Putting a price on software

Diana Cooper of Protecode discusses valuation challenges in the technology sector, specifically issues around when portfolio companies use some element of open source software.

Despite the volatile economic environment, 2011 has been good to the technology sector.  Forrester and Gartner forecasts a 7 percent increase in technology spending for the year. A recent PwC report similarly projected a positive outlook, crediting strong performance to the sector’s “ample cash balances, inexpensive debt and previously established strategic objectives”.

The software industry is leading the pack, capturing $2 billion in venture funding in the third quarter, representing the highest level received by any industry. The third quarter also delivered the highest deal volume for the industry, with 263 rounds completed. Golden Gate and Infor’s $2 billion buyout of Lawson Software, and Providence Equity Partners’ $1.9 billion bid for SRA International ranked among the most notable private equity acquisition announcements in the technology sector.   

Difficulty of software valuation

As these figures suggest, confidence in software has grown by leaps and bounds since the early 1980s when critics were doubtful of software’s inherent value.  The genesis of software valuation only dates back to 1985 when the Supreme Court ruled in Digidyne Corp. v. Data General Corp. that software was valuable independently of the hardware that it attached to. While the ruling ended the debate surrounding the exploitability of software, the fast-paced sector that is no stranger to game-changing innovation presents continuing valuation challenges for appraisers.  

Technology investments carry unique risks, not the least of which is the looming possibility of the emergence of disruptive technologies (think connected tablets, peer-to-peer communications, cloud computing).  At the same time, technology investments also carry potential for huge returns, including unexpected profits linked to the commercialisation of killer applications (think Twitter). 

The rapidly changing landscape of technology requires investors to be particularly attuned to industry trends and developments in order to assess the risks and rewards attached to assets under consideration for investment. This may prove to be a more difficult task for financial investors in comparison with their corporate counterparts.  

A study of 1,441 European firm acquisitions in the period of 1997 to 2003 revealed that financial investors systematically overvalued their targets in relation to strategic acquirers.  The results were linked to knowledge asymmetries – while corporate acquirers benefit from expertise developed through their own R&D, financial investors tend to lack specialised knowledge due to avoidance of industry concentration.

Software Valuation and Mixed Source Software

An important trend to consider in software valuation is the increasing reliance on mixed-source solutions. Mixed-source refers to the combination of proprietary and open source code in a given technology.  In 2010 open source was leveraged within 75 percent of Global 2000 companies.   According to Gartner, this number will increase to 99 percent by 2016.

Even Microsoft, which previously characterised open source as an IP destroyer has adopted mixed-source solutions in recent years, most notably in its collaboration with Novell.

While open source is increasingly embedded into software, there is a lack of clear understanding of its implications on asset value, and valuation guidelines have not been established. In addition to relying on traditional valuation methods, appraisers must consider the unique dynamic impacts of open source.

Open source enhances asset value through delivering time and cost efficiencies in the development-to-market stages, lowering total cost of ownership, and promoting vendor independence. However, open source could also have a diminishing impact on asset value. Because some open source cannot be incorporated into products that have trade secret value, investors of mixed-source technology may face limitations in achieving optimal exit value.  

The fact that target companies may be unaware of the incorporation of open source in their technology further complicates the valuation exercise

Licenses that cover open source code carry unique terms that have implications on code use, modification and distribution. For example, restrictive licenses require users that distribute modified programs to make source code available to downstream users free of royalties. The failure to comply with license obligations can lead to severe consequences, including being forced to come into compliance by releasing the asset’s source code, or paying damages. Infringement suits also result in a loss of goodwill affecting client relationships, distribution partnerships, and consumer confidence, which further diminish exit sale price.

The fact that target companies may be unaware of the incorporation of open source in their technology further complicates the valuation exercise. Factors including increasing reliance on third-party developed code, and the rise of software outsourcing and offshoring have resulted in a loss of control over the composition of code incorporated in software. Receiving inaccurate information regarding code composition renders the investor vulnerable to costly license infringement litigation.  

Options to Consider

Because open source code could be incorporated in an asset without the knowledge of the target company, it is critical for the investor to independently confirm the status of the asset rather than rely on representations and warranties.  This can be achieved through engaging competent external resources that can analyse software assets in the following ways:

Scan source code to identify open source and third-party code
Compare licensing or ownership attributes against the company’s licensing policies 
Detect license violations and incompatibilities 

Once the assets are analysed, the portfolio manager can work with management to develop strategic solutions to achieve optimal exit value. Questions to consider include:

What functions do the open source components perform in the software?  
From a cost/strategy standpoint, is it more efficient and effective to: 
o Become compliant with license obligations?
o Replace the open source components with open source code that carries more permissive license terms, or with proprietary code with similar functionality?
o Remain non-compliant and assume liability?
Open Source Impact on Valuation is Manageable

The emerging mixed-source software environment calls for consideration of the unique value enhancing and potentially diminishing implications attached to open source. Through performing effective pre-investment due diligence to identify the presence of open source, and engaging in systematic post-investment asset management, portfolio managers can achieve optimal exit value on their investments.

Diana Cooper, a legal researcher at open source license management provider Protecode, specialises in M&A and private equity markets with a particular focus in the technology sector.