A transaction involving software code is tricky because the most conventional valuation models don’t yield a satisfying result.

Ultimately, software value is driven by the answer to four questions:

  1. How will the software be used? Software may be intended to make the user’s internal operations work more smoothly, thus generating efficiency benefits. Or, the software might help the owner lower its organizational risk profile? Or, the software might be intended to be monetized with external customers.

  2. Is the software patented? If the software is patented, this can preclude simply reverse engineering the code, or at least can make it more difficult as additional effort is required to ensure that the new code is not infringing on prior art.

  3. How much would it cost to re-create the software, either by reverse engineering or simply writing independent code to replicate the software’s functionality? In a vacuum, a buyer would not pay meaningfully more to buy software code than it would cost to re-create it in some way, provided that patent protection didn’t make that exercise prohibitive. However, we don’t do business in a vacuum, which means that the third and final factor may become important.

  4. What is the opportunity cost of the time involved in replicating the software? While the buyer is figuring out how to replicate the software, they aren’t benefiting from the value of the finished product. They are losing out on efficiency. Further, whereas buying the software yields guaranteed availability, there is always the risk that another party will not be able to replicate the software’s desired functionality and features.

Depending on the answers to these questions, one or more of the following models might produce the more reliable value result and provide the most strategic insight.

Cost of reproduction - determining sofware value as a function of the cost of a market participant to re-create it, if possible. The Constructive Cost Model (COCOMO) is useful and robust for this purpose.

Market comparables - there are transactions involving the sale of software, if you know where to look and how to identify them.

Public companies - there are companies that are effectively publicly traded software code. A software valuation expert knows how to identify these companies and use their market capitalizations to indicate those companies’ respective software valuations.

Relief from royalty model - a cousin of the discounted cash flow method that measures value as a function of the royalties that the owner doesn’t have to pay someone else for use of the software, discounted for risk of the expected profits, and the passage of time.

Excess earnings model - another cousin of the discounted cash flow method that measures value as a function of the cash flow the software code might generate, adjusted for the interaction of value contributed by other assets, such as trademarks or labor.

Real options - framing software as an option to exclusively use and exploit an IP over a period of time.

With/without - determining software value by calculating the difference in the value of a company with ownership of the software and without it.

Software valuation is complicated, but you don’t have to go it alone. If you have a question about the potential value of a software asset or terms of a potential deal, contact us at High Score Strategies to set up a consultation.


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