Protecode Blog

Open Source and its Impact on Valuations Part 2

Open Source License Type and Impact on Valuation

Licenses that cover open source code carry unique terms that have implications on code use, modification and distribution.  For example, some restrictive open source licenses (known as copyleft licenses) require users that distribute modified programs to make source code available to downstream users free of royalties.  The failure to comply with license obligations can lead to severe consequences, including being forced to come into compliance by releasing the asset’s source code, or paying damages.  Infringement suits also result in a loss of goodwill affecting client relationships, distribution partnerships, and consumer confidence, which further diminish exit sale price.

The fact that target companies may be unaware of the incorporation of open source in their technology further complicates the valuation exercise.  Factors including easy accessibility of open source software by resourceful developers, increasing reliance on third-party developed code, and the rise of software outsourcing and offshoring have resulted in a loss of control over the composition of code incorporated in software.  Receiving inaccurate information regarding code composition renders the investor vulnerable to costly license infringement litigation. 

Options to Consider

Because open source code could be incorporated in an asset without the knowledge of the target company, it is critical for the investor to independently confirm the status of the asset rather than rely on the portfolio company’s representations and warranties.   This can be achieved through engaging competent external resources that can analyze software assets in the following ways:

• Scan source code to identify open source and third-party code embedded in software
• Compare the identified licensing or ownership attributes against the company’s licensing policies
• Detect license violations and incompatibilities

Once the assets are effectively analyzed, the portfolio manager can work with management to develop strategic solutions, positioning the investor to achieve optimal exit value.  Questions to consider include:

• What functions do the open source components perform in the product? 
• From a cost and/or strategy standpoint, is it more efficient and effective to:
• Become compliant with license obligations?
• Replace open source components in the product with open source code that carries more permissive license terms?
• Remove the open source components and replace them with commercial or proprietary code with similar functionality?
• Remain non-compliant and assume liability (qualify and quantify the liability)?

A cost-benefit analysis of each of the above options would include the impact on short term and long term business, cost of the effort to change, and potential delays to the transaction as a result of the changes.

Open Source Impact on Valuation is Manageable

The emerging mixed-source development environment calls for consideration of the unique value enhancing and potentially diminishing implications attached to open source. While in many cases, the presence of open source amplifies the value of technology, there are instances in which the license terms associated with the open source components diminish the core intrinsic value of the asset under consideration. Through performing effective pre-investment due diligence to identify the presence of open source, and engaging in simple but systematic post-investment asset management, portfolio managers can achieve optimal exit value on their investments.

Learn more about the 6 most popular open source licenses and their obligations.

This article was written by Diana Cooper, legal researcher for Protecode.