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Features of financial planning in development of commercial software

Michael Kalinichenko
Michael Kalinichenko
StarForce CEO
14 Feb 2019

At the beginning of this century, there was a surge in investment in companies that were engaged in software development. Unfortunately, however, there were few of the companies investment in which turned out to be successful. StarForce CEO Michael Kalinichenko tells about this situation, as well as what should be taken into account when analyzing financial activities of software companies.

— There are a number of explanations of making such an investment in companies developing software. One of the reasons in terms of financial management accounting is that the development of a replicated software is unique.

While working as a COO, I happened to audit a few similar projects and communicated repeatedly with investors and owners. I noticed that most of them transferred the principles of financial analysis from the traditional types of business to software development.

— Unfortunately, in many cases, such a situation leads to making the wrong decisions: either deciding against investing or providing money too easily. It is strange enough that the key factor of misunderstanding is the term ‘software production’. Investors who came from other fields (recently, there were 95% of them but now there are almost none) consider software development as a type of other production activity. All this affects the analysis of the main financial document of the management accounting, which is traditionally called the P&L statement.

Besides, it is necessary to understand that in Russia, management, accounting and tax accounting have their own characteristics that in many cases do not match.

Table 1 presents management accounting in its traditional sense.

It is clear from the table that the larger an item of expenses is, the greater its connection with sales will be. In this case, the classic production of goods and services is exactly in the upper part of the table and is directly related to sales volumes. There is a sold product and its cost; therefore, the cost of production is linearly dependent on sales. This allows quickly managing the expenses, as well as reducing the financial risks significantly. If goods cannot be sold, their production is terminated, the equipment is sold off, and a significant part of the money returns.

However, it is different with software. The cost of developing a program does not depend on the volume of sales. This product is independent; its cost is determined by the level of technology, staff qualifications, and quality management. Moreover, it does not dependent on how many copies of the program will be sold. Judging by the table, the item of expenses should be closer to the bottom of it.

It is not possible to stop unsuccessful production any more. While the program is not ready, there is nothing to sell; when it is already ready, all the money is already spent. In addition, the equipment like computers and licenses for the development tools costs almost nothing.

If we consider all this, it turns out that a software company does not manufacture anything. Mailing electronic licenses, separate CDs or USB flash drives to customers can hardly be considered production. The cost of the process tends to zero in the overall cost structure. On the other hand, the company has a huge item of expenses that is called R&D (research and development). These are variable expenses rather than fixed ones. Therefore, this changes the structure of the investment risks and logic of management and investment decision-making. That means that the costs that are not basic for the classic business become major for software development.

It is not surprising that software development has more in common with the movie business than with the classic production in terms of finances.

High need for stable investment at the initial stage is one the consequences of the cash flow structure for replicated software companies. Besides, funding should have a significant financial strength in order for the initiated development to be brought to commercial implementation. An unfinished house can be sold, albeit with discount; meanwhile, the program the development of which is not completed, does not cost anything. Unfortunately, underfunding is one of the main reasons of IT-start-up failure.

The second typical problem that results from the cost structure is that most investors are certain that after the development of a commercial version of a program, development costs can be significantly reduced or completely canceled. The logic of a person who is not familiar with the development seems obvious: there is a program and it must be sold. Why spend money on new versions? Unfortunately, it is almost impossible to change the long-standing view of an investor. It is equally impossible to explain to a person who does not have their own experience in solving such problems that if the programmers who develop the product are dismissed, it will lead to the loss of a significant part of knowledge, which cannot be fully compensated for by any procedures for documenting the program codes. It is also not easy to talk about how competitors are on the alert, how user interfaces are influenced by fashion, and how the opinion and preferences of the first users cannot be foreseen.

It is worth mentioning that investors very often start to put too much store in technical gurus and believe that their genius and ability can create breakthrough technologies. The consequences are unreasonable increase in the budget for development that is already one of the main items of expenses, as well as the endless development of the next new version that will ‘turn the world upside down’. As a result, money is spent on development that never reaches the sales stage. The company is unable to produce a consumer-friendly product. In the classic business, this situation immediately manifests itself in the financial report as a disproportionate increase in stock. In case of software development, however, the problem can remain disguised for several years.

In conclusion, to get funding, one should employ either independent experts with successful experience in organizing this kind of business, or specialists with a degree in computer science.

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