1. CHARACTERISTICS
Software is commonly divided into system and application software. For valuation purposes it is useful to distinguish the following characteristics in order to assess its marketability and income stream₁:
Valuing software as an asset requires a different process to valuing a company: it involves isolating the cash flows originating from the asset with different methods. There can be multiple reasons for carrying out a software valuation, for example: financial statements and impairment tests, asset disposal, financing, tax reasons, compensation, purchase price allocation and internal value management.
2. METHODS
Valuing software can be challenging due to the unique characteristics of each product.
The income approach is based on future financial projection and it allows for a more detailed valuation as well as for the monitoring of results. Other methods can also be applied when projections are unreliable, as a benchmark or for internally used software. The valuer would need to assess the applicability of each method to the specific case and scope of the valuation, as well as critically review the (often scarce) market information and related adjustments. A deep understanding of the product and its market therefore becomes essential.
3. WHAT CAN AFFECT THE SOFTWARE‘S VALUE? AND TO WHAT EXTENT?
When it comes to software transactions, whether it is an asset deal or share deal, a variety of factors can affect what the software acquiror is willing to pay for the target, emphasising the importance of adapting the software product to the marketplace and identifying the value drivers early on.
A variety of factors can affect the valuation. On the right the graphic shows what these factors could be for the average software company or asset. These can of course vary from buyer to buyer. Already included in the ten factors mentioned are other important criteria such as growth, revenue, stage, brand awareness and organisation effectiveness (for share deals).
High competition and fast growth in the software market contribute to an acquisitive marketplace. The largest companies compete within a few areas, trying to stay ahead by acquiring the latest technology and by refining their existing portfolio with easy to integrate companies or technologies. The high valuation of these companies is often due to the estimated high growth in the respective niche markets, which does not always materialise, but it gives a good overview of what active strategic buyers are looking for to complement their portfolio.
Among the top trends₃ are:
✲ Cloud Computing/ Software as a Service (SaaS)
✲ Digital Transformation/ Customer experience
✲ Big Data & Analytics
✲ Industry 4.0 The Internet of Things/ The Internet of Services
✲ Security
✲ Mobility & Connectivity
✲ Information Systems Standardisation
✲ Cross-company Collaboration
✲ Integration of work & private life
✲ Social Selling
The prevalence of financial investors or strategic buyers (among the most active SAP, Hewlett Packard and Oracle) depends to a great extent on the stage of the company. The same applies to industry multiples, which can vary widely. Therefore, set industry multiples should not be relied upon for advanced valuations: the uniqueness of many companies in the sector and the fast changing market needs would require a very advanced analysis of multiples to find the few comparable deals available.
I will provide examples for different types of valuation in a follow-up post.
Sources:
1. softwarecontracts.net, Free Software Foundation Inc.
2. International Valuation Standards 2012, IDW S5
3. Truffle100.com/ PAC, Digitalic.it/ Unify
Featured image: Akihabara, Tokyo
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