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Calculating the True Price of Software
Pages: 1, 2

But wait, there's more.

Another option included in the license price is the option to upgrade to future versions at some price that will be less than the regular price. Right? That's clearly an option. The same informal poll of enterprise software users asked what they would pay for software when they didn't have the option to upgrade to the next release. The strike price is less standard than regular maintenance. (If you think about it, new versions perform "maintenance" by adding features as opposed to fixing bugs.) Now we're buying an option to upgrade in five years as part of this license.

The underlying price--the price you'd have to pay if you didn't have an option--we'll leave at $100. The next version will be priced the same as this one. Because you're upgrading, you have an option with a strike price of, let's say, $50. That is, you'll be able to upgrade to the new version for only $50. A five-year option for a $100 underlying price with a strike price of $50 and a volatility of 30 percent (with a 5 percent risk-free rate) is about $62.50.

Of course, most software offers new releases more frequently than once every five years--but enterprises don't like to upgrade very often and usually plan on skipping every other release in order to avoid upgrading too often. Then it would be two options. Much like adding additional planetary bodies to a problem in gravitational dynamics, the complexity mounts rapidly. I'm trying to keep it simple. (I suggest follow-up research problems for interested students.)

At this point, the astute reader will have noticed that the sum of the value of the option for the upgrades plus the options for the maintenance is $18.80 + $62.50 = $81.30. That is to say, our $100 software license consists of $18.70 for the value of the actual software and $81.30 for options on future maintenance and enhancements.

This seems to correlate with the reaction I mentioned earlier that software without the option to get maintenance or upgrades is worth significantly less than the software with those options.

In fact, if we suggest that the maintenance is actually worth $25 instead of $20--but the option strike price of 20 is embedded in the so-called license--then the price of the maintenance options goes to $34.15, and the software itself turns out to be worth about $3.35.

The financially sophisticated may take a few exceptions. My interest rate is wrong. The volatility assumption is wrong. There isn't really an option contract, because those prices aren't guaranteed. Not only that, but they aren't really options, they're warrants. The distinction is that options are bought and sold by third parties--there can be a market in options without the participation of the owner of the underlying asset--whereas a warrant is sold only by the owner of the underlying asset. Pricing on warrants, therefore, differs from pricing on options.

Fair enough on all of these objections, but the point I'm trying to make is this. Those who have suggested that open source and free software is somehow not capitalistic, destroying the value of software and other such assertions, have missed this alternative explanation. It is just as likely that the free and open source software folk have stumbled across the financial engineering insight that a significant portion of the value of software is the embedded "derivatives"--options or warrants--on future maintenance and enhancement. Whether one believes that software has intrinsic value is related mostly to one's view on the correct value to use for volatility in calculating the option value. Larger values of volatility mean the software itself is worth less. Smaller values of volatility reduce the option price, and the software is intrinsically worth more.

Therefore, the major difference in worldview between open source advocates and proprietary software license advocates is explainable as a differing opinion on the correct value of the volatility of maintenance and upgrade pricing. People who believe that the pricing on maintenance is stable and unlikely to change see greater intrinsic value in the software. People who fear that the pricing is subject to large fluctuations see no intrinsic value in the up-front license; stripped of the options, the license value approaches $0.

For the open source movement, perhaps a better way to position the change that OSS is making is this: we're converting warrants on future maintenance and enhancements into options, which means that instead of having a sole supplier (warrants), we have created a third-party market (options) of these derivatives.

How capitalistic is that?

Robert Lefkowitz has spent 30 years weaving software for the airline, nuclear power, financial services, and telecommunications industries.

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