Valuing Homegrown Systems

There’s a growing ground-swell of interest in many companies today around the valuation of their homegrown ERP, CRM, order capture and service applications. This issue has come to the forefront for several reasons, the two most dominant ones being many companies are looking seriously at the marketability of these applications in the open market, and second, the need to value intellectual property in their companies as manufacturing is moved offshore.

CIOs as Pitchmen

Weary of spending so much on maintenance, having bug fixes that deliver more bugs than they fix, and having to constantly look at licensing and upgrade strategies, there is a growing group of companies — some in manufacturing, many in services — that are looking to fight back. They are doing this by selling software to each other rather than just buying it from best-of-breed and ERP vendors. A few have actually created development toolkits with APIs to complete integrations. Consultants are getting in on this, developing the API Toolkits.

This isn’t just limited to the U.S., but is happening with even greater frequency throughout Europe. With organic or new growth slowing in companies, management is looking inside for revenue ideas — and settling in on the concept of licensing, selling or developing OEM channels for their order management, supply chain, service and support systems.

CIOs have long defended their homegrown systems as superior in many ways to what best-of-breed and ERP vendors both have to offer. Now it’s their time to prove it.

In watching and at times contributing to these valuations, I’ve run across several truths to keep in mind. They are presented here:

Valuation Truth One: Forecasts Are Useful for Ranking, Not Profit Projections

The tendency of many companies — when they take this strategy seriously of licensing or reselling an internally developed application — is to look for the analyst firms that offer hockey stick forecasts for their applications and embrace their figures, their analysts and their assumptions. If there’s anything the last recession taught everyone, there is no such thing as a hockey-stick forecast, especially in software. It’s the Wild West all over again in software forecasting and the enterprise landscape is being re-carved daily.

These forecasts that show high growth and the trajectory of a jet taking off are rarely accurate. It’s best to use the Compound Annual Growth Rate (CAGR) only as a relative ranking of the opportunity than to take any forecast verbatim. It’s a quick approach to prioritizing opportunities.

Valuation Truth Two: Beware of Valuation Bubbles

Just as Alan Greenspan claims real estate valuations are in regional “valuation bubbles” the same holds true for software valuations.

This is definitely true for web-based security applications and order capture applications masquerading as order management ones. If you look hard enough you can find a venture capitalist to tell you your best-of-breed security app is worth nine times or more you spent to build it — but that is incredibly inaccurate. The same holds true for so many companies that have customized order capture systems — and in an honestly self-important way — many companies call these order management systems when all they are really doing is consolidating orders and doing fundamental channel management. This is even more evident when you consider that a typical order management system sells for $1.6 million or more — and that so many companies consider theirs to be superior to any other — and you can see how alluring the concept of calling an order capture system an order management system can be and then reselling it netting a company millions in revenue.

The bottom line here is don’t believe in software valuation bubbles — they will only lead to major expectation management issues down the road for any company looking to sell portions of their key technologies.

Valuation Truth Three: Go with Bottoms-Up Forecasts Using Net Present Value

There is no magic bullet for defining the valuation of your software, and if any consulting or advisory firm tells you there is, run. The fact is that your homegrown systems are unique, and the percentage overlap to competitors can only be ascertained by someone who knows your apps and the closest competitors. And of that overlap with competitors, there are many other competitive forces at work. So instead of thinking that the order management market may be approximately $3 billion today sliced up by the dominant ERP competitors (SAP and Oracle) with Comergent, IMI, Siebel and Sterling Commerce (due to the Yantra acquisition) being on the best-of-breed side, and your applications are most like Comergents’ for example — then reasoning your market size is Comergent’s revenue. Wrong. Your market size is another level below that.

Take the total market size ($3 billion), then trim it down to best-of-breed revenue that is non-captive (30 percent of the total market), as ERP vendors dominate this arena and generate the majority of revenue (70 percent of the total market is captive revenue generated by these ERP vendors), and that leaves $900 million for all best-of-breed. Now get the range of revenues for the closest competitors — and you get to $300 million. Next, consider what percentage of that figure you can get — possibly 5 percent in 24 months? That’s reasonable as it takes over a year to create an order management application and costs approximately $1.2 million to build one from scratch — and it will take at least that long to add in necessary features to make your homegrown application marketable. The true total available market is $15 million. Quite a far cry from $3 billion, and realize many application markets have dramatic splits between captive and non-captive revenue.

A Final Note: Don’t Shortchange Yourself When Offshoring

When manufacturers move their production offshore and take their homegrown applications with them, too often the homegrown systems’ valuations are a fraction of what their real value is. The net result is like giving a homegrown system a permanent mark-down. For a while companies enjoy inflated financial metrics, and when the inevitable price competition in an industry heats up, companies find that their intellectual property — most often in the form of software purpose-built for their processes — is vastly undervalued. For many companies considering off-shoring their manufacturing and taking home-grown systems with them the message is clear: set realistic valuations on your homegrown systems beforehand, even if you have to take a tax hit. Recovering revenue to support undervalued systems — the core intellectual property of many companies — is very tough to do.

There are several excellent researchers working in this area. Dr. Gio Wiederhold of Stanford University’s Computer Science Department has done several excellent models on precisely this topic. You can find his homepage here.

Bottom line: This is just the tip of the valuation iceberg, literally. There is much more to cover, but if you are looking at selling homegrown systems, be sure to follow the market sizing logic in Valuation Truth Three and if you are going offshore, be smart about valuing your intellectual property. You’ll be much stronger financially in the long run for it.