When companies consider implementing enterprise software, the standard operating procedure is to review a public company’s finances before deciding to implement the solution. If the software company is private, the potential customer often asks for the right to see its financial statements. A potential client wants to know that the software company they will be working with and relying on will still be in business later on. And, even if the company is not on the verge of bankruptcy, they want to see that they are successful enough to continue investing in the solution.
In the enterprise software market, there are extremely fast-growing companies that Wall Street loves that seem to be hemorrhaging money. How can they grow so fast? Why would potential customers choose to work with software companies that lose so much money year after year?
In 2021, Coupa posted losses of $180.1 million on sales of $541.6 million. They are growing rapidly, growing 39% year over year, but that seems like big losses in percentage of sales.
Nevertheless, the consensus among Wall Street analysts is that Coupa is a good investment. Of 20 financial companies covering Coupa, 14 rate them as a buy and 6 rate them as a hold.
The rule of 40
A software business is a digital business, it doesn’t operate like a traditional brick and mortar business. I remember a case study when I was in business school where a fast-growing, profitable manufacturer nevertheless went bankrupt. The problem? Their cash flow has not kept pace with their sales. The company was paying for raw materials at a faster rate than its customers were paying for its products. They simply ran out of money. The lesson is that the viability of a business is not just about profit and loss, positive cash flow is essential. For fast-growing companies, the phrase “cash is king” reflects this lesson. Investors are willing to provide sufficient funding to fast-growing companies if they believe a company can slow growth and increase profits at will. That’s why investors have continued to fund Amazon’s growth, despite their continued losses, for so many years.
In recent years, the rule of 40, the idea that a software company’s combined growth rate and profit margin must be greater than 40%, has gained traction. Growth and profit margin are the only two inputs needed for the rule of 40 formula. To calculate whether a company is above or below 40, simply add the growth percentage to the company’s gross margin .
The Rule of 40 has been popularized by venture capitalists in recent years as a key performance metric for SaaS companies. The metric captures the trade-off between short-term viability and investment in growth. Software companies that can beat the rule of 40 have valuations twice as high as those that miss that mark. These high-growth SaaS companies are also generating returns up to 15% higher than the S&P 500.
There is a financial website that does these calculations, and many more. They report that Coupa is at 58.2% on this metric.
GAAP versus Non-GAAP
Software executives and many in the financial community say the generally accepted accounting principles (GAAP) used in tax reporting point to an incomplete store for digital businesses. According to them, GAAP makes perfect sense for companies that deliver physical goods to customers. Non-GAAP earnings – an alternative accounting method used to measure a company’s profits – can give an idea of the company’s ability to generate operating income that can be hidden in high-growth companies and heavily in debt. Non-GAAP earnings are reported in addition to mandatory GAAP earnings.
Commonly used non-GAAP financial measures include earnings before earnings before interest, taxes, depreciation and amortization (EBITDA), free cash flow, core earnings and funds generated from operations. Non-GAAP results, however, can be misleading. You can think of high debt as something that a high-growth company will find more and more manageable as it grows. For a growing company selling software as a service model, revenue grows year after year because it’s multi-year contracts. It’s like the experience of many people buying homes; it becomes easier to pay the mortgage payments as the homeowner gets increases, but their payments stay the same. At Coupa, for example, non-GAAP revenue made up 102% of revenue in fiscal 2016, but only 62% last year.
In addition to non-GAAP methods of calculating profit and loss, companies also frequently provide other measures to the financial community as basic measures of success. For Coupa, a key measure of success they share with investors is growth in spend under management. As mentioned, at the end of 2021 it was over $3 trillion, last fiscal year it was under $2.4 trillion, and the year before it was under $1.1 trillion. .
It’s understandable that a company might be hesitant to do business with an enterprise software company that’s losing big bucks quarter after quarter and year after year. However, those who understand the rule of 40 understand that some of these ventures are not as risky as they seem.