Exaggerating the Progress on the Path to Profitability: a Temptation for High-Growth Marketplaces and SaaS Businesses
Exaggerating the Progress on the Path to Profitability:
The Temptation for High-Growth Marketplaces and SaaS Businesses
Both Marketplaces and SaaS businesses can show a great long-term profitability. Once the product-market fit is in place, the platform is adding value to the customers, and the network effect keeps clients locked in, the longed-for “flywheel effect” starts to deliver. Sustainable revenue streams are established, customer churn is contained, and customer acquisition costs are reduced, leading to a healthy profitability and a positive business outlook.
How to evaluate the progress towards profitability for the growing companies?
The simplest answer is always the same: cash flow. Having positive free cash flow allows the company to fulfil its obligations and invest back into the business without raising additional funding – and is the most reliable indicator of healthy business fundamentals. Alas, high-growth businesses, especially coming from a low base, are not likely to have positive free cash flow due to high investments required, and EBITDA-type measures become leading in understanding profitability.
Valuations of growth businesses are highly dependent on their profitability and cash flow outlook. Moving profitability timeline forward by as little as one year can give a significant bump to the valuation (15-20%), even if the company does not outperform forecasts on other metrics.
The businesses that rely on “growth investors” (rather than “value investors”) for their fundraising can be tempted to focus on reporting the metrics – including financial ones – that exaggerate their progress on their path to profitability. Especially for smaller privately held companies that face less stringent statutory reporting requirements and GAAP reconciliation transparency, it can make it harder to evaluate true progress on the path towards profitability.
In this post I will use the real-life examples from well-known SaaS companies and a fictional example of a high-growth company financials to illustrate how using non-GAAP financial profitability measures can shift the perception of progress and the company valuation without any change to the underlying fundamentals.
The Long-term Profitability Outlook for the Marktetplaces and SaaS Businesses
Many well-known Marketplaces and SaaS businesses have demonstrated strong long-term profitability margins. In the previous edition of the Path to Profitability Newsletter, we talked about the margin pressure on the Classifieds and online Marketplaces businesses in more detail. The overall profitability continues to be very healthy for these businesses.
Schibsted’s Nordic Classifieds Marketplaces, Adevinta’s French and German operations, and Allegro Poland all deliver high double-digit operating margins after 20+ years of operations.
The profitability picture for the SaaS businesses looks more intriguing. At the first look, many of the large SaaS businesses have been highly profitable in Q4 2022, generating non-GAAP operating margins in high double-digit percentages (34% for SalesForce, 42% for Oracle, 28% for ServiceNow). On the other hand, the GAAP operating income margins are considerably lower for these companies (3%, 26%, and 8% respectively), raising the question of whether SaaS business fundamentals are as profitable as those of other Technology-driven companies, such as Online Marketplaces.
Let’s look at the Salesforce example in a bit more detail. First observation is that the gap in the operating margin measures is consistent over time. It suggests a Jekyll and Hyde type dichotomy: SalesForce the GAAP company operates in the 3% margin area (similar to offline Grocery Retail industry), while SalesForce the non-GAAP SaaS star appears to deliver a nearly 30% margin. What is behind this?
Three major cost components drive the differences, in total accounting for 25ppt of the operating margin:
- Amortization of purchased intangibles – referring to the acquisitions such as Slack and increasing in value 70% YoY. The nearly $0.5 billion per year cost is amortization only, with the total value of Slack acquisition a whopping $27.7 billion that will be hitting the Salesforce P&L in the years to come.
- Stock-based compensation expenses: increasing 24% YoY, at the rate higher than the revenue growth of 18% YoY. Almost $0.8 billion in stock-based compensation has vested in a year, reflecting the market cap growth over the past 5 years after those grants were distributed.
- Restructuring costs: Salesforce has announced a workforce reduction of 10% and estimated the one-off costs at nearly $1 billion in 2023 alone (up to $2 billion in total). A non-GAAP view suggests that restructuring is a rare one-off event; companies with a longer operating history may argue otherwise.
A Temptation for High-Growth Technology-Driven Businesses: Exaggerating the Progress on the Path to Profitability
Let's walk through an example to demonstrate how designing financial non-GAAP metrics can impact the perception of the progress towards profitability. Let's use a fictional company – let’s call it “Upwards Inc” – which could be a Marketplace or a SaaS business. The common denominators are the high need for cash to jump-start growth, and a long-term profitability once the “flywheel” starts to deliver:
- High level of investment into Technology Platforms and Software Development
- High growth rate of the customer base and committed future revenues
- High customer acquisition costs during the growth stage
Schematically sketching Upwards Inc financials, it will reach positive cash flow and profitability in Year 3 and will be delivering a roughly 50% margin in Year 6.
However, the same business with the same fundamentals can paint a different financial picture – reaching adjusted EBITDA profitability in Year 2 rather than Year 3, and showing a 4ppt higher margin in Year 6.
How do businesses do that?
1. Capitalize software development costs. Depending on the market where they operate (there are differences both within Europe and with the US), rules for capitalizing software development costs vary. For the companies who make expensive and increasing investments into software platform development, reporting software development costs as Capex may translate into significant optical improvement to the P&L.
In the example of Upwards Inc, its software platform development costs grow 50% in Year 2 and another 33% in Year 3. Capitalizing these costs reduces P&L impact in the first three years by nearly 40%.
2. Report revenues at the time of a sales booking rather than of value delivery or a payment. The rules around revenue recognition are increasingly stringent, so the Enron times of booking a 10-year $10 million contract as revenue in Year 1 are over. However, especially for the post-payment model serving business customers, there might be a significant delay in receiving cash, increasing the gap between the actual cash flow and the EBITDA profitability metric.
In the example of Upwards Inc, the revenues are growing rapidly (3x in Year 2 and another 2x in Year 3). Having the 90-day payment terms creates an almost 15% gap in the revenues reported and cash received over the first three years of operations.
3. Use a high level of stock-based compensation. Unlike salaries, stock-based compensation schemes are not seen as upfront cash payments and can take 4 to 5 years to vest. This is a great way for the growing companies to preserve cash while giving strong incentives to their employees.
At the same time, as SalesForce or other SaaS companies in the example above show, once these grants start to vest, the delayed effect on the P&L can be very high (9ppt of the margin for the SalesForce example). If grants are dependent on reaching profitability, this can be an interesting way of accelerating profitability optics with a heavy margin impact later on.
4. Report one-offs as EBITDA adjustments. A very common topic throughout the 2022 are the restructuring costs. Many companies have been hiring at a high rate in the past 2-3 years, and are now executing significant layoffs, connected with high restructuring costs (severance pay, stock-based compensation vesting, changes to the facilities etc.). SalesForce in our example expects to spend up to $2 billion on this.
It is an open question whether restructuring should instead be seen as a “regular cost of doing business.” With the ongoing expected uncertainty over the economic outlook, will we keep seeing regular “overcorrections” by the businesses – overhiring during the boom times and restructuring during the downturns? And should this be interpreted as a one-off, or as part of the fundamentals?
Profitable business models take time to be executed, especially for platform and customer-acquisition intensive businesses such as Marketplaces or SaaS. While it is tempting to shape the view on the company financials in the way that accelerates its progress towards profitability, the fundamentals of a healthy business remain the same:
- Growing customer base
- Growing ARPU
- Cost base that is growing slower than the revenues
- Positive Cash Flow.