Archive for September, 2015

The rules applied by the Financial Accounting Standards Board (FASB) extend to some pretty important business assets:

  • Software
  • Patented technology
  • Trade secrets
  • Databases

Patents have been valued for quite a while and their valuation presents no problems. Royalty income streams from licensing comparable intellectual property assets are the basis of valuing your patent portfolio. However, putting a value on trade secrets or software is likely to cause issues especially if you are considering business acquisition or merger.

Valuation of technology and, in particular, software technology often results in large sums that are likely to impact your bottom line, at least in the short term.

Software valuation challenge – useful life

The main issue when valuing software is how to set the useful life. Why is this an issue? Software is unique in that it is constantly undergoing change. As new technologies come along that improve user access, increase available computing power, or provide better ways to communicate your results, software must be improved to keep up.

So software products are likely to change even in the short run. If you value software in its current product form, the value is likely to be lower due to the short expected life. On the other hand, if the software technology is valued by factoring the change in, the value will be much higher.

Values of R&D assets and business goodwill

In the US, the Securities and Exchange Commission (SEC) has created the requirement to evaluate the so-called in-process research and development assets or IPR&D for short. If you are buying a software company, you would need to assign considerable value to this asset class because R&D needs to be written off right away. The amount of business goodwill is thus reduced.

The idea is that you can’t include the value of future generation software once the current version is fully completed. Put differently, software eventually becomes different enough to treat it as a new business asset.

In the past, most companies tried to maximize this IPR&D and minimize business goodwill. Now, because goodwill can no longer be amortized, the situation is reversed.

So what it means to you is that there is a disconnect between the business owners looking for low values and short asset lives, while the government will want exactly the opposite. As the saying goes, you can’t avoid death and taxes.

Take a look at the public capital markets, and one thing becomes immediately obvious: the higher the shares turnover for a given company, the higher its valuation tends to be. This is because investors love liquidity, i.e. the ability to trade business ownership interests quickly, with minimal costs, and at a predictable price.

Smaller companies are usually less liquid, with fewer shares trading on a given day. The result is that such companies have to generate higher returns to attract the investors.

In the formal language of business valuation, the companies that are less liquid have a higher cost of capital and higher returns than their larger, more liquid counterparts.

The situation with private companies is even more challenging. There is no direct measure of liquidity because these companies do not sell stock to the public. So there are no reported stock prices to go by.

This relative lack of liquidity for private companies has a very strong effect on their value. In numerical terms, the company’s discount or capitalization rates are increased.

Public capital markets are silent as to how much this lack of liquidity affects the value of private companies. The way you can account for this is to calculate the values of similar public companies whose stocks are actively traded and then apply a marketability discount when valuing a private firm.

You can’t assess the impact of low liquidity directly by looking at the private companies. However, you can estimate the levels of relative lack of liquidity by studying public companies whose stock turnover differs.

Pick two sets of companies, one comprised of large, actively traded firms, the other consisting of companies whose stock sells on occasion. You will notice the significant difference in historical returns. The lower the trade volume, the higher the returns required to keep the investors happy.

Note that this liquidity value premium is not to be confused with company size. To see this, compare returns of companies that trade at about the same volume but differ in size. You will see that the company size, i.e. market capitalization, is an independent predictor of returns. Larger firms tend to have lower returns, no matter the liquidity.