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After exploring the going concern analysis in last week’s blog, our attention this week will focus on the various approaches and methodologies in the valuation of a software company under a going concern assumption.
Under a going concern assumption, the valuation is typically performed by one of the following approaches:
The Asset-based Approach is typically used to value pre-revenue companies in the early startup stages. A common issue with the Asset-based Approach is that it does not reflect a company’s potential in generating future cash flow, nor does it recognize any brand or intangible value that the company may have already developed.
One element of the Asset-based Approach is the cost to duplicate. Based on this approach, the theory supports the idea that an investor would not pay more for a software company than what it would cost to duplicate the technology the company has. These costs may include the research and development costs, adjusted for technological advancements that may have since occurred that would speed up the pace of the development, the costs of registered patents in relation to the technology the software company has and costs related to prototype development (if any).
Sometimes, the cost to duplicate may include a “time to market” premium. This premium reflects the time saved by the purchaser, as the necessary steps (and time) required to produce a product has already been performed by the software company.
Under the Asset-based Approach, other considerations may include whether the incurred costs have contributed, or can be reasonably expected to contribute, to the future operations (cash flows) of the software company, whether these costs can be traced directly back to the product (i.e., software), whether the costs are reasonably current given that software technology changes rapidly and whether the incurred costs are comparable with industry standards.
In reality, excessive costs incurred due to inefficiencies are not rewarded. Nonetheless, the purchaser will ultimately consider whether any evidence exists to show that the company can recover the incurred costs through future sales by reviewing whether the product/software has been tested and how many units/subscriptions must be sold in order to recover the incurred costs. Another important consideration is reviewing whether there is market potential for this product or software, including the size of the market and whether there is a viable plan to exploit this market potential.
Stay tuned for next week’s blog where we will explore the Market-based Approach.