The intellectual property value of software

Clearly value and cost are not the same thing, and yet in the software industry, when people talk about the value of software they only consider the cost of producing it, and very little is said about the benefits obtained from using it.

When it comes to appraising our products, we software developers let economists, lawyers, distributors and others define how much our product is worth.

An interesting article written by Gio Wiederhold and published in the September 2006 issue of Communications of the ACM [1] discusses this important matter.

Wiederhold reminds us that “assigning value to intangible property is assuming greater and greater importance, as our society moves from dependence on hard, tangible goods to a world where knowledge and talent creates the intangible goods we need and desire”.

Valuing intellectual property

Tangible goods are the product of a combination of human labor, capital, machines and management, yet the quality of the human resources has little effect on a company’s financial valuation. The books only reflect the value of inventory and finances, but do not account for the value of the workforce.

Book value has little to do with the value investors assign to software companies. Wiederhold gives us the example of SAP, whose book value in 2003 was 6.3 billion euros, but if you took the share price in that period (about 100 euros) multiplied by the number of shares outstanding (315 million), you find that the German company’s shareholders valued it at 31.5 billion euros.

Investors base this value mainly on the earnings they expect to get from their shares. The difference, that is, the 25.5 billion, is due to SAP’s intangible property, shared by the company and its shareholders. Around 2004 the value of the SAP brand was estimated at some 6.8 billion euros. The rest, the 18.4 billion euros, has to do with the value of the software and the knowledge needed to produce it, improve it and sell it.

A software company’s reputation can grow through promotion and advertising, while the value of its software grows through investment in research and development. These last two components are the intellectual property of the business.

When a company changes owners it’s important to value the quality of its workforce, in proportion to each individual’s strategic value to the running of the company. In the case of technology companies this value is a considerable amount.

Still, software is the most “tangible” intellectual property of a business of this kind, and yet its valuation is poorly understood, which leads to numerous problems.

The ownership value of software

Software ownership is not limited to companies that develop software as an end product. Most businesses today create, buy, maintain and benefit from software. Banks don’t work without software, nor do manufacturing companies, transportation companies, and so on. Without a billing or accounting system many companies wouldn’t function; designs are computer-aided; so is the planning of production processes, and there are countless other applications.

The better a business exploits the software at its disposal, the more profitable it will be. When the business is based on producing software, the value of the business is tied to sales.

Whether the model is based on selling licenses or on associated services, the difference will lie in the timing and the volume of revenue, with the license sales model growing exponentially, versus the linear growth of selling services.

Software as a product sold through licenses has one fundamental difference from other intangible goods. When a new version of a software package is released, interest in the old versions drops, but since the cost of copying and packaging software is very low, there is no benefit in selling obsolete software.

While a book written a couple of years ago can be sold for 80% of the price of a new copy, with software it makes no sense to sell an earlier version for that same percentage. Supporting old versions only generates costs for the vendor, while obsolete software only brings inefficiencies to the customer.

In theory, the buyer of packaged software is willing to buy the next version based on prior experience with the product, trust in the company that develops it, and whether the software’s new features are relevant and useful. Otherwise, the buyer should keep the current version or look for an alternative.

The problem is that software markets are all-or-nothing games. Later on we’ll see why this happens, but in software the tendency is toward monopolies, and so the buyer of packaged software is forced to sign maintenance contracts and buy renewal licenses.

What about open source software? In open source software, or free software, producers release or give up this degree of control. By its nature, it’s very hard to get users to pay for licenses for open software, and open source or free software business models naturally turn into pay-for-services models rather than license models.

This is important. Free software really is socialist, because it tends toward social control of the intellectual property of software, preventing a few from concentrating and controlling the price through control of intellectual property (the new source of capital in the information society).

In this first article we have introduced some concepts. We’ll continue with an exploration of Wiederhold’s article, and how we can apply it to businesses based on free software as well as on proprietary software.

[1] Communications of the ACM, Vol.49 No.9, Sep. 2006