Valuation of Software Intangible Assets

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1 Valuation of Software Intangible Assets Eric A. Thornton Senior Associate (703) ASA International Conference San Diego, California August 28, 2002 San Francisco, California Portland, Oregon Chicago, Illinois New York, New York Washington, D.C. Atlanta, Georgia

2 Presentation Outline Description of of data processing intangible assets Reasons to to value computer software Types of of computer software Typical valuation approaches Remaining useful life Special considerations Illustrative example

3 Data Processing Intangible Assets Computer software For For sale sale or or license (product software) For For internal use use (operational software) Automated databases Intellectual Property Copyright protection for for software and and databases Copyright protection for for multimedia works Protection of of mask works under the the Semiconductor Chip Protection Act Act of of 1984 Patent and and trade secret protection for for software Trademarks and and trade names (packaged software, domain name)

4 Reasons to Value Computer Software Transactional reasons establishing a purchase price, royalty rate, rate, transfer price Financing reasons assessing collateral value, value as as part part of of a solvency opinion Taxation reasons purchase price amortization, charitable contribution, assessment value for for ad ad valorem property taxation Bankruptcy reasons assessing solvency of of the the software owner/user, identification of of licensing/spin-off opportunities Controversy reasons quantifying copyright infringement/breach of of contract damages Management information reasons identifying, quantifying, and and managing the the value of of the the intellectual property

5 Types of Software System Software Operating systems: Windows Languages: COBOL, C++ Utilities: Anti-virus, backup Business Operation Applications Accounting: Payroll, general ledger Manufacturing Control: Bill of of materials, inventory control Engineering: Computer-aided design

6 Types of Software (cont.) Office Automation Word Processing: WordPerfect Spreadsheet: Excel Groupware: Lotus Notes Educational/Recreational Reference: Encyclopedia, atlas Tutorials: Foreign language, math Games: Card/board games, simulators

7 Software Valuation Approaches/Methods Cost Cost Approach Reproduction cost cost vs. vs. replacement cost cost Trended historical cost cost method Software engineering model method Income Approach Income or or cost cost savings Discounted cash cash flow flow method Relief from from royalty method Market Approach Availability & comparability issues Market transaction method Market replacement cost cost method

8 Software Engineering Models COCOMO Constructive Cost Cost Model Barry W. W. Boehm, Software Engineering Economics, COCOMO II II 1997, re-calibrated annually, Center for for Software Engineering, University of of Southern California SLIM Software Lifecycle Management Lawrence H. H. Putnam, Quantitative Software Management, Inc. Inc. (QSM) Computerized model, for for license Checkpoint/KnowledgePLAN Capers Jones, Software Productivity Research, Inc. Inc. (SPR) Computerized models, for for license

9 Typical SW Engineering Model Inputs Metrics Lines of of code code Function points (IFPUG, Mk Mk II) II) Feature points (SPR) Platform/Environment Hardware, operating system Language, tools, utilities Development practices Product Type Type of of application Complexity, required reliability Lifecycle (debugging, documentation) Personnel Capability and and experience Fully-loaded cost cost

10 Income Approach Discounted Cash Cash Flow Flow Method Need identifiable income stream Usually used used for for product software or or databases that that are are sold sold or or licensed Project income, expenses (excluding amortization/depreciation), and and capital expenditures over over remaining economic life life (may (may differ from from tax tax life) life) Include capital charge when additional assets are are used used to to produce the the revenues Discount to to a present value Relief from from Royalty Method Similar to to DCF DCF but but project cost cost savings to to the the owner, who who would otherwise have have to to pay pay royalties on on revenues earned from from the the asset asset Empirical analysis of of market-derived royalty rates rates for for comparable assets

11 Market Approach Market Transaction Method Arm s-length market transaction data data Typically expressed as as dollars per per line line of of code code or or dollars per per function point point Apply to to subject software lines lines of of code code or or function points to to estimate value Adjust for for material differences between comparable and and subject software Due Due to to lack lack of of data data available, often often used used only only as as reasonableness check Market Replacement Cost Cost Method Contemplates replacement cost cost of of the the software in in the the open open market Cost Cost of of comparable commercial off-the-shelf software packages Request hypothetical proposals to to develop comparable software Consider the the value of of proprietary rights

12 Obsolescence When an an intangible asset is is less useful than its its ideal replacement, its its value should be be adjusted to to reflect loss of of economic value due to: to: Functional obsolescence: impairment of of its its functional utility according to to current market standards Technological obsolescence: inefficient or or outdated programming language or or hardware Economic obsolescence: market conditions, competitors Physical deterioration: not not generally applicable to to data processing intangibles

13 Remaining Useful Life Analysis Income approach to to estimate the the projection period Cost Cost approach to to estimate the the amount of of obsolescence, if if any any Market approach to to select, reject, or or make adjustments to to comparable/guideline transactional data data Factors affecting expected remaining useful life life of of data data processing intangible assets: Legal determinants Contractual determinants Functional determinants Technological determinants Economic determinants Analytical determinants

14 Typical Remaining Life Analysis Method Theory developed at at Iowa State University in in the the early 1900s Estimate historical attrition rate rate Develop survivor curves based on on historical attrition rates Match subject survivor curves to to Iowa (or (or other) curves, using least squares method Resulting curve and and average life life are are used to to predict future mortality Similar to to actuarial analysis performed by by insurance companies to to estimate human life life spans For For data data processing intangibles: Data are are not not often available for for this this type type of of analysis Could examine retirement of of lines of of code (rewritten or or replaced), objects, modules, programs, or or subsystems

15 Special Considerations Ownership Source code code for for software packages is is frequently sold/licensed to to companies that that modify the the programs Do Do not not include lines lines of of code code not not owned in in software engineering models Obsolete and and Duplicate Code Remove obsolete code code from from analysis Do Do not not count multiple copies/versions of of same same program (adjust for for cloning ) Software Development Life Life Cycle Consider which phases of of the the life life cycle have have been been completed and and which are are included in in the the model you you are are using Software Metric Counting Conventions Use Use counting conventions consistent with with the the engineering model you you use use

16 Illustrative Example COCOMO Inputs Delivered Source Instructions generally, source program lines of of code excluding comments Development Mode Organic (e.g., business models) Semidetached (e.g., inventory) Embedded (e.g., avionics) Cost Drivers Product attributes Computer attributes Personnel attributes Project attributes

17 COCOMO Effort Equations Organic: Semidetached: Embedded: MM = 3.2 (KDSI) EAF MM = 3.0 (KDSI) EAF MM = 2.8 (KDSI) EAF Where: MM = Man-months KDSI = Thousands of of delivered source instructions EAF = Effort adjustment factor (product of of the the cost driver effort multipliers)

18 COCOMO Cost Driver Examples Programming Language Experience: Rating Description Multiplier Very low < 1 month 1.14 Low 4 months 1.07 Nominal 1 year 1.00 High 3 years 0.95 Required Software Reliability: Rating Description Multiplier Very low Slight inconvenience 0.75 Low Low, easily recoverable losses 0.88 Nominal Moderate, recoverable losses 1.00 High High financial loss 1.15 Very high Risk to human life 1.40

19 COCOMO Cost to Develop MM MM Application DSI Organic Semi. Accts payable 29, Accts receivable 35, Bank Rec. Fixed assets 23, General ledger 32, Totals 121, Documentation Adj. (9%) (3) (13) Total man-months 155 Cost per man-month $8,750 Cost to develop $1,356,250 EAF = 0.32 $60,000 average annual salary 75% benefits and overhead

20 SLIM Inputs Effective source lines of of code Application type(s): business, scientific, telecommunications, system software, etc Customization of of the the life cycle 4 phases: Feas, FC, MB, Maint milestones Options: reliability, accounting, and documentation Productivity adjustments: Tools/methods, technical difficulty, personnel, reuse Constraints Maximum time, effort, cost, peak staff Minimum peak staff, mean time to to defect

21 Synthesis of SLIM and COCOMO Cost Approach Values Application PM SLIM MM COCOMO Accts payable Accts receivable Fixed assets General ledger Totals Documentation adj. (14.56) (16) Cost per PM/MM $ 8,750 $ 8,750 Cost to develop $1,288,175 $1,356,250 Indicated Value Using Equal Weighting: $1,322,213 $1,320,000 (rounded)

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