How Long Does SaaS Retain Value? Thoughts on Section 174 Software R&D Amortization
By
Andrew Ishimaru
Low-code tools are going mainstream
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Multilingual NLP will grow
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Combining supervised and unsupervised machine learning methods
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Automating customer service: Tagging tickets and new era of chatbots
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Detecting fake news and cyber-bullying
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There's been some talk lately about the implications of IRS Rev. Proc. 2023-11, specifically Section 174, which explicitly declares software development spending to be categorized as research and development spending, and be amortized over at least a five-year period.
This is a big deal because it changes those costs from regular pre-tax operating expenses to post-tax capital investments.
A startup with $1m in ARR and $1m in costs with $800k in dev payroll would pay no tax before this change.
Now, they pay hundreds of thousands.
But that begs the question.
What is the actual useful life of shipped code for a SaaS product?
There's a few ways we might think about this:
- The useful life of the specific code as a part of a larger codebase
- The useful life of the features that were shipped
- The useful life of the research and development from that time period
In a highly competitive SaaS world, the incremental value of a feature very well may be less than 5 years relative to competitors in the market.
Let's say you're working at Hubspot in 2014, a fast-growing inbound marketing platform that's looking to launch its next $100m business line. You build an awesome tool called Sidekick that tracks email opens and sales teams everywhere start using it.
But inevitably, copycats pop up.
There is no exclusive right to email tracking, so all your competitors copy it and build one too.
Within 3 months, there are over a hundred clones on the market, all with the same features.
Now for the billion dollar tax question: How should the capital investment in developing Sidekick be treated?
On one hand, that code & those features still live on today as part of the broader Hubspot platform.
Millions of people used it, and it drove a ton of value in kickstarting their next $100m business line. Which today, looks more like $1b with a B.
On the other hand, it was only a unique feature set for a few months, then it was just a commodity product everyone else had too.
You could make the argument that it only had a useful life of a few months before everyone moved onto the next thing.
And then of course, there's the value created from the code itself.
Sidekick was free. But it was used as a gateway to signing up for Hubspot.
So should the useful life of the code be attached to the value it creates?
In a direct monetary sense, that discrete code generated $0 in revenue.
In an ecosystem sense, it probably helped create billions in equity value and hundreds of millions (if not billions) in revenues.
And what happens if you literally stop using the code?
For example, if you refactor your code base in 2016 and replace all the code your developers wrote in 2014, should you accelerate amortization? You aren't using that code any more.
What if you re-write half the code, and keep the rest? You literally replaced half the code, but you're really building on a lot of the up-front work that was done when the code was first shipped.
What if you add some additional code to each line? It's a small effort now, but it completely changes the literal code that was shipped. You might make the argument that the original code has reached the end of its useful life, and now new code has been written.
There are implications for SaaS CEOs
In the new world of SaaS, competitive markets drive down the useful life of features, and thus, code, and thus, R&D efforts that created that code.
This tax code change is in some sense, just another market force that's changing the optimal way to run a SaaS company.
Thinking about software development as a capital expense, rather than an ongoing cost, is a rational development in a maturing industry.
Turns out, you don't need that many people to run a software company.
But if you want to turn an idea into a billion dollar ARR company, you probably need to raise a lot of VC capital.
It is possible to do this without raising money!
But it is much harder, and probably will take longer, unless you're one of the lucky exceptions to the rule.
