Valuation of Computer Software Assets
by Shahan Islam, Esq. and Stanley H. Kremen, CDP
Software as a Capital Asset
A company may own millions of dollars worth of buildings and factories. It may own much equipment, and computer hardware may be listed among such equipment. These are known as tangible assets, i.e., assets that you can touch, feel, see, etc. However, its most important asset may be its intellectual property which is an intangible asset. Intellectual property may consist of, among other things, patents, copyrights, trademarks, unpublished works, databases and trade secrets. Of course, one may also touch, feel, and see a patent, trademark or copyright as these things are typically printed on paper. However, the asset is not so much the piece of paper, but rather what it represents, namely a property right for some kind of unique technical or creative development. Computer software is an extremely important asset that contributes significantly to the overall value of a company. Software can enjoy various types of intellectual property protection including patent protection, copyright protection, trade secret protection, trademark protection or a combination consisting of these various modes of protection. (1) At times, due to lending, investment or taxation requirements, software assets will require valuation. This article addresses the situations in which software may need to be valued, different methods of valuation and factors to be considered in determining the value of software assets.
Protection of Software Assets
"The Congress shall have Power . . .
To promote the Progress of Science and the useful
Arts, by securing for limited
Times to Authors and Inventors the exclusive Right
to their respective Writings and Discoveries . . .
To make all Laws which shall be necessary and
proper for carrying into Execution the Foregoing
Powers . . ."
THE CONSTITUTION OF THE UNITED STATES
With these words, in 1789, our founders laid the groundwork for the granting of copyrights and patents.
Modern copyright law was codified by Congress on July 30, 1947 when it enacted Title 17 of the United States Code. This law has been amended many times, the most significant taking place in 1954 (2) which permitted authors to obtain copyright protection by publishing their works with the copyright notice ©, the name of the copyright owner, and the date, without requiring registration, deposit or fee. The Copyright Act of 1976 states that to be protectable under the law, a publication has to be an original work of authorship that is fixed in any tangible medium of expression (3). This section of the code provides examples of works that were covered under the statute (4):
Computer programs were notably absent from this list. The Copyright Act of 1980 defined a computer program as "a set of statements or instructions to be used directly or indirectly in a computer in order to bring about a certain result." (5). However, the Act limited the scope of protection as follows:
"In no case does copyright protection for an original work of authorship extend to any idea, procedure, process, system, method of operation, concept, principle, or discovery, regardless of the form in which it is described, explained, illustrated, or embodied in such work." (6)
This provision helps point out the difference between copyright protection and patent protection. Copyrights cannot protect ideas -- they can only protect specific expressions of those ideas. Most software programs enjoy copyright protection. However, the owner of a computer program cannot obtain copyright protection for an algorithm (i.e., the method used by the software to accomplish its task). He can only protect the physical embodiment of the program. Anyone else can write a different program using the same algorithm with impunity. (NOTE: This is not to say that another author can translate the original work into a new language or that he can develop another program that looks and acts exactly like the original.) The new author can create another program so long as the original owner cannot show substantial similarity between the protectable expression in both works.
Copyright protection derives from publication or use and not from registration. Today, the mere publication of a work (or creation of that work for the purpose of distribution) accrues copyright protection for the author. Use of the © symbol is no longer required, and the author need not assert copyright reservation in the body of the work. Such protection is assumed. However, the © notice serves as a deterrent to would-be infringers and helps to establish willful infringement, possibly leading to increased damages awarded to a copyright holder. Nonetheless, in the event of infringement, copyright registration with the U.S. Patent and Trademark Office must be secured prior to the commencement of litigation. The author may apply for such registration within three years after the date of infringement. Copyrights last for the life of the author plus 50 years, or for 150 years if the author is a corporation.
Patent Protection for Software
A United States patent is a government granted right accorded to inventors for inventions that are new, useful and non-obvious over the "prior art." (7) A patent allows the patent owner or licensee legally to exclude others from making, using or selling the invention within the country. A purpose of the patent system is to encourage the development of technology by rewarding the inventor with these exclusive rights and to advance scientific knowledge since patents are public documents. The patentee may sell the patent outright, license the rights to others either exclusively or non-exclusively or, should he desire, not use it at all.
A software patent affords much stronger protection than is available for copyright software. However, it is sometimes difficult to obtain a patent for software. A software patent, unlike a copyright protects the idea or concept of the software, and also every expression of that idea.
A patents term can last up to 20 years from filing of the patent application, but commences on the date of the patents issuance. After its term, a patent expires, the development enters the "public domain," and anyone else has the right to make, use or sell the invention.
A patent owner may sue anyone he believes has infringed the patent without authorization. (8) A valid defense to an infringement charge is that the patent is invalid -- i.e., it was erroneously granted since it does not possess the required amount of novelty, utility and non-obviousness. (9) Alternatively, a patent may be found unenforceable because of inequitable conduct by the patentee before or after the patent is granted or if the patentee is not sufficiently diligent in pursuing his rights. An example of inequitable conduct would be where the patentee hid a prior art reference that may have affected an examiners determination in granting the patent.
Trade Secret Protection for Software
There are many reasons for the owner of software to choose not to obtain either patent or copyright protection. Software patents may be difficult to obtain, and they require full disclosure of the idea or process. Copyrights are easy to obtain. Yet, sometimes, even a partial disclosure can jeopardize an authors competitive edge. Even where no disclosure is made, others can discern the underlying ideas from a particular embodiment. These underlying ideas can then be used to generate new software that the original author neither owns nor controls. Often, the best course of action is for the author to maintain his work as a trade secret.
In the United States, trade secret protection derives from the common law as well as from statutes that vary from state to state. In order to obtain trade secret protection, the owner must treat what he wants to protect as a trade secret. There are several factors that determine whether or not software is a trade secret: (10)
Unlike patents or copyrights, there is no set time limit for trade secret protection. Software that is a trade secret can enjoy protection into perpetuity or it can lose its protection without notice. For instance, if the secret is revealed or discovered, it is no longer a secret. Therefore, for the software to be protected, its secrets must be disclosed in a controlled manner. Usually, this is done by agreement. Employees and licensees should sign confidentiality agreements. Beyond this, state laws protect owners of trade secrets from unscrupulous thieves.
Trademark Protection for Software
Clearly, one cannot obtain trademark protection for a program. However, certain elements of a software package may be eligible for trademark or service mark protection either at the federal or state level. If a particular program is part of a larger software product line, the name of that line could enjoy such protection. Trademark protection can possibly be obtained for icons in a GUI (Graphical User Interface) software system. (Of course, design patents can also be obtained for icons.) In game programs, a trademark can be asserted for a particular character who is associated with the owners business. For example, in the program, "Mario Teaches Typing," the Mario character enjoys trademark protection. In this case, trademark protection can be very valuable as fewer people would want to buy a package labeled "Robert Teaches Typing."
Multiple Levels of Protection
Software can simultaneously enjoy patent, copyright, trade secret and trademark protection. For example, suppose a new type of software that is a non-transactional multi-dimensional spreadsheet is developed that allows sophisticated programming to be performed. This concept acts as a base to permit applications similar to those already on the market to be developed more rapidly than with any other development tool. Furthermore, end-user applications developed using this concept occupy a minuscule amount of disk space and are easily maintained. Non-programmers can use such a program with ease to develop new applications. If something comes out not quite as expected, the code for that portion of the application can be thrown away and new code can be easily inserted.
The creator of such a system has a number of options. He can patent the concept, and, once the patent issues, nobody else can create software that employs that concept without his permission. However, it takes time for a patent to issue, and the term of a patent can last up to twenty years. He can then manufacture the software product in several different embodiments, and can obtain copyright protection immediately for each of the embodiments in object code format. Such protection will outlast the usefulness of the program. However, he can elect to treat the source code as a trade secret, and license it with restrictions to developers who want to make changes to the code to meet their own requirements. Furthermore, certain elements of the software can enjoy trademark protection. These elements can provide a marketing edge for the owner of the software. Clearly, the more protection enjoyed by the software, the more valuable it is to the owner or to a prospective buyer.
Situations Which Require The Valuation Of Software
The Purchase or Sale of Software Assets
When a prospective buyer wishes to purchase all rights, title and interest to a software asset from an original owner, it is essential that the value of the software be known. This does not only determine the price paid to purchase the asset. It also helps the prospective buyer decide whether or not it would be better to purchase the software from the owner or to build a new software package with similar functionality himself.
Acquisition of a Company Owning Software Assets
Suppose Company A would like to acquire Company B. What should it pay? What is the value of Company B? When companies were comprised mainly of real estate and machinery, valuation was easy. In many large-scale mergers and acquisitions today, the value of a companys intangible assets, particularly software, could eclipse the value of all other assets. New emphasis has therefore been placed on these assets and their values.
Financing of a Business Owning Software Assets
It is often possible today to raise significant capital through private placements or initial public offerings by companies that do not presently have incoming revenue from a product or service. Capital may be based upon the strength of a companys software assets, or other intellectual property.
Joint Ventures and Licensing
Companies sometimes pool expertise or bring certain assets into a venture they share or pay to use assets that are owned by another. In most cases, the assets involved are intangible, such as software. The financial terms of the joint venture are frequently dictated by the value of the software.
Various Tax Situations
When parents die and estate taxes must be assessed, any intellectual property owned by the parents, either as patents, copyrights, trademarks, etc., may need to be valued. The same applies to the assessment of income and property taxes. In addition, certain states provide tax credits for the purchase of capital items such as software as well as research and development credits for software development. In some cases federal tax guidelines provide tax advantages for software acquisition. Furthermore, because purchased software is a capital asset, it must be depreciated, and its value must be known.
For insurance purposes, the value of all capital assets (including software) must be ascertained. It is an asset that may be substantially more valuable than the tangible assets.
Prior to pursuing litigation (or defending litigation), the value of intellectual property may need to be assessed. Pre-litigation strategy, however, usually involves determining what might be the potential damages awarded and the probability of various outcomes -- rather than attempting to determine the monetary value of the intellectual property. The two inquiries, though related, are quite different.
Splitting the property in failed marriages now goes beyond bank accounts, homes and pension plans. Businesses that are part of marital property often possess intangible assets, including patents, copyrights, trademarks, etc.
Effect of Protection Type On Valuation of Software Assets
A software asset that has no protection has minimal value. If it is in the public domain, or it can easily enter the public domain, its main value is to an individual user for day to day use. However, certain software packages that are in the public domain are sold widely by their original developers. For some reason, competitors are unwilling to enter into the particular niche market. Nevertheless, it is safe to say that the broader the protection enjoyed by a software product, the greater the value of that product. Multiple levels of protection, as described above, enhance the value of the product by the greatest amount.
Patent protection for software provides the owner with a virtual monopoly for the idea or concept embodied by the software. Obtaining a patent insures against someone else producing another software product that uses the same methodology as described in the patent. Copyright protection insures against software piracy, i.e., someone else copying the product or producing a product substantially similar to the original software. However, copyright infringement requires that the infringer have access to the original work. If the substantially similar work was developed independently, there is no copyright infringement. On the other hand, patent protection extends even to independent development where the infringer had no access to the original work. Trade secret protection is the minimum protection that can be obtained. Ownership can only be enforced by ordinary contract law and some applicable statutes.
In appraising the value of software, one must take into account the level of protection. The protection lifetime for software patents or copyrights is probably greater than the useful life of the software product itself. Therefore, patents afford greater protection than copyrights which afford greater protection than trade secrets. The value of such protection can be quantified in determining the depth of market penetration. Clearly, a protection mechanism that enables more of the competition to be eliminated makes the software product more valuable.
Factors Affecting the Valuation
Industry and Competition
Some of the most important factors that should be considered when seeking intellectual property comparability are the target industry itself, profits derivable from the target industry, barriers to market entry, market share, whether new technologies are available and future growth prospects of the company. The value of a business is greatly influenced by an industry in which the property is used. Industry cycles and economics can limit the value of a business and the intellectual property that it possesses.
Certain industries are more volatile than others. These industries may experience technological breakthroughs frequently and regularly. The computer software industry is extremely fast moving, where products become obsolete even before they are introduced into the market. If the target industry of the software shifts and evolves regularly and frequently, this decreases the value of the software asset by decreasing the duration of its profitability.
Further, you must consider whether the target industry is in its infancy or is established and how this affects the amount and duration of profitability. Competitors can affect the amount and duration of profitability of the software by introducing competitive alternative products and by developing a superior new product. There may exist known competitors with known alternative or superior products. You may not know of any competition. Competition can limit the duration of the value of the product. If a competitor has a known alternative product, this affects the amount of profits you can expect from the software. A technological breakthrough of a superior product may abruptly terminate the profitability of a software package, therefore decreasing its value. Further, if the competitors are well known in the industry and you are new to the industry, the reputation of your competition may pose barriers to entry and thus increase the costs associated with the product.
Economy and Market Conditions
In order to accurately assess the value of a software product, the market conditions are extremely important. For example, if inflation is high, the revenue generated by the software may increase, but the costs associated with the product may also increase. Further, if inflation is high, consumer spending habits may be affected and may influence the commercial success of the software. If, for example, the software relates to a leisure or luxury industry or the price is very high, consumers will be less likely to respond favorably during inflationary periods.
In addition to general economic conditions, economic conditions for the target industry are important to consider. For example, the cellular phone industry is currently experiencing extreme growth. In contrast, the commercial airplane industry is experiencing a slowdown. Applicability of the software to a strong target industry increases the value of the product.
Risks of Emerging Technologies
Emerging technology presents a unique valuation challenge, because it has yet to prove its viability, either scientifically or commercially. With the absence of a historic track record, the value of emerging technology must be based upon the prospects for economic benefits of the short-term and the long-term. The potential competition that emerging technology represents can affect the economic remaining life of intellectual property. An example of this can be where a software product was developed to operate as a text based system at the same time that GUI was emerging into the marketplace. WINDOWS technology tended to make MS-DOS applications obsolete. When looking at intellectual property transactions as market indications of value, care must be taken to assure that the effect of emerging technology is comparable with the asset being valued. The existence of research that is expected to make the subject property obsolete must be reflected in the value decision.
Sometimes a company engenders instant name recognition with consumers. The company name may be a household name, such as IBM or Toyota, or the company may hold a recognizable trademark, such as XEROX or Windows. A well-known company or trademark could increase the profitability of software by heightening consumer confidence in a product or decreasing the market and entry costs. For example, if the software relates to personal computers and the company is IBM, the value of the software may increase as consumers will have high confidence in the product and IBM would not need to devote substantial funds to establishing a name and reputation in the computer industry.
Cost of Development and Commercialization
In valuing the software, the necessary steps to make the product commercially viable must be evaluated. For example, time and effort necessary to ready the product for the commercial marketplace, such as production costs, advertising expenses, and market entry costs must be considered. There may be regulatory costs which must be considered to obtain government approval. These costs multiply as the products marketplace is expanded from one country to multiple countries.
Other Factors Affecting Value
In addition to the above factors, government regulation could pose a significant barrier to commercialization. If the target industry is one that is heavily regulated, the costs of entering the industry will increase and the risk that the software product will not be profitable will increase.
You must also consider the risks associated with an investment into this product. For example, a company must forego certain investments in order to invest in the value of a product. A company may sacrifice certain securities investments, research and development opportunities, or other more certain forms of investment in order to devote funds to developing the intellectual property. In considering the value of the software, you must factor in the risk associated with the software by appropriately discounting its value to reflect the amount of risk posed by the software. An example of high risk software would be a product designed to determine the exact amount of radiation dosage that would be given to cancer patients.
Barriers to entry can enhance the value of intellectual property. Barriers include distribution networks, substantial capital investments, and well-entrenched competitors. As such, intellectual property within a market that also presents high entry barriers is possibly more valuable than similar property that operates in a more open industry.
Different Methods of Valuation
Valuation (also appraisal) means providing an opinion as to an amount of money payable at a particular time in exchange (i.e., through an assignment or sale) for property. Value may be continually changing as future benefits from the property increase or decrease with the passage of time, place, potential owners, and potential uses. For valuing intangible assets and intellectual property (software in particular), four different approaches can be used: the capitalization, income, cost and market approaches.
The Capitalization Approach
The capitalization relationship for any asset is expressed as:
This relationship assumes that the capital value of the asset is unchanging. The income is the net potential income after expenses. The rate is the return necessary to satisfy an investors requirements plus a rate of return of the invested capital. Equity and mortgage interest rates must be taken into account if financing is involved. Therefore:
Example: Assume that the potential revenues of a software program is $15,000,000 and the anticipated lifetime is five years. The gross annual income is $3,000,000. It is anticipated that the expenses will be 25%. Therefore the net annual income will be $2,250,000.
Now, assume that the investor anticipates 90% financing at an annual interest rate of 6.25% and requires at least a 15% return on his 10% equity. The rate of return on investment is computed as follows:
.90 X .0625
.10 X .15
Now, the investment is returned over a five year period or 20% per year. Therefore, the overall rate is:
.07125 + .20000 = .27125
The asset valuation is then seen as:
The Income Approach
Using the income approach, the value of any asset can be expressed as the present value of the future stream of economic benefits that can be derived from its ownership. This approach can provide very credible valuation conclusions for many types of intellectual property.
Factors important to successfully using an income approach include determining:
Of course, the amount of economic benefits is best measured by the amount of net cash flow to be derived from use of the property.
The present value factor can be calculated using the formula:
Using our example above, with a life of five years and assuming no salvage value:
Factor @ 15%
The Cost Approach
The cost approach provides indications of value by studying the amounts required to recreate the software for which a value conclusion is desired. Cost approach valuation usually begins with a determination of the current (as of the appraisal date) cost to obtain an unused replica of the software. This is called "cost of reproduction new." The cost of obtaining a property of equivalent utility is called the "cost of replacement." When there is a difference between these two amounts, it is usually because the cost of replacement represents a less costly substitute, which is one element of functional obsolescence. The next step is to take into account physical depreciation of the software over time.
The cost approach does not directly incorporate information about the amount of economic benefits that are associated with the software. Information about the trend of the economic benefits is also missing from consideration, as well as the duration over which the economic benefits will be enjoyed. The risk associated with receiving the expected economic benefits is not directly factored into the cost approach. If the cost approach is chosen, the adjustments necessary to reflect the effect of obsolescence must be separately calculated and are often difficult to quantify.
The Market Approach
The market approach provides indications of value by studying transactions involving sales of software assets similar to the software for which a value conclusion is desired. This method is used widely in determining the value of a home. For instance, appraisers try, if possible, to find "comps" -- i.e., purchase prices of comparable homes in the area. Requirements for successful use of the market approach include an active market, transactions involving comparable property and arms length transactions between independent parties.
The most difficult aspect of the market approach as it applies to intellectual property is comparability. Even if pricing information for software were available, the price at which the software is exchanged may have little to no bearing on the value of other software assets.
Choice of Valuation Methodology
Whether to choose the capitalization approach, the income approach, the cost approach, or the market approach depends upon the reason for which an appraisal was requested. If Company A intends to develop an exclusive market for a software product and finds that Company B has a competing product, Company A needs to make a decision whether to buy the software from Company B or to create a new software product from scratch. This buy or build decision will also depend upon the depth of penetration of Company Bs software in the selected marketplace. However, in this case the cost approach would probably be best. Another reason for using the cost approach would be for tax purposes. If building the software is not an option (e.g., Company A desires to enter the market quickly) and there are several companies that have produced and sold similar software products, then the market approach could be used. Another reason for using the market approach might be for insurance purposes. Finally, if Company A desires to acquire Company B where the principle asset of Company B is the software asset, either the capitalization approach or the income approach can be used. They both yield comparable results.
A companys software may be its most important asset. Thus, it is crucial that you devote time and effort to value a companys software products, carefully consider the various approaches available to value the products, and thoroughly assess the various factors described above. This article merely provides an overview of certain considerations. There may be other factors important to the particular product at issue that you should consider in valuing the product. Further, the advice of an attorney and an expert will likely be necessary.
© Shahan Islam and Stanley H. Kremen 1998. All rights reserved.
1. Friedman, Marc S. and Taylor, Lindsey H., Basis of Intellectual Property Protection For Software Under U.S. Law, Computer Forensics Online, Vol. 2, No. 1, November 1998, http://www.shk-dplc.com/cfo
2. 17 U.S.C. §102(a), (1976)
3. Friedman, Marc S., Hildebrand, Mary J., Lipner, Seth E., Vendors Guide to Computer Contracting, Prentice Hall Law & Business, Englewood Cliffs, New Jersey, 1992
4. 17 U.S.C. §101, (1980)
5. 17 U.S.C. §102(b), (1976)
6. Nicholson, Margaret, A Manual of Copyright Practice for Writers, Publishers, and Agents, 2nd Ed., Oxford Univ. Press, New York, 1970
7. 35 U.S.C. §§ 102-103
8. 35 U.S.C.A. § 281
9. 35 U.S.C.A. § 282