Papers: Valuation Techniques and the Economics of Software as a Service

A significant amount of literature favors the notion that a real-options approach to capital budgeting is superior to the conventional discounted cash flow technique when uncertainty is present in the investment opportunity. Unlike traditional licensed-based software, SaaS inherently provides the buyer with the flexibility to change the course of the investment as uncertainty related to the product or service is resolved. In this respect, SaaS changes the game with regard to the economic benefits provided by the product or service. The SaaS model builds management flexibility into the investment decision and that same flexibility may be valuable when uncertainty is present. With that said, the question at hand is whether or not conventional valuation techniques such as DCF can be counted on to make accurate SaaS capital budgeting decisions. And if such methods cannot be counted on, do OPM techniques such as binomial lattices or modified Black Scholes models provide a more accurate picture of their value? The final and perhaps more important question seeks to understand which of the two methods is most likely to be used by finance professionals when making SaaS capital budgeting decisions. This paper will show that a considerable gap exists between those that intend to use conventional DCF models versus more sophisticated OPM techniques when making capital investment decisions that involve SaaS. This gap should be a concern for those that buy or sell products and services delivered via SaaS for the value of flexibility may go unrecognized.