The Box S-1, Delayed IPO, and the Genius of Tien Tzuo

While I did my own post on the Box S-1, I also noticed that fellow CEO blogger, Tien Tzuo of Zuora, had done a post of his own with the catchy title These Numbers Show That Box CEO Aaron Levie is a Genius.  I saw the post, clipped it to Evernote, and I decided to read it on my next flight.

That trip was a few days ago and at 35,000 feet I decided that Tien Tzuo was also a genius.  Not because he did a nice post on Box, but because he is devising an new accounting for SaaS companies which reflects them more accurately than current GAAP, and – rather amazingly– I’m guessing he came up with this more than 5 years ago.

You see, being a natural cynic, I had tended to dismiss Zuora’s “subscription economy” mantra as part Silicon Valley narcissism (lots of businesses have been selling subscriptions for a long time —  just because it’s new to us doesn’t mean it’s new to the world) and part marketing pitch.  In hindsight, I think I dismissed it too quickly.

While I’d seen one of Tien’s presentations, the concepts didn’t resonate with me until I read his post on the Box S-1.

I’ve always believed two things about SaaS companies and GAAP:

  •  GAAP P&Ls are not particularly reflective of the state of a SaaS business.  (Because expenses are taken now, but revenue is amortized going forward.)
  • The faster a SaaS company is growing, the less reflective the GAAP P&L is.

Box provides an extreme example of the second point, so it’s a good one to study.

However, with the exception of the CAC ratio, I’d defaulted to using other existing metrics that I thought captured things better, such as bookings and cashflow.  What I’d never tried to do was invent a new set of metrics that actually capture a SaaS business better – and that’s exactly what Tien has done.

Here are Tien’s core SaaS metrics:

  •  ARR (annual recurring revenue).  Everybody uses this one.  Tien however makes the clever and basic observation that current quarter subscription revenues * 4 is a good proxy for starting-quarter ARR.
  •  Gross recurring margin (GRM).  ARR – annualized COGS.  Tien argues this is the true gross margin on the business, and is equivalent to the steady-state gross margin if the business shut down all sales and marketing and stopped growing.  By Tien’s math, Box has GRM of 79%, Workday 83%, ServiceNow 78%, and Salesforce 85%.
  • Recurring revenue margin (RRM).  ARR – annualized ( COGS + R&D + G&A).  Tien argues this is margin on the recurring part of the business, including the recurring costs of delivering the service, enhancing it (as SaaS customers expect) and operating the business.  It notably excludes S&M, which is seen as a discretionary expense driver by how fast you want to grow.  By Tien’s math, Box has an RRM of 20%, Workday 28%, ServiceNow 40%, and Salesforce 57%.
  •  Customer acquisition cost (CAC) ratio.   I’ve covered this ratio extensively already, so I won’t redefine it.  I will note that Tien calculates Box’s CAC at around 2.0, which is higher than my estimate of 1.6.  However, we define CAC slightly differently (mine is based on new ARR, his on net new ARR) so I would expect mine to be lower since it’s not offset by churn.

And when you look on Tien’s metrics, Box looks pretty good.

If Tien’s Right, Why has the Box IPO Been Delayed?

Because Wall Street doesn’t care right now.  I think there are a number of reasons for that:

  • The general shellacking that SaaS stocks have taken in the past few months.  Many are off around 50%.
  • The unsustainable cash burn.  You might think it’s easy to back off growth, but it’s not. Growing fast means hiring like crazy and hiring like crazy adds the annualized cost of the new staff to your run rate.  Last I checked, Box was burning $20M+ per quarter and unless cash comes from somewhere that hiring party will end abruptly and unpleasantly — in the short-term at least.
  • Lifetime value concerns.  Tien’s math is silently predicated on a 100% renewal rate, and thus a high customer lifetime value (LTV).

Let’s look at this in more detail.

Tien’s metrics assume that if you have $150M in ARR and you turn off growth sales and marketing that you stay $150M forever.  That’s not true.  You actually enter a decay curve where you shrink by your churn rate each year.

Upsell and price increases can more than offset churn resulting in the hallowed negative churn rate, in which case you would actually grow every year, even without sales and marketing.  This appears to be the case at Box which claims a 123% net customer expansion rate.

So if the future looks like the past, things look pretty good for most SaaS companies and for Box in particular.  But what driver underlies that assumption?

Switching costs:  the cost of switching from offering A to offering B.  High switching costs ensure a high renewal rate regardless of whether you are delighting customers.  (Think of all those folks who write big maintenance checks to SAP or Oracle; they’re usually not “delighted” in my experience.)

And low switching costs, in my opinion, are Box’s potential Achilles’ Heel.  As a customer, and a happy one, I intend to renew for a while.  But if something better came along, well, it’s just not that hard to switch.

Put differently, Box’s file sharing isn’t that “sticky” — compared to a CRM or ERP system (and all the work you do to configure it, write reports, et cetera).

Put differently once more, what Box sells is much more of a commodity than other enterprise software offerings.

Despite that, this issue isn’t obvious in my opinion:

  • Switching costs can take subtle forms.  You can argue that part of Amazon’s success has been of the switching costs associated with account setup.  It’s not a huge cost, per se, but seemingly enough to cause me to just buy off Amazon instead of using Google Shopping or another price comparison engine.  Electronic wallets were supposed to fix this, but they didn’t.
  • Brand/trust.  Switching costs can also include what you lose in brand/trust by moving off an existing known supplier.  Box will certainly try to argue that leadership, trust, and brand are a big part of their value, and a cost to those who move away from them.
  • Entry barriers.  Box and Dropbox have both raised huge amounts of money and will work hard to create barriers to entry.  Switching costs to new entrants are only relevant to the extent there actually are new entrants.  The fundraising Box and Dropbox have done have basically scared, for the time being, everybody else out of the category.

So is Box theoretically very sticky?  In my opinion, no.

Might Box end up sticky in practice?  Quite possibly yes.

In which case Tien is right, and he’s a genius.  Which in turn makes Aaron Levie one, too.

4 responses to “The Box S-1, Delayed IPO, and the Genius of Tien Tzuo

  1. Excellent analysis. The ‘stickiness’ which roughly translates into LTV of a customer is the key open question here.

    Box’s stickiness comes from – users and files. Files are not very sticky as I can move them; users are not sticky – although ‘usage’ can be sticky if you have a UX that is very differentiated. Today, I can go between most cloud storage UX and not notice the difference. Apps – on top of Box can be sticky. They are starting on this journey; let’s see how far it goes.

    By comparison – Salesforce is sticky at UX/workflow level. Once you get used to it as a sales rep, you resist using something else. It also has tons of apps. Very sticky.

    Zendesk is also sticky at UX/workflow level.

    Box has an opportunity to be a ‘platform company’ – this makes it very valuable but is also a tougher task than just an app company that automates one or two workflows for one or two user types.

  2. Thanks for the excellent write-up. We had met a few months ago at a Warriors game and discussed S1 analysis. Do you happen to remember the platform/tool which has public S1 numbers in a digestible excel/data format?

    Thanks in advance for your help!

    Best,
    Rohit D

  3. Thanks Dave, I’m using EDGAR’s interactive S1 for now, which is also downloadable in a CSV format.

    Best,
    Rohit

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