In this blog we discuss SaaS companies’ shift toward profitability. We discuss the companies that are successful, those that are not, and how some of these companies are egregiously abusing stock-based compensation, which reduces shareholder returns and under-reports expenses.
SaaS’ shift toward profitability
Software-as-a-service (SaaS) companies often exhibit a J-curve in their cash flow due to the nature of their business model. They invest heavily in customer acquisition and product development upfront, which results in negative cash flow in the early stages. However, as the customer base grows and recurring revenue kicks in, their cash flow typically turns positive over time.
The time it takes before cash flow becomes positive varies greatly. In an environment where capital was cheap (as in the past decade), the time is longer, lasting years – well into their lives as public companies. These companies oftentimes choose to be unprofitable, trading away positive cash flow for faster growth. But with the rise in interest rates, the cost of capital has become much higher. As a result, many SaaS companies have started to shift their focus toward profitability. One of the primary ways they achieve this is by reducing headcount. This is why layoff announcements are greeted by share price rallies nowadays.
We have started to see the results of this shift over the past four quarters. In Figure 1 below, we show how the median FCF margin (free cash flow as a percentage of revenue), a measurement of profitability, of SaaS companies evolved over 2022. We performed this analysis on 89 SaaS companies.
Over 2022, the median FCF margin improved notably, from 0% at the beginning of 2022 to 8% at the end of the year. Although there’s a significant spread in the data, this trend indicates that SaaS companies increasingly emphasize profitability as interest rates rise.
Here’s the breakdown of FCF margins for the different companies. Notice the wide variability. Clearly, some companies are more successful in achieving profitability than others.
Hiding in plain sight
Other than layoffs, another way to improve profitability is not to use cash to pay your employees, but rather use stock-based compensation (or SBC) instead. While SBC is not new, its usage dominates compensation packages in the tech industry. Many tech companies rely heavily on SBCs to attract talent from the tech giants by making stock compensation a significant portion of employees’ compensation, often rewarding 50-60% of total compensation with stocks.
SBC is a non-cash expense, which means it is excluded from the cash flow statements. As a result, it can be overlooked as expenses (it is reflected in GAAP Net Income statements, however). In other words, using free cash flow as a proxy of profitability (as we have done above) can significantly exaggerate profitability if the company relies heavily on SBC.
In addition to exaggeration of profitability, in the current environment where stock prices are depressed, overreliance on SBC creates a recursive loop whereby companies are forced to issue even more shares (as the price per share declines, these companies have to maintain constant compensation levels, so they must issue more shares), causing more shareholder dilution and further pushing the share price down.
In Figure 4 below, we show the time trend of SBC as a percentage of revenue for 89 SaaS companies. The black line represents the median value.
The median SBC as a percentage of revenue has more than doubled from the beginning of 2018 to the end of 2022 (from a median of 9% to 19%). This is a hidden cost to look for when considering which SaaS companies to invest in. Here’s the breakdown of SBC/revenue (see Figure 5 below).
C3.AI (ticker: AI) takes the top spot for abusing SBC as a compensation tool. It spent about 84% of its last twelve months of revenue on SBC. This presents a significant dilution to shareholders. While the company’s share price rallied these past few months, possibly due to adjacency to the AI hype, the level of dilution is so high that it makes the company highly overvalued. SBC abuse is not the only reason investors might want to avoid this particular company. Recently, a short report was published about the company, alleging the company exaggerated business partnerships and sales contracts.
PS: To be fair, this SBC issue is not limited to SaaS companies – some unprofitable tech companies also have extremely egregious SBC practices. Robinhood and Coinbase, two top retail fintech, spend ~42% and ~70% of revenue on SBC, respectively.