SaaS Accounting Quote...

Hey - I was listening to the Meb Faber podcast, episode #177 with a very smart investor named Alex Rubalcava. He said this around the 17 minute mark…

“Software has become a totally different kind of a business model over the last 20 years. No one sells software anymore on a on a one-time license fee basis. It’s all sold on a subscription basis. And that makes the company much more financially analyzable and it makes it much more predictable. And it becomes a company that earns a different valuation multiple when that happens. And when you’re looking at a SaaS company that’s growing, that incurs all of its customer acquisition costs and R&D up front and then earns that revenue back over time – if they’re growing, they will not show GAAP profits, period.

And so, profitability is the wrong measure there. You have to look at essentially what you might consider a growth accounting statement or a cohort retention statement. These might be the new analogues of an income statement and a balance sheet for a SaaS company. You have to look at what is their customer retention? What is the payback period on customer acquisition costs? You have to look at how well they up-sell, all those kinds of things in order to have an estimate of whether it’s a good business or not and GAAP accounting was not built for that.”

I know this quote is not newsworthy to most here but it inspired me to find a post in which - I think - Saul said that GAAP accounting can actually call something in a SaaS company a loss when it’s actually a profit. Is that true? And if anyone can point me to that post or explain how this could be I’d appreciate it. I’m trying to better understand the reason more value oriented investors I admire are so perplexed by the board’s success. They clearly understand the terrific business models of Cloud/SaaS companies yet seem so genuinely uncomfortable with the perceived increase in risk.

Thank you!

BD

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it inspired me to find a post in which - I think - Saul said that GAAP accounting can actually call something in a SaaS company a loss when it’s actually a profit. Is that true? And if anyone can point me to that post or explain how this could be I’d appreciate it. I’m trying to better understand the reason more value oriented investors I admire are so perplexed by the board’s success.

Hi Dan, I think this is the quote you were looking for, from my February end of month post
Saul

"Coupa had $22 million in Free Cash Flow. Free Cash Flow is real money that they have in the bank, any way you look at it.

GAAP wants you to believe that they had a net loss of more than $26 million!

If GAAP had any reality, and if they had a “real” NET LOSS of $26 million, then where did that $22 million of free cash flow, that they have already put in the bank, come from??? (That’s real money). The adjusted net income of positive $14 million sure makes a lot more sense with that $22 million of positive free cash flow than that $26 million GAAP net loss, now doesn’t it?

That’s what I mean when I say that GAAP is make-believe, and useless for understanding how the company actually did. It may make some accountants happy, but even the CFOs and CEOs of our reporting companies almost always say they use the adjusted results internally for planning and for evaluating how their companies are doing."

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A very simple example to put a little meat on the concept, GAAP say that stock-based compensation has to be taken out of GAAP income, even though the company has paid nothing and really the only ones who have to pay for that in the end are the stockholders by dilution. So, if one made a small profit, but issued a lot of stock options, the latter could easily wipe out the former and give one a GAAP negative income.

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I cannot get my head round the arguments made on this great board around the SBC adjustment from a shareholder perspective. Whereas I understand that there is no cash flow involved, the shareholder dilution is real. If for example our company which makes £100 in profit is owned by 2 people. An IT director is hired who is paid a nominal salary but is given share options worth 1/3 of the company. If for example the company now turns a 50% increase in profit to £150, but the original shareholders still earn the same £50 from the fast-growing profits because of dilution. On this basis the adjustment of the SBC would seem to make sense. Maybe someone can point out what I am missing in a private message because this is clearly OT

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Maybe someone can point out what I am missing in a private message because this is clearly OT

I gave it a try some time ago:

June 11, 2002
Options Math

https://softwaretimes.com/files/options%20math.html

Denny Schlesinger

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I cannot get my head round the arguments made on this great board around the SBC adjustment.

Hi Fireblade,

Company ABC hires some great new engineers to work on R&D. Because of the intense competition in tech, it has to give them stock options so they will have a stake in the success of the company. This costs the company absolutely nothing, not a penny, but it dilutes the stock by 5%, so instead of making 20 cents this quarter, they only make 19 cents. That makes good sense.

But GAAP decided to righteously punish the naughty tech companies for giving stock options and makes them double count them, and also take them as an imaginary cash expense, even though there was no cash expense, so instead of having a profit this quarter of say $3 million they make them take an imaginary loss of say $4 million or $6 million, which makes no sense, as they actually made $3 million.

For more on GAAP vs Adjusted, there is a good section in the Knowledgebase Part 2 about it.

Saul

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I cannot get my head round the arguments made on this great board around the SBC adjustment from a shareholder perspective. Whereas I understand that there is no cash flow involved, the shareholder dilution is real. If for example our company which makes £100 in profit is owned by 2 people. An IT director is hired who is paid a nominal salary but is given share options worth 1/3 of the company. If for example the company now turns a 50% increase in profit to £150, but the original shareholders still earn the same £50 from the fast-growing profits because of dilution. On this basis the adjustment of the SBC would seem to make sense. Maybe someone can point out what I am missing in a private message because this is clearly OT


That is correct, hence you also need to take into account share dilution when looking at revenue and operating income growth. For this reason, I closely monitor the share dilution as one of the key metrics in evaluating the actual per share growth of my stocks.

Suppose you have company A and B, both with 100 shares and 100 revenue in year 0. In year 1, company A grows revenue 50% and does not dilute shares. Revenue growth per share is therefore 50%. Company B grows revenue 50% and incurs 5% share dilution due to SBC. The revenue growth per share is therefore approx. 43% (150/105 is revenue per share in y1 vs 100/100 in y0). This is obviously a real expense to existing shareholders.

However, it makes sense to look at non gaap numbers as non gaap EPS already accounts for the dilution (i.e. the profits are distributed over more shares compared to last year). By including SBC directly in the income statements, you will account for it twice, first due to the additional expenses in the IS and then by distributing that reduced profit over more shares.

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The point is not that the options don’t matter. The point is that they have nothing to do with the profit or loss of the company. The shareholders are impacted; the company isn’t.

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essentially SBC asks shareholders to pay for the staff (maybe mostly to the executives and key employees that make the thing happen) that is producing this growth.

The question is: is that worthwhile? that should be posed on a business to business basis.

tj