Oct 2004 Gio: Worth 1

What is Software Worth ?

Gio WiederholdStanford University and MITRE Corp.

October 2004, revised Dec.2004

www-db.stanford.edu/people/gio.html

Oct 2004 Gio: Worth 2

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

life

create

useassess its value:inconsistentlysubjectivelynaivelybadly

Oct 2004 Gio: Worth 3

Why a Concern

• Making decisions about creative tradeoffs– Elegance versus functionality– Rapid generation versus maintainability– Careful specification versus flexibility

• Dealing with customersDijkstra model: for self-satisfactionEngineering model: formal process driven Startup model: see if it sticks to the wall

• Gain respect: know what you are doing

Oct 2004 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 low1. Loss of income to the creators in the USA

2. And loss of taxes to the US treasury

3. Excessive profits kept external to the USA

4. Increased motivation for external investment

Oct 2004 Gio: Worth 5

Intangibles

• Product of knowledge by• Cost of original >> cost of copies

1. Books authors

2. Software programmers

3. Inventions engineers

4. Trademarks advertisers

5. Knowhow managers

6. Customer Loyalty long-term quality

Ever

Even

Less

Tangible

Oct 2004 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

1. Bookvalue – sum of all tangible assets [10K] €6.3B 20% 2. Market value = share price × no. of shares €31.5B 100%3. 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.

Oct 2004 Gio: Worth 7

Software is slithery !

Continuously updated

1. Corrective maintenance bugfixing reduces for good SW

2. Adaptive maintenance externally mandated

3. Perfective maintenancesatisfy customers' growing

expectations

Life time

Ratios differ in various settings

100%

80%

60%

40%

20%

Oct 2004 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

Oct 2004 Gio: Worth 9

Effect: SW Growth

R and W

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]

at 1.5 year / version

Deletion of prior code = 5% per year [W:04]

Oct 2004 Gio: Worth 10

Observations

• Software cannot grow exponentiallyno Moore's Law here

Because1. Cost of maintaining software grows exponentially

with size [Brooks:95]

2. Can't afford to hire staff at (exponential rate) 2

3. Cannot have large fraction of changes in a version

4. Cannot impose version changes on users < 1 / year

5. Deleting code is risky and of little benefit

except in game / embedded code

Oct 2004 Gio: Worth 11

Price remember IP =f(income)

• Price stays ≈ fixed over timelike hardware Moore's Law

Because1. Customers expect to pay same for same functionality

2. Keep new competitors out

3. Enterprise contracts are set at 15% of base price

4. Shrink-wrapped versions can be skipped

• Effect

The income per unit of code reduces by 1 / size

Oct 2004 Gio: Worth 12

Growth diminishes IP

at 1.5 year / version

Oct 2004 Gio: Worth 13

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 P

Oct 2004 Gio: Worth 14

Sales curves

0

2,000

4,000

6,000

8,000

10,000

12,000

14,000

16,000

18,000

Erlang m = 12

Erlang m = 6

| | end of time horizon| 9 years|

^ 50,000 w hen| Erlang m ~ infinite

For 50 000 units over 9 years

Oct 2004 Gio: Worth 15

Software users

Companies that

1. develop & sell software * • Basis of IP: income from sales

2. purchase & license software for internal use• Do not generate IP with software

3. develop software internally for their own use• Basis of IP: relative SW expense × all income

(Pareto rule)

4. combinations

Oct 2004 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

Oct 2004 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

Oct 2004 Gio: Worth 18

Combining it allfactor today y1 y2 y3 y4 y5 y6 y7 y8 y9

Version 1.0 2.0 3.0 4.0 5.0 6.0 7.0

unit price $500 500 500 500 500 500 500 500 500 500

Rel.size 1.00 1.67 2.33 3.00 3.67 4.33 5.00 5.67 6.33 7.00

New grth 0.00 0.67 1.33 2.00 2.67 3.33 4.00 4.67 5.33 6.00

replaced 0.00 0.05 0.10 0.15 0.20 0.25 0.30 0.35 0.40 0.45

old left 1.00 0.95 0.90 0.85 0.80 0.75 0.70 0.65 0.60 0.55

Fraction 100% 57% 39% 28% 22% 17% 14% 11% 9% 8%

Annual # 0 1911 7569 11306 11395 8644 2646 1370 1241 503

Income K $0K 956 3785 5652 5698 4322 2646 1370 621 252

SW IP 25% 0 239 946 1413 1424 1081 661 343 155 63

Due old 0 136 365 400 311 187 93 39 14 5

Disct 15% 1.00 0.87 0.76 0.66 0.57 0.50 0.43 0.38 0.33 0.28

Contribute 0 118 276 263 177 93 40 15 5 1

Total $ 989 K ≈ $ 1 million

Oct 2004 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.

Oct 2004 Gio: Worth 20

Alternate business model

Consider maintenance and its income

long-term "Service model"

• More assumptions – now include cost1. Original cost $494 000 (used to estimate 2.)

2. Maintenance cost 20%/year of original cost

3. Maintenance fee 15%/year of original price

4. Lag = Δ (t cost , t income) = 1.5 years 5. Stop maintenance when cost > total income

Oct 2004 Gio: Worth 21

Effect of service modelSW cost $494K today y1 y2 y3 y4 y5 y6 y7 y8 y9

Version 1.0 2.0 3.0 4.0 5.0 6.0 7.0

Maint.cost 0 99 165 231 297 363 429 495 560 626

disc. for lag 0 122 203 285 366 447 529 610 691 772

Income - cost 0 834 3581 5369 5332 3875 2117 761 -70 -520

Aggreg.sold 0 860 4558 9755 14477 17352 18262 17806 16645 15233

Maint. Inc. 0 0 129 684 1463 2172 2603 2739 2671 2497

Sum 0 834 3710 6052 6795 6047 4720 3500 1977

15% disc/year 0 725 2806 3980 3885 3006 2040 1316 562

Total $ 19170 K ≈ $ 2 million after paying $1 780K (disc.) for maintenance

Good time to quit if no maintenance income

20% if designed for maintenance

typical

Cost of actual maintenance = 3260/(494+3260) = 87% of total

Generates income10 more years

2601

850

Oct 2004 Gio: Worth 22

Long Term

Red

uce

mai

nten

ance

Oct 2004 Gio: Worth 23

Service model

Analysis shows profitability in service model

• To achieve such a beneficial model1. Management must value maintenance

2. Marketing and sales must provide feedback

3. Education and training must recognize the value of maintenance and maintainability

– Often ignored today1. Academics don't teach it (3/850 pages [Pressman:01])

2. Companies give maintenance tasks to novices Experienced programmers should maintain their work

«

Oct 2004 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