Cs207 6
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This document contains notes from a CS207 class on intellectual property valuation of software. The syllabus covers topics like why software should be valued, open source software, intellectual capital, principles of valuation, business models, and risks of outsourcing. The notes discuss how personnel are the largest cost for tech companies and represent intellectual capital. Software is the primary intellectual property that is generated by people and embedded in products and services.
Cs207 6
- 1. CS207 #6, 2 Nov. 2012 Gio Wiederhold Hewlett 103 Homepage at https://cs.stanford.edu/wiki/cs207/Main/HomePage 2-Nov-12 Gio: CS207 Fall 2012 1
- 2. Syllabus: 1. Why should software be valued? 2. Open source software. Scope. Theory and reality 3. Intellectual capital and property (IP). 4. Principles of valuation. Cost versus value. 5. Market value of software companies. 6. Sales expectations and discounting. 7. Alternate business models. 8. Allocation 9. Life and lag of software innovation. 10. The role of patents, copyrights, and trade secrets. 11. Licensing. 12. Separation of use rights from the property itself. 13. Risks when outsourcing and offshoring development. 14. Effects of using taxhavens to house IP. 2-Nov-12 Gio: CS207 Fall 2012 2
- 3. People & IP Last week, 26 Oct 2012, Vishal Sikka CTO of SAP • Focus on personnel Largest cost item in a hightech company Represents the creative part of intellectual capital • Software is the primary Intellectual property Generated by people Consumed by people internally Embedded in products sold services rendered 2-Nov-12 Gio: CS207 Fall 2012 3
- 4. Review of layers Intellectual Resources Public & Intellectual Capital Private Rights owned by the business Intellectual Assets Available for transfer Intellectual Property Legally protectable Patents Copyrights Trade secrets Trade marks Contracts covering intellectual capital 2-Nov-12 Gio: CS207 Fall 2012 4
- 5. Software users & IP Companies that 1. develop & sell software → * • Basis of IP: income from sales and services 2. purchase & license software for internal use • Do not generate IP with software 3. develop software internally for their own use • Basis of IP: relative SW expense × all income 4. combinations 02-Nov-12 Gio: CS207 Fall 2012 5
- 6. Allocation 1. When there are multiple products 2. When there are other contributors to income a. Substantial hardware b. Financial consultants in financial firms c. Experts in call centers d. Brand name Not all of the income can be allocated to software Pareto Optimum 02-Nov-12 Gio: CS207 Fall 2012 6
- 7. Pareto Optimality (not Pareto Efficiency : 80/20 rule) The point were any change lowers the total benefit/cost 1. Spending more on software will have less benefit than spending on other stuff a. People 1870 startup: Rome Railway Co. b. Hardware c. Advertising 2. Spending more on people … lowers the total benefit/cost Conclusion: • If a company is managed optimally, we can allocate IP contribution by multi-year spending patterns 02-Nov-12 Gio: CS207 Fall 2012 7
- 8. Management • Responsible for optimal operation • Invest to obtain greatest benefit • Lags differ People 3 months to a year Computers 1 months Communication 3 months Cloud services Acquisitions 3 months to 3 years, or never Outsourcing contractors 3 to 6 months 2-Nov-12 Gio: CS207 Fall 2012 8
- 9. Review Allocation • For the Pareto-optimality allocation of income one simply uses cost. But recall: Do NOT use cost as a surrogate for value, value of intangibles come from income. 1) Some spending supports routine income computers, facilities, cloud services, outsourcing … 2) Other spending supports non-routine income creative people: engineers, programmers, marketeers those should be valued, taking leverage and lag into account Approach: only consider 2) the `Residual’ ←economists’ term : 2-Nov-12 Gio: CS207 Fall 2012 9
- 10. Lag measures Prior effort “Gestation period” E Staff Growth: Linear Effort total = ½ E x T A simple metric: lag vs completion= Centroid of prior expenditure here @ 33% (without discounting) Overall @0.33→ 100 87.5 75.0 62.5 50.0 37.5 25.0 12.5 0.0 2-Nov-12 Gio: CS207 Fall 2012 T left 10
- 11. Marketing • Business model must allocate spending optimally Technology, as needed, long life and lag & Marketing, necessary, less lag, slower growth For large 10 IT companies the average value allocated to their brand name is 22% (BW survey). • Interdependence viral Consistent CS207 Relevant Linked by a common name and label Honest FLASH 2-Nov-12 Gio: CS207 Fall 2012 11
- 12. Various Lags Manufacturing & distribution delay Release to Production ←→ Distribution to Sales Sales ←─→ Revenues → development lag Centroid of Costs → Centroid of total revenue development cost .. Testing ~60%→ Sales lag . Research, Design, Implementation ← −−−−−−−−−−−−− → Development done → ←→ marketing lag time → Marketing Centroid of pre- ← Costs sales marketing costs Post-sales marketing, part of sales cost 2-Nov-12 Gio: CS207 Fall 2012 12
- 13. Expense leverage A valuation based on cost 1. Collect the expenses ei over the total lag period p 2. Adjust past costs by a capitalization rate d, ai= (1+d)p-i 3. For year i = 1 → p estimate the R&D retained ri =1- 1/p 4. Aggregate retained to the end date, R = Σ ri x ei x ai 5. From experience, publications obtain an expected leverage m; m can range from 1 to 20 ... 6. Expected value of IP V = m x R m≈2 in the first model we used But the estimation of m is verrrrrrrrrrry iffy Technological advances are rarely stable But could be used for a) venture investing m = 6 – 20+ b) advertising -- much untrustworthy data c) stable maintenance component only 2-Nov-12 Gio: CS207 Fall 2012 13
- 14. SW Lags Development done → β ← General Revenues → availability ↔ Sales development lag ←→ Costs → includes testing Centroid of revenue &Test ing ←−−−−−−−→ sales lag . Research, Implementation ← Costs Centroid of pre-sales ↔ marketing lag time → marketing costs Marketing 2-Nov-12 Gio: CS207 Fall 2012 14
- 15. 100% Quantified model efforts during SW development Effort → 100% level is based on effort at time of completion TotalDevelopment 75% @ 0.33→ 25% Testing @0.08 . 50% → 62.5 25% % Implementation 12.5% Research @0.35 → 0 start 0.75 left 0.50 left 0.25 left done Total development period 2-Nov-12 Gio: CS207 Fall 2012 15
- 16. Start-up development A startup is unlikely to ramp up linearly Use exponentional growth, exp 0.025 Assume 1. 12.5% research Given that idea is clear, only towards for implementation 2. 25.0% testing Minimal and risky 3. 67.5% left for implementation • Overlap research and implementation until testing starts • Overlap implemtation and testing until RPS Results Overall centroid @0.27 before RPS -- later Research from 1.00 to 0.33, centroid @ 0.65 before RPS Implementation from 0.67 to 0.00, centroid @ 0.29 before RPS Testing from 0.17 to 0.00, centroid @ 0.08 before Hiring rate at RPS 21%, at the limit for effectiveness Ignore different 2-Nov-12 Gio: CS207 Fall 2012 staff salaries 16
- 17. Graph of start-up development 21% effort Testing starts when growth 17% time remains → 100% Res., Imp, & Implementation starts when Test @0.27 → 25% 80% 67% time remains → Testing 60% Research ends when 33% time remains → 40% 12.5% Research 62.5% 20% @0.65→ Implementation @0.29→ 0 start 0.75 0.50 0.25 done 2-Nov-12 Gio: CS207 Fall 2012 17
- 18. Start up with 15% research and 50% testing effort Relative Effort → 100% Res., Dev, & Test @ 27% → 75% Research ends and Testing starts when ~37% time remains → 50% 50% Implementation starts when ~69% time Testing remains → 25% ~ 15% Research ~ 35% @0.12→ @0.66→ Implementation 0 @0.35→ start 0.75 0.50 0.25 done 2-Nov-12 Gio: CS207 Fall 2012 18
- 19. Development in mature company with 12.5% research and 25% testing effort, 38% effort growth 62.5% implementation at start Res., Imp, & 5% company staff growth Test @0.42 → 100% Available Testing starts when Relative Effort → ←−−− 40% time remains 75% resources Research ends when ← 65% time remains T ←Implementation starts when 50% 85% time remains R I 25% @0.46→ 0 @0.85→ 1.00 0.75 0.50 0.25 done Values based on finite integration, exp= 0.05 2-Nov-12 Gio: CS207 Fall 2012 19
- 20. Product revision, Mature development 35% effort growth with 50% testing effort at start 100% Available resources Overall 75% @ 0.38 → 50%T Effort → 50% @0.22→ 50% R & I 25% @0.58→ 0 8%R start 0.75 0.50 0.25 ← Research ends and Testing starts done when 67% time remains 2-Nov-12 Gio: CS207 Fall 2012 20
- 21. Summary: Maturity effect 100% Effort Maturity effect → 75% @0.42→ 50% Testing @0.33→ 25% @0.26 → Research Implementation 0 start 0.75 0.50 0.25 done Total development period 2-Nov-12 Gio: CS207 Fall 2012 21
- 22. Lag differs less than development period Testing R&I done done start Testing R&I start done Testing Effective lag = Development period × Centroid fraction R&I done start done 2-Nov-12 Gio: CS207 Fall 2012 22
- 23. Ongoing development New considerations 1. Have staff already a. Early versions rapid growth, but observe ~20% limit b. Later, best grow slower 2. Can overlap version development a. Don’t let valuable staff be idle b. Missing features should already be understood c. Rapid analysis of problems to allow next version fixes d. Any research should be done before major staff effort 3. Adequate testing to keep reputation 2-Nov-12 Gio: CS207 Fall 2012 23
- 24. 2nd version technical lag 100% Staff becomes available when prior version enter testing 25% Testing Relative Effort → 75% for version n All 100% Starts at .057 0.57→ 0.19→ 50% Implementation Research for for version n version n release release 25% Research & Implementation ←0.76 1.50 1.251.00 0.75 0.50 0.25 done ←−−−−−−−−−−− Version n development interval −−−−−−−−−−−−−→ 2-Nov-12 Gio: CS207 Fall 2012 24
- 25. Mature ongoing technical lag Staff becomes available when prior version enter testing Overall 25% Integration @ 0.63 → 75% Research & and Testing Effort → Implementation for @0.21 . version n release → 50% @0.77 → Testing n-1 25% 1.50 1.25 1.00 0.75 0.50 0.25 done ←−−−−−−−−−−− Version n development interval −−−−−−−−−−−−−→ 2-Nov-12 Gio: CS207 Fall 2012 25
- 26. 2nd Version substantial testing 100% Effort → 43% Testing during version n 56% 75% All@0.61→ interval T@0.33→ 50% R&I @1.00 → 25% Release 0.25 done 1.50 1.25 0.75 0.50 version n 2-Nov-12 Gio: CS207 Fall 2012 26
- 27. Version development, mature growth, much testing 100% Overall @0.77→ 75% Testing at 35% effort Research & Implementation during version n effort towards version n interval @0.33→ release 50% Effort → @1.00→ 25% 1.50 1.25 Release 0.75 0.50 0.25 done version n 2-Nov-12 Gio: CS207 Fall 2012 27
- 28. Determine technical lag 1. Determine type of development Validate from a. Startup personnel b. Simple records c. Mature d. Ongoing ? 2. Determine interval of development ←→ ? 3. Does testing contribute to IP? 4. Determine growth of personnel effort Lag, because it precedes IP diminution, has a large effect on economic valuation 2-Nov-12 Gio: CS207 Fall 2012 28
- 29. Multi Version product effort and lag Effort total = 8.6 x original effort Test ratio: 37% Overall @0.42→ Testing @0.38→ 100 Releases: 87.5 75.0 initial 62.5 ver.2 50.0 ver.3 37.5 ver.4 25.0 ver.5 12.5 → 0.0 ver.6 latest 2-Nov-12 Gio: CS207 Fall 2012 29
- 30. First to market advantage v1(O) Effort total = 8.6 units Overall @0.42→ s(O) Original Multi Version efforts and lag → start Re-creation Original product creation time Competition (drawn to scale) Growth Rate 20%/year average Effort total = 5.4 units Overall Competition/ Original multi version source @0.33→ Effort ratio R/O = 0.63 100 75.0 50.0 25.0 0.0 Time ratio (t(R)-s(R)/t(O)-s(O)) = 0.41 t(O)=s(R) t(R) Effective Lag ratio = 0.23 But at that point the original is 3.5 versions ahead of the competition! 2-Nov-12 Gio: CS207 Fall 2012 30
- 31. Discussion • A long-lived product is hard to displace if It is well maintained, but that becomes costly Keeps up with all standards • Internal replacement Should be easier But has not been in practice 2-Nov-12 Gio: CS207 Fall 2012 31
- 32. Lag conclusion (snake in the grass) Lag is the effective development period Has a large effect on early valuations 1. No income during that time 2. A chance for others to overtake you We assumed a lag of 2 years in the examples. Depends Startup Simple Testing on product Model Testing R&I development start R&I Mature strategy Effective lag = Development period × Centroid fraction Testing Separate paper on website R&I 2-Nov-12 Gio: CS207 Fall 2012 32
- 33. Setting License fees Say you want to delegate sales in Europe to some company EUsales that can do it easier over there • How do you set the fees or royalties? 1. You have computed a value of your SW of $1M But without discounting, it is actually $1.6M = Σ(due old, slide 5) You will also maintain the SW 1.36M = Σ(maintenance cost, slide 12) The total due is $3M 2. You expect the European sales will be 40% of total, 20 000 The reason for not discounting is that funds arrive at the same times. • To earn the same you should charge 1./2.= $150/unit It does not matter how EUsales sells it and what it charges Complexities are required language, interface improvements 2-Nov-12 Gio: CS207 Fall 2012 33