What's My Software Worth? Jan 27 2016

A prospective client recently asked this in regards to a proposed build for their startup. I know an accountant who would say, “it depends,” although he says that in response to just about any question.

Unfortunately, there’s not a formula for post-construction software value as you might have with a house. With a house, you can generally assume that $X in lumber and $Y and labor multiplied by some kind of “neighborhood value multiplier” results in a rough estimate of a home’s value. In software, there are no “materials” costs, so it’s all labor. And the labor has a much bigger range of effectiveness in software than, say carpentry. One programmer really can be 10 times more productive than another. I’m no carpentry expert, but I suspect carpentry is at least an order of magnitude less variable.

In the housing market, the value of a newly constructed house is usually a little greater than the sum of its parts. This is what keeps real estate developers in business. You spend $X on materials, $Y on labor, and sell the house for $Z, such that Z = X+Y+Profit (at least in “normal” housing market periods). Extreme profits are only possible through externalities basically unrelated to the labor or the materials… cases where the developer correctly predicts (or creates) a hot new neighborhood. To draw our parallel with software further, let’s call the choice of neighborhood, “the idea,” and the effort of the construction team “the execution.” We could say, then, that in real estate, “the idea” is the dominant factor in the value of the finished product… building your spec house in the right neighborhood can easily make up for the mistakes of a set of underperforming contractors.

In software and startups, the reverse is true. Execution is dominant. Investors love to invest after you’ve demonstrated success in bringing on customers (i.e. after the “house” has been demonstrably proven to be the best built one on the block). Even genius ideas struggle to find investment when they lack effective execution.

It’s hard to imagine poor construction leading to a “valueless” house. Startups, on the other hand, go out of business all the time, and sometimes poor development is a key reason. These startups aren’t technically worth $0, but in the sense that they were unable to find a buyer, there is a mathematical sense in which they are worth $0.

With there being no counterpart for a “materials expense” in software, it becomes important to realize that there isn’t a “minimum relationship” between the expense going in, and the resale value coming out. A half finished house is never worth $0, it’s worth at least the value of the raw materials that went into it. This is because there is an open market for construction materials (even damaged ones), and another market for fixer-upper homes. Equivalent secondary markets don’t really exist in software. There are some buyers who might buy a company’s software with an eye towards modifying it and “fixing it up” so to speak. But these buyer’s don’t have “comps” of other similar “distressed software”. And they’re likely to put little weight on the seller’s claimed construction costs. In the end, the value of the the software is some number relating to what they think it would cost to create from scratch (which is an option for every buyer unless there is some patent or intellectual property involved). In other words, if you build a company for $5 million, and try to sell it, but the investor is convinced they can build the same thing with $1 million, they’re not going to pay you 5X to avoid the risk that their version would be worse. And keep in mind that software keeps getting cheaper to build. If it cost $5 million in 2016, the same code might cost $4 million in 2017.

This is a key reason why being lean and efficient and not “over” building is important. You’re never guaranteed to get $1 back in value for every $1 you put in.

Let’s say you spend your $5 million creating a business that is making $100,000/month in revenue. It’s spending $10,000 per month on marketing, and seeing $15,000 in new recurring revenue connected to that marketing spend. Its growth metrics, in other words, are known. Buyers for this business couldn’t care less about how much was invested to create the business. Its value is all about the values of its current and future revenue potential.

Now let’s say you spend your $5 million attempting to create software which, when used, cures the cancer of the person using it. Life changing. World changing. But not done yet. Still buggy, and only effective for 1 in 1,000,000 users (and possibly no better than a placebo). When this business talks to investors, they’re going to care a lot about the amount of money invested already. They’ll want to get to know the team of scientists and gauge their level of confidence that the problem will be solved, even though it’s not solved yet.

I chose the nonsense “cancer software” reference because it should be clear to you your idea is not that great. And if I’ve established that even “miracle cancer software” isn’t worth $1 for every $1 invested, then you should also be convinced that your idea continues to be worth $0 until its in the marketplace. It’s worth $0 until the first customer touches it. It’s worth $0 until the first customer pays for it. So launch already! What’s your software worth? Nobody knows…. until you launch it.