A challenge for companies, specifically those who develop software, is the decision to record development time and costs as assets or expenses. Compounding the challenge is the question of whether the method chosen impacts the value an investor or potential buyer may place on the company. In part one, we discussed factors to consider when selecting the appropriate method. This installment outlines how this selection might be perceived from an investor or valuation perspective.
Valuation and investor considerations
After a company has properly applied ASC 350 or ASC 985, their financial statements will be a key data metric for an investor or potential buyer. However, does the investor or potential buyer care whether a technology or software company has an asset described as capitalized software on its balance sheet or not?
From a valuation and investor perspective, the answer is likely “no” since the balance sheet is only one of the many items an investor or potential buyer will consider. Book value and asset or “cost” value have little to do with how investors value companies in the software industry, where intellectual or intangible property (IP) are dominant.
As an example, we can look at software giant SAP’s Annual Report for 2014 and learn that its book value (assets less liabilities) was about €12.5 billion, but using the market price of the shares (about €58) and the number of shares outstanding (about 1.23 billion) the shareholders of SAP value the company’s equity at €71.3 billion. As is common in the software industry, the investors in SAP base the value on the expected income to be realized over time from holding an ownership interest in the company, and not just on the assets listed on the company’s balance sheet.
In any transaction, investors will want to review not only historical company financial statements, but forecasts or projections for the company or individual software products. If the company is in the business of producing software that is then sold to others, the expected income becomes a function of the volume of software sold and its price, as well as when new versions of the software are planned for development and sale. If the company uses internally developed software, the valuation becomes a function of the contribution to the income of the company, such as increases in productivity. Many times the existing value of software at the date of a transaction has little to do with the initial research and development costs.
Valuing software for financial reporting purposes
When valuing software for purposes of financial reporting (ASC 805 and ASC 820) due to a purchase price allocation or impairment test, there are three commonly used valuation methods:
- Cost approach: In valuation of software, this method is referred to as reproduction cost or replacement cost. This method attempts to capture the total cost to recreate a duplicate version of the software and takes into account functional, technological, and economic obsolescence. If the software is expected to produce cash flows, this method typically receives less weight than an income or market approach to value.
- Income approach: Typically in this method, an analysis of a profit-split between the software creator and the licensee is used. This often goes hand-in-hand with the Market Approach.
- Market approach: This approach commonly considers a relief from royalty method, which uses comparable licensing agreements to determine a market-derived royalty rate appropriate for the license of the software owned or created by the company.
It is worthwhile to note that when using the market or income approaches to value, the initial research and development costs of the software are ignored and value is determined from the future revenue and earnings.
Ultimately having an asset described as capitalized software should not impact company value from a valuation or investor perspective. A potential buyer will consider many items in addition to a company’s balance sheet, and typically asset cost is not at the forefront for investors valuing companies in this industry. What is key for companies is to apply the appropriate accounting guidance and properly document relevant activities.
For more information on this topic, or to learn how Baker Tilly software and technology specialists can help, contact our team.