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Computer software valuation: don't be led astray by a quick approach.

Computer software is a valuable business tool for your client, and for many different reasons for. It can be held as nontypical loan collateral, enhance the purchase price in buy-sell negotiations and be used to transfer wealth intergenerationally. Frequently, unsophisticated analysts apply broad brush formulas or rules of thumb to the valuation of computer software. These quick approaches can lead to misleading results as to the relative value of what can be an important intangible asset to a business enterprise. Therefore, a current, accurate determination of the value of a company's computer software is often critical to the firm's current owners, potential buyers, management, lenders or other interested parties.

The first part of this article will present some of the reasons why the valuation of computer software can be important. The second part will present some generally accepted valuation approaches. Finally, an example of the most common approach will be offered to illustrate the key variables that are necessary for conducting such an appraisal.

Reasons for a Software Appraisal

A myriad of reasons exists for quantifying the value of a firm's computer software. Some of these reasons are financial-related, others are tax-related motivations.

Acquisition Financing

In many business acquisitions, the value of computer software is an important consideration in collateralizing either cash flow-based or asset-based financing. The valuation of computer software may directly impact the refinancing or recapitalization of an established business, outside the realm of an acquisition or transaction.

Business Sale/Purchase

As with the value of any business asset, the specific value of computer software plays an important role in the overall valuation of a business enterprise. Obviously, an overall business valuation is an important consideration in the determination and negotiation of a business purchase or sale price. Because computer software is typically a depreciable asset for federal income tax purposes, its value may have a greater impact on the overall business value than other assets which may not generate tax amortization benefits, such as going concern value of goodwill.

Buy/Sell Agreements

Buy/sell agreements are used for both ownership succession as well as estate tax planning purposes. In many instances where computer software is an important operational asset of the firm, the value of the computer software may be contemplated by the buy/sell agreement valuation formula.

Management Stewardship

The valuation of computer software and its impact on the overall business valuation, may be an important consideration on the periodic assessment of the effectiveness of management's stewardship of business assets.

In addition, the valuation of internally-developed computer software may directly impact the measurement of the performance of the firm's data processing management.

Intercompany Transfer Pricing

In many firms, computer software is developed by a centralized headquarters staff, but these internally developed systems are used by the various divisions and subsidiaries. The appropriate intercompany transfer price for the use of software should be a direct function of that asset's value. Depending on the relative locations of the firm's branches and subsidiary operations, the transfer price for the use of internally developed computer software can have both Federal and state income tax implications.

Intergenerational Wealth Transfer

Many family business owners look for ways to transfer wealth and income to second and third generation heirs. This wealth transfer provides for the heirs and helps manage the value of the business owner's estate. Since many business owners are reluctant to transfer direct equity interests to family members, they may choose to transfer direct or beneficial interest in the firm's computer software. A license agreement can be drafted whereby the firm is guaranteed the beneficial use of the software while guaranteeing royalty income to the family members. In this way, the wealth and income can be transferred to heirs, controlling equity interest will remain with the business owner, yet the value of the business enterprise in the transferer's estate will be reduced by the value of the transferred computer software.

Gifting Programs

Taking advantage of the annual gift tax exclusion, family business owners can transfer beneficial interest in the firm's computer software to various family members. Based upon a type of licensing arrangement described above, the company will retain the use of the software while the owner maintains direct equity control.

Business Valuation/Estate Planning

In many cases where computer software is a material asset of the family business, periodic software appraisals will help determine the value of the business equity and the value of the business owner's estate. Even if the business owner does not implement gifting or other wealth transfer programs, these periodic appraisals will allow the business owner to plan for long term tax considerations.

Approaches to Determining Value-In-Use

The three generally accepted approaches used to value the computer software intangible asset are the market approach, the income approach and the standard cost approach.

In employing the market approach, the appraiser gathers data pertaining to recent sales of comparable software systems. The comparability of these other systems revolves around their technical attributes and how similar they are to the subject software. Adjustments may then be made to reflect differences in utility, time of sale, and functional characteristics between the subject system and the comparable systems. The market approach is certainly reasonable when the subject software was itself purchased in the market place. This approach may also be reasonable for systems developed internally, but that have generic applications (such as general ledger accounting) for which there are software systems available in the market place that may be subjected to comparison. In practice, however, it is often difficult to use this approach for the purpose of appraising internally developed, unique application software systems.

The income approach measures the present worth of the anticipated future economic benefits specifically associated with the subject computer software. This particular approach requires the projection of the net cash flow generated by the sales revenue, license income, or royalty income associated with the distribution of the software system in the marketplace. While this approach is relevant for companies engaged in the sale of software, it may not be applicable for data processing or other service firms where software is used in the delivery of services rendered. As a general rule, it is difficult to apply the income approach to software developed by a company for its internal use.

The cost approach considers the basic appraisal concept of replacement cost new as an indication of value. The theoretical concept underlying the cost approach is that no astute investor would pay more for a computer software system than the amount for which they would have to replace the system from scratch.

Under the cost approach, the value of the computer software is determined by reference to how much it would cost to recreate the data processing utility of the subject system. Estimates are made of the amount of time and effort required to redesign and reprogram the computer system so that it would provide the user with the same functional utility as the subject software.

There are various types of cost estimation methods used by appraisers in the software valuation process. Among these methods, the various algorithmic models are generally considered to be the most reliable and the most supportable.

These algorithmic models all relate some quantitative measurement of the system attribute, such as the number of lines of code, to an estimate of the amount of time and effort required to replace the system. The more detailed versions of the algorithmic models take into account the specific attributes of the subject system in translating the quantitative measurement into a replacement time estimate. These algorithmic models are usually based upon either empirical data or on software engineering economics. Thusly, these models are really mathematical models relating the technical attributes of the software system to estimates of software development time. This estimate is usually denominated in number of estimated man-months.

Once a development time estimate is determined, standard cost accounting techniques may be used to quantify the current cost of one man-month of system design, system analysis, system coding and other system development activity. Even small businesses keep accurate records with regard to payroll costs related to their data processing and associated personnel. When direct payroll costs are determined, standard cost accounting techniques can be used to identify and quantify the indirect costs associated with the software development process. These indirect costs include payroll taxes, employee benefits, materials and supplies, clerical support, an allocation of hardware and real estate costs, and an allocation of management and supervisory personnel costs. The total cost of a standard unit of estimated software development time is the sum of the direct payroll costs plus the associated indirect costs.

After combining the estimated replacement time with the standardized unit costs, the cost to replace a software system of the same size as the subject may be derived. At this point, any appropriate obsolescence factors are recognized to adjust the replacement cost. These adjustments are made for possible design defects within the subject, or for external factors observed in the market place which would detract from the value of the system, even as replaced in a new condition.

An Example

Suppose that a brokerage house spins off its portfolio management subsidiary to a management group. The new owners require an appraisal of its proprietary, internally-developed computer software systems for the purpose of establishing its relative value on the balance sheet for loan securitization purposes.

The appraiser would spend a considerable amount of time meeting with the members of the company's software development team. The appraiser would interview them in order to determine the technical attributes of the computer system, of the computer on which it runs, and on the type of programmers and analysts that would be required as part of a hypothetical project to replace the functionality of the computer software system. After gathering this data, she would combine it with the number of lines of code of the system to determine, for instance, that it would require 550 man-months to replace or rewrite the software. This time estimate includes all phases of the system development life cycle, including the time required to conceive, design, write, de-bug, install, implement and create the necessary supporting system documentation.

Another analysis of the company's accounting records indicates that the fully loaded or direct plus indirect cost for single man month of the development team's time would be $7,000. The appraiser is also convinced that obsolescence of any kind is irrelevant because the system was only just completed several months before the contemplated transaction took place. The company's management also told the appraisers that they have had discussion with smaller money managers who were interested in licensing the portfolio management system for their own clients.

As a result of the foregoing analysis, the appraiser concludes that the fair market value of the company's proprietary software is $3,850,000 (that is, 550 man-months multiplied by $7,000). This conclusion represents the portion of the divested company's total asset value belonging to the computer software intangible asset.

As you can see, the valuation of computer software can bring substantial benefits to a firm's balance sheet. It's well worth the time and effort to consider several approaches and make the maximum return possible.

Tom Millon is a senior manager in the Chicago office of the Deloitte & Touche Valuation Group. He specializes in the valuation and appraisal of intangible assets and litigation support appraisals. For more information, Mr. Millon can be reached at (312) 946-2918.
COPYRIGHT 1992 National Society of Public Accountants
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1992 Gale, Cengage Learning. All rights reserved.

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Title Annotation:Debits & Credits
Author:Millon, Tom
Publication:The National Public Accountant
Date:Sep 1, 1992
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