How to value a software asset?
In this article, we’ll discuss how to value software and the commonly used approaches for software valuation that use historical and forecast financial data.
Employees increasingly rely on software solutions to automate and enhance fundamental business processes, from sales order input and inventory management to payroll processing and financial reporting. To determine if the cost spent on that software is efficiently used or not, software valuations have indeed become the most essential factor in business functioning. In this article, we’ll discuss how to value software and the commonly used approaches for software valuation that use historical and forecast financial data.
Valuing a software asset in business
Software asset valuation systems leverage a combination of processes and technology to optimize the way software applications are used, tracked, and maintained throughout their lifecycle. Numerous benefits can be obtained through the usage of software valuation.
What is a software asset?
The term “Software Assets” refers to all computer software, data rights, and documentation used in the business. Licensable software, data rights, and documentation are only included in the Business Assets if they are part of a Contract and are then subject to the terms of the contract. This includes any licenses and agreements.
How do software assets work?
Any application/program that an organization/company uses in the course of its commercial activities is considered a software asset. It is critical for firms to monitor and manage such assets since they may provide compliance concerns, dangers to corporate reputation, and even existential threats.
Seller will make reasonable attempts to get Buyer the right to utilize any software or rights that are not transferable by Seller, and Buyer will help Seller in such efforts. The transfer of any Computer Software Assets is not a requirement for closing unless clearly stated otherwise in this document. Any fees or royalties associated with obtaining this right will be the responsibility of the buyer, and the seller is under no obligation to shoulder any of those costs or expenses on behalf of the buyer.
Importance of having software assets in your business
The software assets are important to a business because:
- Streamlines operations, assisting both the IT department and employees in navigating extremely lengthy and tiresome processes.
- Easily determine the license status of installed software without physically comparing it to license contracts.
- Automate the generation of reports including the most critical KPIs for your organization and/or department.
- Automates processes.
- Possibility of configuring reminders and alerts (before a contract needs renewal or if someone needs to approve a new software).
- A single repository for all license documentation.
Why should businesses value their software assets?
Software valuations are frequently required as part of the acquisition and disposition of corporate assets. Due to the high rate of Capital Cost Allowance applicable to software purchases, recognizing the full fair market value of the software provides a tax benefit to the purchaser. Recognizing the full fair market value of the software provides a tax benefit to the purchaser (CCA).
Aside from litigation (shareholder disputes, disputes over ownership between employees and shareholders, and copyright infringement), other reasons for valuing software include financing (e.g., determining the value of collateral or a sale-leaseback arrangement), cross-border transfer pricing, and tax planning.
Financial reporting and valuation standards for software assets
As investments in software increase, determining their worth as drivers of company value becomes increasingly critical. Both IFRS and GAAP are “mixed models”, with distinct approaches to accounting for intangible assets acquired through a company combination versus those generated internally.
The former must be valued at fair value at the time of acquisition, recorded on the acquirer’s balance sheet, and subsequently amortized or subjected to periodic impairment tests. Internally produced intangible assets are typically not recorded on the balance sheet, and associated costs are expensed as incurred under GAAP. Such assets are recognized under IFRS only if specific criteria are met.
When it comes to the income statement, GAAP generally requires an amortization charge for intangible assets that are on the balance sheet and have a “determinable” useful life, as well as a charge in research and development or sales and administration expenses for uncapitalized internally developed assets. Additionally, it may contain an impairment charge for goodwill or capitalized intangible assets with unknown useful life. Analysts comparing organizations across borders must be aware of the unique intangible distinctions between GAAP and IFRS.
How to value software assets in a business?
Valuation of software in a business might require an understanding of certain aspects and metrics that the software withholds. With the right and appropriate knowledge of the methods of valuation of the software assets, you will be able to determine their value.
We’ve listed the essential metrics for software asset valuation ie., Functionality, Technology, Adaptability, Documentation, and also the methods such as Cost Approach, Trended Historical Cost Method, Software Development Cost Models, Market Approaches, and Income Approaches. Let’s see how they hold in brief now,
Importance metrics for software asset valuation
An important stage in the valuation process is determining the software’s value drivers. Several important factors of market value include the following:
- Functionality – Simple-to-use, maintainable, efficient, and broadly applicable software will fetch a greater price than a complex or burdensome solution. For instance, is the software compatible with the most recent Windows or other platform versions?
- Technology – Given the rapid growth of software, it is necessary to examine the amount of innovation, the ease of modification and updating, the remaining usable life or obsolescence, and the cost of replacement. For instance, is the software written in a commonly used, up-to-date language? Is the software less beneficial than its perfect substitute? Additionally, the valuation must take into account the degree to which the software’s intellectual property is legally protected. These factors must also be balanced against the reality that software that functions well (i.e. software that clearly satisfies the business objective) does not automatically lose value simply because it is not created in the latest programming language.
- Adaptability – Software that is strong, quickly scales to larger business structures, and integrates smoothly with other software programs would necessarily fetch a higher premium.
- Documentation – The valuator considers the scope and quality of documentation written for both programmers and end users. For instance, is there an acceptable help system or user and developer manuals?
Methods to value software asset
The cost, market, and income approaches are used to value software. Because each highlights various value drivers, it may be beneficial to combine approaches in some circumstances.
Under the cost method, based on the principle of replacement, value is based on the expected cost of replacing the software with one of equivalent capability. There are two types of costs: reproduction costs, which assess value as the cost of recreating an exact copy of the software, and replacement costs, which measure value as the cost of recreating the software’s functionality. The cost technique is often employed in valuing internal-use software.
Trended Historical Cost Method
The trended historical cost method quantifies actual historical development costs, such as programmer personnel costs including allocations of costs such as payroll taxes, overhead, and a profit component. and then time adjusts or trends them to the valuation date using an inflation index. The difficulty in implementing this reproduction cost method is that in many circumstances, historical records of development costs are absent or are jumbled with those of operations and maintenance.
Software Development Cost Models
Valuators can employ sophisticated models established by software developers to predict development time and expenses. The main variable in these cost estimation models is the program’s size or functionality, which is commonly expressed as the number of lines of code or “function points” (a standard measure of software complexity).
The COCOMO II model estimates development effort based on program size, which is quantified in lines of code. Various product, platform, staff, and project attributes are rigorously considered to define program complexity. The cost of reproducing the software’s function points is also assessed. Function points quantify a program’s functionality from the perspective of an outside user, i.e. the program’s functionality given to the user.
It is then estimated how much it would cost to reproduce each function point, using data from actual software development projects, such as the International Software Benchmarking Standards Group’s database of over 1,200 projects representing over 70 programming languages.
Both models above estimate the number of manpower necessary to write the code. This is done by multiplying the number of development hours by a cost per person-hour that includes basic salary, benefits, payroll taxes, and overhead.
The market approach determines value by comparing it to similar software packages and adjusting for variations. The issue in using this method is the lack of reasonably comparable transactions, especially when dealing with internal-use software designed to specific standards. Unlike software, more data is accessible on transactions for software development companies’ shares.
Software value is measured in terms of future earnings, cash flows, or cost savings. The discounted cash flow method determines the software’s worth as the present value of future net cash flows (related to revenues less expenses).
The cash flows are solely estimated for the software’s remaining life. The valuator must calculate an appropriate discount rate that takes into account general economic, product, and industry risks. The software is valued using the current value of the expenditures spent if it had to be licensed from a third party. This is based on published license prices for similar software found in intellectual property databases and other sources.
Get your Software Valuation with Eqvista!
Determining the value of a software can help you in justifying the purchase or sale of that software asset. Getting a software valuation not only finds your software’s value, but also help your company get more funding and investors. Thinking of getting a software valuation done? Eqvista has you covered! To learn more about our software valuation service, please don’t hesitate to contact us.