  • There are also financial benefits to developing software as a capital investment as opposed to an operational expense.

  • The majority of software costs are incurred during the period after the developed software is accepted. These costs are primarily due to software maintenance, which here refers both to the activities to preserve the software's existing functionality and performance, and activities to increase its functionality and improve its performance throughout the life-cycle.

  • Successful software products have many versions, long lifetimes, and corresponding high maintenance cost ratios over their lifetime. Software lifetimes before complete product substitution is needed are 10 to 15 years, and are likely to increase.

  • Version frequency is determined by the rate of changes needed and the tolerance of users to dealing with upgrades.

  • Maintenance costs of such enterprise software amount to 60% to 90% of total costs. So, for example, if the company has monthly maintenance contracts of $100,000 times 12 months = $1.2 million X 2 = $2.4 million as a baseline company value component.

  • If the income per unit of software sold is constant, then any income increases are due to growth of unit sales. For software being sold, sales can increase until its market is substantially saturated. Let's use an example where they had 4 years remaining on a services contract and the last 3 years were $200,000 per year in revenue with approximately 50% gross margin. We would take the final three years of $100,000 annual gross margin and present value it at a 5% discount rate resulting in $265,616. This would be added to the earlier 2X recurring year 1 revenue from above. Again, this financial analysis is to establish a baseline, before we pile on the strategic value components.

Valuation Methods

There are many generally recognized ways to value a software business, although not all will be appropriate for your particular company, and a weighting of the various selected methods should be used. Each of these methods is briefly described below.

1. Sales Multiple
A quick and easy way to estimate the value of a software company is by applying a multiple to your annual revenue.

For companies with significant direct costs of sale such as purchased hardware, applying the multiple to gross profit is more appropriate. There is some latitude in valuations based upon the growth of the company, using trailing (last 12 months), actual (fiscal year projections) and forecasted (next twelve months or fiscal year) revenue. The sales multiple method is not often used when revenues are highly volatile or declining. Sales of software companies typically occur in the 1 to 2 times revenue range, although sales at higher and lower multiples do occur.

2. Book Value Method
Book value is the amount of assets on the books in excess of the liabilities on the books. Book value for a software company may be influenced heavily by the company’s policy with respect to capitalizing software development costs. Book value is often multiplied by a multiple of 2 or 3, then used as a sanity check against other methods.
There is a formula can be adjusted for unusual swings in sales or earnings. A rapidly growing company may use next year's numbers with a present value discount. Since this is the "public" price, you need to adjust by 20% - 50% downward to reflect the normal discount for stock of privately held companies.

  • This formula developed by “David Dunn-Rankin”:
[(net profit margin / 5%) + (growth rate / 10%)] divided by 2 = multiple of revenue valuation

3. Price Earnings Ratio
4.Internal Rate of Return Method
5. Free Cash Flow Model
6.Replacement Value
7.Liquidition /Salvage Value
8.Recent Internal Transaction Price

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