When a company is in merger-and-acquisition mode and has a list of possible takeover targets, its focus is often on revenue, market share, and brand recognition.
However, underlying this is a crucial, often-ignored asset that can significantly sway the final deal: source code.
For a business that is heavily reliant on technology, source code can significantly affect its overall valuation. Whether this is a software-as-a-service business, a mobile app company, or an embedded systems specialist, source code is a crucial part of the equation.
Here are five major ways source code can affect company valuation during an acquisition.
1. Clear Ownership of Source Code Enhances Asset Value
The first question a potential buyer should ask before an acquisition is: Who owns this source code? If a takeover candidate can’t clearly prove ownership of the source code, it’ll have an immediate effect on valuation.
Companies must ensure they have clear, proper documentation of source code ownership. There are a number of issues that can materialize in this regard, such as the following:
- Contractors were not bound by proper IP assignment agreements
- Developers were using third-party code without proper licensing
- There was improper use of open-source code
For example, if a company is using open-source code managed by an organization such as the Free Software Foundation, that organization has specific rules that dictate how the code can be distributed. It’s important to consider source code ownership when valuing a company.
2. The Quality of Source Code Can Signal Operational Risks
The quality of a company’s source code is a major indicator of its overall operation. The acquirer may perform technical due diligence, including bringing in third-party specialists, to assess the following:
- Maintainability of the code
- Documentation standards
- Security vulnerabilities
- Scalability of the architecture
If the buyer believes significant restructuring efforts will be required after the acquisition, they may negotiate a lower purchase price to offset the anticipated costs. On the flip side, if the code is clean and the architecture is scalable, a premium takeover offer may be warranted.
During the due diligence process, it’s worth speaking to a source code expert. Such a professional can help buyers and sellers understand the ins and outs of source code and how it can potentially enhance the value of a takeover target.
3. Proprietary Technology Provides Competitive Advantage
Proprietary source code may be the company’s most defensible competitive advantage. If the software contains proprietary algorithms, patented business processes, or highly specialized functionality, it can significantly enhance the acquisition value.
Buyers will often pay a premium for software that’s difficult or impossible to replicate or has an established demand in the marketplace.
4. Scalability and Potential for Integration Impact Growth Potential
The valuation model used in an acquisition is often based on the company’s expected future earnings, not past earnings.
If the system is not scalable or is difficult to integrate with other systems, the growth may be limited. For example, the acquiring company may need to integrate the software with other systems, such as a customer relationship management solution. If the system is well-designed with the right frameworks, the scalability is high. Scalability is good for valuation as well.
If the system is older and needs to be re-engineered to be scalable, the valuation may not be as high as the takeover target expects.
5. Security and Compliance Affect Risk Assessment
Security and compliance have now become major valuation factors for companies.
The source code may pose risks to the buyer. If the target didn’t follow the best practices in source code development, the buyer might be at risk. During the technical due diligence process, the acquiring company may perform security tests to assess risks like outdated libraries, weak encryption, or inadequate access controls.
If the company’s source code poses security risks, the acquiring company may offer lower consideration for the company or may even back out during the due diligence process.
Source code is much more than just a bunch of files stored within a repository. It represents intellectual property, operational infrastructure, competitive differentiation, and growth potential.
For technology-driven companies, coding and intellectual property best practices aren’t just operational. They’re strategic business decisions that impact enterprise value when acquisition opportunities arise.
