{"id":628,"date":"2014-03-17T09:06:56","date_gmt":"2014-03-17T08:06:56","guid":{"rendered":"http:\/\/www.telekta.com\/blog\/?p=628"},"modified":"2014-03-17T09:06:56","modified_gmt":"2014-03-17T08:06:56","slug":"what-is-your-asset","status":"publish","type":"post","link":"https:\/\/www.telekta.com\/blog\/2014\/03\/what-is-your-asset\/","title":{"rendered":"What is your Asset?"},"content":{"rendered":"

A better way to value technology license product company value
\n<\/strong><\/em><\/p>\n

\"\"<\/a>In the famous book Rich Dad Poor Dad<\/em>, Robert Kiyosaki redefined the accounting term “asset” to mean something you own that generates money<\/em>. Using his definition, the house you live in may be an asset for accountants, but an expense according to him (and now me). I found this redefinition very useful in my personal life and then soon found myself trying to redefine asset as I looked at evaluating company value for purposes of company merger or payout.<\/p>\n

Using a Kawasaki-esque, practical approach, we see that the the Intellectual Property (IP or source code) is only valuable if and when people buy licenses. Moreover, existing license sales are only valuable if the licenses can be sold at a profit and the number of customers is only valuable if they are receptive to buy more licenses or support.\u00a0 Given this, how can we measure the value of the asset in a meaningful way?<\/p>\n

I have never been impressed with any company evaluation equation in the technology sector nor have I found accounting standards good arbiters of success.\u00a0 However, in the case of mature mode, enterprise class software, I believe there is a simple measurement of one single value that defines the value of the asset in the same intuitive and useful way as Kawasaki.\u00a0 That single measurement:\u00a0 Total value of list license price under an active maintenance contract<\/strong> (LLPUAC) is directly proportional to company value and that two different companies (in the same sector) could be directly compared by looking at the ratios of their LLPUAC values to determine the ratio of their relative company value<\/em>.\u00a0 I believe that this one single measurement encompass nearly everything likely to be important about a company (or product) value in this category.\u00a0 This means that lines of code, annual revenue, human capital, brand equity, cost of sales, and other common measures are irrelevant once you have LLPUAC.\u00a0 My reasoning:<\/p>\n

Let’s start with some baseline assumptions on this type of mature-mode, enterprise class license sales.\u00a0 Some typical numbers: average discount of 50%, cost of an indirect sales channel is often 30+ percent, renewal rates of maintenance contracts are about 70 percent per year and average maintenance fees are slightly more than 15 percent per year.<\/p>\n

Now, let’s look at all the factors not<\/strong> included in my valuation:<\/p>\n

1. License Sales<\/strong>: Don’t factor, because sales will continue until the marginal cost of sales exceed income.\u00a0 Why?\u00a0 Assume we have a 100K\u20ac list price for a license.\u00a0 Based on the assumptions above, revenue from the license sales is likely to be between 0 and 20K\u20ac after channel costs and discounting.\u00a0 But “long tail” maintenance fees are based on list<\/span> price and will look like: 15%(100K)+70%*15%(100k)+70%*70%*15%(100K)…<\/i> \u00a0which is more than 35K\u20ac (note, just a slightly higher percentage in customer retention (renewal rate of maintenance contract) can double this number). As a result, most companies recognize that installed license growth is better than trying to improve the cost of sales– thus sales revenue and costs usually expand (and become less efficient with each incremental addition) until new customer license sales stop contributing to the company’s margin .\u00a0 If a company is not at max-expansion mode today, they likely should be and the “asset” price should reflect the way the company could be run. This also explains why I believe the average discount price is insignificant in comparison to the maintenance outlook.<\/p>\n

2. Maintenance Revenue<\/strong>: Maintenance is typically based on the list price of the license.\u00a0 Maintenance customers have little choice but to pay the established rate due to high change costs in this business sector.\u00a0 The major limitation to excessive maintenance fees is loss of customer good will.\u00a0 If a company is charging 25 percent, the short term revenue will obviously be significantly different than if it charges 10 percent, but the long term revenue will reflect the bad will impact on renewal rates (as well as planned follow on products).\u00a0 Even if the long term revenue stream is different, changing the annual maintenance fee is an easy change to make and thus not a good measure of product value.\u00a0 Reflected “asset” price as the way the company should be run means maintenance renewal rates and maintenance fee percentages are not important factors.\u00a0 This also explains why the average revenue per customer measurement is less important since it is the list price that drives what should be extracted.<\/p>\n

3. Service Revenue:<\/strong> Initial implementation services are often break-even on average (similar to licenses — always competitive situations and higher uncertainty).\u00a0 Ongoing services are more profitable and should be directly proportionate to customer engagement which is also proportionate to maintenance renewal rates which is the basis of my asset redefinition. Thus I leave it out.<\/p>\n

4. Cost of Engineering<\/strong>: The cost of engineering is justified only if it is creating value.\u00a0 This is measured by customer renewal rates and new licenses.\u00a0 The code otherwise has no market price since it likely could never find a buyer for it alone.\u00a0 Thus again, it is already covered.<\/p>\n

5.\u00a0 Cost of Overheads<\/strong>:\u00a0 Overheads can always be restructured, especially in a large enterprise.\u00a0 Again, because we are evaluating the asset based on an assumption of management as it should be, we can ignore it.<\/p>\n

Note, that company value is proportionate to LLPUAC.<\/p>\n

Company value = k * LLPUAC<\/p><\/blockquote>\n

This \u201ck\u201d value will be different for different industries, but the real usefulness of this is that a change in LLPUAC results in a change in valuation.\u00a0 Even if we are not selling the company, merging companies, or selling off the product division, LLPUAC can be a useful tool for management.\u00a0 The equations below show that<\/p>\n

Increasing Company Asset Value means:<\/p>\n

New License Revenue<\/span> > Maintenance Contract Revenue * (100%-Contract Renewal %) * Avg New License Discount% \/ Average Maintenance Contract Fee%<\/p>\n

or<\/p>\n

Maintenance Contract Renewal %<\/span> > 100%- [( New License Revenue \/ Maintenance Contract Revenue) * (Maint Contract Fee% \/\u00a0 Avg New License Discount%)]<\/p><\/blockquote>\n

Using our example assumptions:<\/p>\n

New License Revenue > 1M\u20ac* (100%-70%)*50%\/15% (=1M\u20ac)<\/p>\n

however, if we sold just half as much revenue (0.5M\u20ac) with even higher discounting (60% discount), what improvement in my renewal rate would be required?:<\/p>\n

Renewal% > 100%-[(0.5M\u20ac\/1M\u20ac)*(15%\/60%)] (=87.5%)<\/p>\n

Notice the high sensitivity to maintenance renewal rates.\u00a0 Using this example, one would need to more than double your new license revenue to correct for a 15% change in renewal rates in order to keep the company the same path.<\/p>\n

For a mature mode software license company, it is common that all engineering and overheads are covered by maintenance fees. But if the company completely stopped selling licenses, there would be a continuous (but declining) long tail of revenue and profits. \u00a0In our example, each year, 30% of the income leaks out from the non-renewing customers (100%-70%=30% leakage). Partially this is due to uncontrollables such as companies dying or changing ownership. But it can also be caused by things that are partially controllable such as the customer switching to a superior competitor product. Zero leakage is simply impossible. Thus each year more new licenses must be sold to generate maintenance fees to replace this maintenance fee leakage.<\/p>\n

Increasing the maintenance contract renewal rate by lowering maintenance fees or increasing list license sales by increasing new license discount rates will increase long term value but this strategy is limited by cashflow realities.\u00a0 Better is focusing energy on increasing new license sales and improving customer retention for maintenance contracts.\u00a0 Alternatively, increasing maintenance fees or reducing costs of sales (to focus on the most profitable sales) will boost yearly cash flow but will rapidly reduce the stored company value.\u00a0 This cashflow boost often creates complacency at exactly the time you need to correct your company’s trajectory.\u00a0 Knowing when your company value is increasing or decreasing is critical before you can look at other, secondary factors such as cashflow, profits, cost of sales, discount rates, etc.<\/p>\n

When a product\/company is in cash cow mode, that is, further growth is not possible and there is shift to “milking” profits from customers, the company is usually highly profitable but it is not always obvious that the business is almost certainly deteriorating.\u00a0 This happens because most of the traditional accounting and intuitive feelings are still trending positive while LLPUAC indicates a more true indication of the company’s health.\u00a0 As the asset dissolves, so too does the source of revenue to fund product improvements, new products, or enter new markets. Further cost cutting will often maintain profitability in the mid term, but likely will further reduce sales reach and product investment.\u00a0 It takes just a few years in dissolving asset mode to render the return of a product to growth mode impossible.<\/p>\n

Finally, when the maintenance revenue drops below the minimum cost of engineering and overhead to keep the product functioning, the product is essentially dead. \u00a0Coincidentally you will note that its asset value was at maximum just before it entered into cash cow mode.\u00a0 This is also the same moment when the customers were likely most positive about the product\/company and receptive to other products and services at that point as well.\u00a0 Moreover, as the company approaches the point of “product death”, customer goodwill is likely to be at an all time low. \u00a0Thus, the customer base also tracks our new definition of an asset. \u00a0Finally, it is important to note that the product is dead even though some customers remain who will pay the maintenance fees.<\/p>\n

What do we do with this new asset definition?\u00a0 I submit that it provides a simple measurement to better understand the value of a technology product.\u00a0 \u00a0\u00a0It establishes a growth measurement, sales targets, renewal retention targets, and fixed engineering costs. \u00a0However once the product lifecycle enters cash cow mode, it is time to shift the targets and use these profits to fund the next initiative.<\/p>\n

The message here is that the asset owner should not wait for the other indicators to catch up to the proposed new asset number.\u00a0 If a product is already in cash cow mode and the new product will not address the same customer base in the near future, it might actually be better to sell off the cash cow product business entirely and focus on a new future with a war chest of money and no management distractions.<\/p>\n","protected":false},"excerpt":{"rendered":"

A better way to value technology license product company value In the famous book Rich Dad Poor Dad, Robert Kiyosaki redefined the accounting term “asset” to mean something you own that generates money. Using his definition, the house you live in may be an asset for accountants, but an expense according to him (and now […]<\/p>\n","protected":false},"author":2,"featured_media":0,"comment_status":"closed","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[1],"tags":[],"class_list":["post-628","post","type-post","status-publish","format-standard","hentry","category-uncategorized"],"_links":{"self":[{"href":"https:\/\/www.telekta.com\/blog\/wp-json\/wp\/v2\/posts\/628","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/www.telekta.com\/blog\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/www.telekta.com\/blog\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/www.telekta.com\/blog\/wp-json\/wp\/v2\/users\/2"}],"replies":[{"embeddable":true,"href":"https:\/\/www.telekta.com\/blog\/wp-json\/wp\/v2\/comments?post=628"}],"version-history":[{"count":20,"href":"https:\/\/www.telekta.com\/blog\/wp-json\/wp\/v2\/posts\/628\/revisions"}],"predecessor-version":[{"id":719,"href":"https:\/\/www.telekta.com\/blog\/wp-json\/wp\/v2\/posts\/628\/revisions\/719"}],"wp:attachment":[{"href":"https:\/\/www.telekta.com\/blog\/wp-json\/wp\/v2\/media?parent=628"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/www.telekta.com\/blog\/wp-json\/wp\/v2\/categories?post=628"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/www.telekta.com\/blog\/wp-json\/wp\/v2\/tags?post=628"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}