What is Software Worth ?

1. What is Software Worth ? Gio Wiederhold Stanford University and MITRE Corp. October 2004, revised Dec.2004 www-db.stanford.edu/people/gio.html Gio: Worth

2. create life use assess its value: inconsistently subjectively naively badly Current State • Software producers traditionally care about • Cost of writing high-quality code • Time to complete products • Function & capabilities • When the value is a concern • Business people • Economists • Lawyers • Promoters Gio: Worth

3. Why a Concern • Making decisions about creative tradeoffs • Elegance versus functionality • Rapid generation versus maintainability • Careful specification versus flexibility • Dealing with customers Dijkstra model: for self-satisfaction Engineering model: formal process driven Startup model: see if it sticks to the wall • Gain respect: know what you are doing Gio: Worth

4. Why me • Much software is being exported as part of offshoring (offshore outsourcing) • It is typically property – i.e., protected • If it is not valued correctly – i.e., too low • Loss of income to the creators in the USA • And loss of taxes to theUS treasury • Excessive profits kept external to theUSA • Increased motivation for external investment Gio: Worth

5. Ever Even Less Tangible Intangibles • Product of knowledge by • Cost of original >> cost of copies • Books authors • Software programmers • Inventions engineers • Trademarks advertisers • Knowhow managers • Customer Loyalty long-term quality Gio: Worth

6. Valuation of intangibles • Principle The sum of all future income discounted to today (NPV) • Example Value of a well-known company (SAP) • Largely intangible – like many modern enterprises • Bookvalue – sum of all tangible assets [10K]€6.3B 20% • Market value = share price × no. of shares €31.5B 100% • Difference:value of SAP’s Intangibles€25.2B 80% • How much of it is software ? • No numbers given, although it’s the majority of its property. We have just the stockholders’ guess. Gio: Worth

7. 80% 60% 40% 20% Life time Software is slithery ! Continuously updated • Corrective maintenance bugfixing reduces for good SW • Adaptive maintenance externally mandated • Perfective maintenance satisfy customers' growing expectations 100% Ratios differ in various settings Gio: Worth

8. IP sources for • Corrective maintenance • Feedback through error reporting mechanisms • Inadequate protection • 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 Gio: Worth

9. R R and W Deletion of prior code = 5% per year [W:04] at 1.5 year / version Effect: SW Growth Rules: Sn+1 = 2 to 1.5 × Sn per year [HennessyP:90] Vn+1 ≤ 1.30% × Vn [Bernstein:03] Vn+1 = Vn + V1 [Roux:97] Gio: Worth

10. Observations • Software cannot grow exponentially no Moore's Law here Because • Cost of maintaining software grows exponentially with size [Brooks:95] • Can't afford to hire staff at (exponential rate) 2 • Cannot have large fraction of changes in a version • Cannot impose version changes on users < 1 / year • Deleting code is risky and of little benefit except in game / embedded code Gio: Worth

11. Price remember IP =f(income) • Price stays ≈ fixed over time like hardware Moore's Law Because • 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 Gio: Worth

12. Growth diminishes IP at 1.5 year / version Gio: Worth

13. P 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 Gio: Worth

14. Sales curves For 50 000 units over 9 years Gio: Worth

15. Software users Companies that • develop & sell software * • Basis of IP: income from sales • purchase & license software for internal use • Do not generate IP with software • develop software internally for their own use • Basis of IP: relative SW expense × all income (Pareto rule) • combinations Gio: Worth

16. *Fraction of income for SW Income in a software company is used for • Cost of capital typical • Dividends and interest ≈ 10% • Routine operations -- not requiring IP • Distribution, administration, management ≈ 40% • IP Generating Expenses (IGEs) • Research and development, i.e., SW ≈ 25% • Advertising and marketing ≈ 25% These numbers are available in annual reports or SEC 10-Ks Gio: Worth

17. Discounting to NPV Standard business procedure • Net present Value (NPV) of revenue 1 year later = R×(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 only $0.28 Also means that bad long-term assumptions have less effect Gio: Worth

18. Combining it all Gio: Worth

19. Result of Example • Selling 50 000 SW units at $500 ≈ $ 1M not $ 25M Once it’s 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, spend less than ≈ $500 000 to develop the software product. Gio: Worth

20. Alternate business model Consider maintenance and its income long-term "Service model" • More assumptions – now include cost • Original cost $494 000 (used to estimate 2.) • Maintenance cost 20%/year of original cost • Maintenance fee 15%/year of original price • Lag = Δ (t cost , t income) = 1.5 years • Stop maintenance when cost > total income Gio: Worth

21. 2601 850 Good time to quit if no maintenance income Generates income 10 more years Cost of actual maintenance = 3260/(494+3260) = 87% of total typical Effect of service model  20% if designed for maintenance Gio: Worth

22. Reduce maintenance Long Term Gio: Worth

23. Service model Analysis shows profitability in service model • To achieve such a beneficial model • Management must value maintenance • Marketing and sales must provide feedback • Education and training must recognize the value of maintenance and maintainability • Often ignored today • Academics don't teach it (3/850 pages [Pressman:01]) • Companies give maintenance tasks to novices • Experienced programmers should maintain their work « Gio: Worth

24. Knowing what software is worth • Allows rational design decisions, as • Limiting development efforts • Programming investment for maintenance • Allows rational business decisions, as • Choice of business model • Where and when to invest • How to assign programming talent • Improve focus of education in software • Consider quality, not just quantity in assignments • Effectiveness of curriculum Gio: Worth