One of the ironies of our high tech age is that developers and designers seem to know very little about the value of software as a product. There are all kinds of encouragements and advice on how to be a lean startup, to utilise Agile for development, to ship early and often and so on. But these are just methods to attaining a given goal in, hopefully, a faster and better way.
Admirable as some of this guidance maybe, software applications and software businesses are often created seemingly without very much understanding of the real, inherent value of Intellectual Property (IP).
Techies (and most other people it should be said) find that due to the lack of any absolute way of directly applying a useful metric they are reluctant to engage with the intangible. The value of IP, like the value of marketing doesn’t lend itself easily to quantification — the lifeblood of the engineering process.
That means it is left to other people such as investors, lawyers, promoters and, of course, the tax authorities, to care about what a piece of software is worth.
There all kinds of intangibles but fortunately, software is one of the more tangible intangibles. An intangible is not valued on the cost of the production but on the cost of the future income it will bring. If you want to value software you have to assess the future income stream.
A piece of Intellectual Property (IP) is not the same kind of commodity as say, a brick.
Like nearly all commodities, bricks only have a value when they are in demand, usually at a time when a wall or a house is going to be built. Otherwise they are either inventory lying around incurring costs or are highly illiquid constituents of a construction.
As far as accounting systems go, money made from commodities such as bricks or professional services are classed as routine profits. Due to the unquantifiable nature of IP it is regarded as being non-routine. This is an important distinction because as you will see this is where the real money is.
There are also two other important factors concerning IP. It is extremely portable and it is highly recyclable.
The same IP can be used again and again. The core IP of most of the major pieces of software that we use, spreadsheets, word processing programmes and the like have changed little over the years. All we have had, for the most part, is the same basic function with new features, different user interfaces and other assorted bells and whistles.
The IP value of a given piece of software remains constant from one version to the next and is different in value from the what the customer perceives and will pay for in terms of updates and new features.
Also, that core IP can be stored anywhere in the world or even merely said to be stored anywhere, by means of filling in a few registration forms.
Gio Wiederhold, Professor Emeritus at Stanford University, was at NUI Galway last summer to receive an Honorary Doctorate. While he was in town he gave a talk entitled “How to Value Software in a Business and Where might the Value Go?” and afterwards spoke to Technology Voice.
“Our attitude to software generation has not changed with the times. If software is misvalued, creators don’t get the value from it and the government doesn’t benefit from it in taxes. — This can result in a disincentive for investors to invest and a lack of future job creation.
“IP is poorly understood but is essential to generating profits. As a consequence it is easy to misvalue and in the United States you are not even allowed to put it on the books. As the typical tax official is unable to determine the value of IP.”
Just to muddy the waters further, companies and corporations can very easily take advantage of the extreme portability of IP.
“A company can live in many places.” Gio says, “When you have IP you can separate the rights of the IP from the location of the IP.”
This means that parent corporation can have a holding company in a tax haven somewhere like the Cayman Islands whose only purpose is to hold the registration for the IP. It is then able to receive fees from the licensing and pay no tax.
But try as they might, corporations still need people to work for them; developing new products, dealing with customers and so on. Also, large corporations need to keep going 24 hours a day so having to have operating bases in Europe becomes a consequence of doing business.
Choosing English speaking Ireland with its low rate of corporate taxation and highly qualified workforce was a no-brainer for many US corporations when it came to establishing an overseas location.
But that doesn’t mean that the Exchequer of Ireland gets anything like the money it would do if the IP was registered here. Taxes collected from multi-national is based on routine profits. According to Gio, “Routine profits are earned when a good job, well done, has been rewarded, and on average generate profits of 5 to 7%. Non-routine profits which are based on IP can earn up to 80% profits.”
So, a parent corporation can have a subsidiary in Ireland. It can then have that Irish subsidiary licence its IP from a holding company set up in the Cayman Islands or tax haven of choice and taxes from the non-routine IP profits are, quite legally, avoided.
“Because the IP is overseas, multinational companies and Ireland [unlike the UK and the US] only legislates for taxes on its own territory then these companies are only liable for taxation on their routine profits.
“Ireland’s corporate tax rate of 12.5% is only applied to the usual routine profits and not to the profits from the IP which are a cost on the books as they are often a licence fee to a shell company in a more favourable jurisdiction.
“Because of these practices the US loses about $180 billion a year.”
So what to do? According to Gio, “Companies are smarter than any government. This is not about closing loopholes. It’s not that simple. This is a whole system.”
Thanks to Professor Wiederhold for the use of Loss of Revenue to US Government image.
More material on this subject is available from the infolab website.