SaaS X-Ray and IPO Markets w/ Stan Zlotsky (Pendo.io)
Disruption = Growth, Spreadsheets vs. Real life, and Building better SaaS Cos
I had the pleasure to host Stan Zlotsky for a 45-minute Q&A on September 21st, 2023, a day after Klaviyo’s IPO. Stan previously helped lead the SaaS Applications team at Morgan Stanley under Keith Weiss as Executive Director. He was the main driver behind the now well-known SaaS X-Ray report, which was one of the first frameworks to dive into unit economics and margin potential of many of the popular publicly-traded SaaS companies at the time. Stan left Morgan Stanley in 2022 and is now SVP, Head of Finance and IR at Pendo.io. You can find him on his LinkedIn.
Some of the topics we cover:
The required metrics for SaaS companies to go public vs. 2020
How investor understanding of SaaS business has changed over the 10+ years he’s covered software
Aligning and educating internal teams on the proper external/investor metrics to track
Adapting SaaS X-Ray for internal use (and the difficulties)
The differences between excel models and real life
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Please enjoy my interview with Stan Zlotsky (lightly edited for clarity):
Thomas Robb: Stan and I worked together at Morgan Stanley where he helped lead the SaaS Applications team under Keith Weiss as Executive Director. He was the main driver behind the now well-known SaaS X-Ray report, which dove into the unit economics and margin potential of many of the popular public SaaS companies at the time. We had the opportunity to work together for about two years when I covered vertical software and I learned much of what I know about software economics, SaaS metrics, and modeling from Stan. Stan, thanks again for joining us today.
Stan Zlotsky: Thanks, thanks for having me. And you're very kind.
Thomas Robb: Probably top of mind for everyone right now is after two years of no software IPOs we finally got three tech IPOs, one of which being software. Klaviyo sounds massive with very impressive customer economics and SaaS metrics. Any thoughts on the IPO market opening back up and how you’re looking at the metrics required to go public now?
Stan Zlotsky:
Well as much as I'm on the corporate side of the world right now, I still spend a fair amount of time at various investment conferences and talking to both public investors as well as sell-side research analysts. And as much as you know, we just had three successful tech IPOs... I'm not going to talk about the Mediterranean fast food IPO.
Frankly, my opinion is I think investors were ready for tech IPOs, maybe five or six months ago, it's just that the companies of the caliber that was necessary to break the ice, still needed time to get ready. And when you think about the cohort of software names that have been waiting for the IPO market to open, somebody has to be the first one of the bunch. Klaivyo is probably as good as it gets, in terms of breaking that ice of the IPOs, especially on the software side.
Investors were ready but were suffering from a hangover of 2021 IPOs. And my sense is, even if 2022 was a more normalized year, from a macro perspective, investors needed the time to kind of figure out, “What the hell did I just buy? What are these IPOs which I had three days to do due diligence? What does the company do? What's the name of the CEO?” So they are finally comfortable with that cohort of names and some are good, some are not so good.
Klaviyo opened the gates for software. From the initial conversations that I've had with various bankers, the question that was coming out of some of the investor meetings was: How can you get into high-teens or maybe into the 20s from an EBIT margin perspective? And what that signals to me, yes, investors are definitely ready to receive growth software IPOs. They're not fully ready yet to pay for the ones that are just pure growth without some kind of associated profitability on the back end. So if you think about the spectrum of the profile of companies that went public in 2021, on one end, you have complete growth, and the other end, you have complete profitability. The pendulum was fully on one side, all people cared about was growth, growth, growth, growth. And then, through ‘22, the pendulum fully swung the other way. And what everybody cared about is profitability and, cash flow. The pendulum is slowly starting to come into more of a steady state and the closer we get to the middle, that's when I think a lot of a lot more companies are going to be willing to go public. Because they're going to be able to demonstrate healthy growth, with the big improvements in profitability that they all went through in 2022 and 2023.
Thomas Robb: I think that's super interesting. On the pendulum side, we were hearing the exact same thing from our investors. First, why are you not growing faster? And then three months later, wait a minute, why do you have all these people? Why are you not operating for profitability? It’s an important decision so you have to choose a sustainable middle ground based on your business dynamics and maximize long-term value, not switch strategies every three months.
Stan Zlotsky: At the end of the day, the reason investors are so drawn to technology is because of disruption. And disruption intrinsically implies growth. It's a delicate balance between growth versus profitability, and you need them to be in some balance. But at the end of the day, if all technology companies and software companies focused on delivering profitability, I don't think there'll be as much interest from investors in buying these types of companies and those types of stocks, because then you might as well go buy GE, or another big industrial name or utility name.
Thomas Robb: I remember at Morgan Stanley covering CDK and you had Shopify, on one end, that was growing 100% a year and losing a ton of money. While CDK was growing like 4% a year, but had like 35% EBIT margins [representative figures, not actuals], and everyone's just like, oh, wait, we didn't realize that software could actually generate EBIT and it could actually get that high. I think investors are just starting to realize there are more options on both sides.
And that kind of leads me to the next question. You've been in the industry for so long now, and I feel like you've probably seen an entire lifecycle of not only investors but also companies and how they operate. What has been the change over the 10-12 years that you've been covering software companies? I think especially on the investor education side where it went from there two public software companies to now there's 50 or 100 or whatever it is, it took a long time for everyone to just understand the business model and the potential of it.
Stan Zlotsky:
On the investor side, one of the biggest changes is just investors understand recurring revenue, SaaS models. Back in 2010, there were just a lot of questions like, what does it mean to have recurring software expenses? Where does this show up on a company's income statement? And how much do I want to ultimately pay for it? I remember back in the days when I first got started when I was doing an IPO, a good chunk of the conversation with investors was spent on just like, okay, and this is a recurring SaaS model, and it's ratably recognized on a daily basis. And so, this means that this happens to the balance sheet, and there's a deferred revenue component. There's a lot of education, like financial education around the model that was being done. Fast forward to when I was running IPOs in 2021. It was like, I get it, let's walk through the key metrics. A lot of companies started to actually disclose ARR. Compared to back in the day, there were significantly fewer companies that would talk about ARR.
All these tech companies, software companies specifically, when they're young and before they reach $100M of ARR and even beyond that, ARR is all you care about, that is how you manage your business. That is how you do everything, all your financial planning is based on ARR. And all of a sudden, you go public, and you're not going to talk about ARR. It just makes no sense to me. And so I'm really glad to see a lot more companies starting to talk about ARR because, frankly, if you're a public company, you should be talking about the metrics around which you are actually managing your business. And if ARR is how you're managing it, you should be talking about it.
And so one of the things on the operating side that I've seen change is companies that are going public or getting ready to go public, they've truly become better businesses. So it's not just, hey, we're a hot startup and we have this really cool idea, and we're making a ton of money. But they've actually truly created scalable businesses that can get really big, that have solid management teams. What we're seeing in ‘23, that is probably the biggest transformation near term is all these companies realize that to be a successful public company, I can't just be a really cool startup, you actually have to be a really good business.
In 2010, if you're selling SMB software, people were like, oh my God, your users are going to be a disaster, and you're never going to make money. And I remember HubSpot, a big software company now, but I remember doing the IPO in 2014, I literally had a portfolio manager hanging up on me about 10 minutes into the call. When he asked me, “Hey, what's their gross revenue retention?” And I was like, well, the company doesn't talk about it, but it's probably somewhere in like the low 80s. And he's like, “Say What?!” and I’m like Low-80’s and he’s like, “Oh, this is not going to work”. Click. Hindsight is 20/20. He lost out on an opportunity to make a ton of money because what he didn't appreciate was that’s just the nature of SMB businesses, but what they're building is a really solid business. And they can scale very effectively, which is what HubSpot has demonstrated.
Thomas Robb: We had similar issues when covering Shopify, which is also a massive business now. And obviously, their biggest partner or one of their biggest partners is Klaviyo which is highly levered to their success. And investors would be like, “What do you mean they charge $30 a month and everyone on the platform just sells fidget spinners?”. So you get investors simplifying the business to “ok they sell fidget spinners and collect 3% on processing fees” and having to argue no, no, you have to understand customer economics and over time they grow and a small percentage become Mizen and Main that actually pay them thousands of dollars.
Behind the scenes, how has the pivot been to corporate and getting internal team members who are not used certain financial metrics and public markets to start focusing on those key metrics and helping them understand what they mean to investors? I'm assuming you have a lot of touch points across your organization which requires trying to get everyone aligned that these are important and we have to start looking at them.
Stan Zlotsky:
It's been very eye opening, getting into the corporate world, after spending all these years on the sell side and looking at all these companies in a public space. And you're just living and breathing these metrics on a daily basis. And then you get inside these companies, especially on the younger side and people will just have no idea. And efficiency metrics were not even something that they thought about. Metrics like magic number were not even discussed in board meetings. It was all about, hey, how fast do you think you can grow? You think you can grow 60%? What about 70%? So in order to grow 80%, you need how many sales heads? That's a great answer, go grow 80%. And that's how financial planning was done. Now, it's how can we grow responsibly? How can we grow efficiently? And that was not in anybody's lexicon a year and a half ago, especially at young tech companies, young software companies. And so I've had to do a fair amount of education within my own company, as I'm sure you you've been doing inside of yours as well. This is what investors are going to be looking for. Of course, they're gonna be looking at growth. But this is going to be the second derivative of how they're going to be thinking about your growth. And they're also going to be doing all this slicing and dicing of your profitability to figure out what are your incremental margins? How much more profitability can you deliver over time? And that's, frankly where I came up with the idea of the SaaS X-Ray that you and I worked on during our days at Morgan Stanley.
And that was a fascinating piece of work that we did. Essentially what it did was look at all these companies as, you're an amazing hot startup growing 60-70%, but you have at the same time 40-50% negative EBIT margins. Are you as good of a business as that company that is growing 20%, but has positive 20% EBIT margins? We wanted to determine the best way to compare these two types of companies. And what the SaaS X-Ray work did was essentially sliced and diced all these software companies into how much do these companies actually spend per dollar of ARR revenue that they bring in? Once that prospect becomes a customer, now they're going to be a customer for the next 10 years, how much money are you going to make from that? And as you mature as a company and your growth rate naturally, decelerates, how profitable could you get? What do your current unit economics support as far as profitability down the line?
I'm sure you know, you heard a lot of investor calls “What the heck is this?” When we published the first version in 2017 and now six years later, that's a staple of Morgan Stanley's research.
Thomas Robb: Doing that math the first time you're like, oh, wow, this is super powerful, and you ask “Why does everyone look at NRR?” It's clear that expansion is wildly profitable and that's what drives incremental margins.
I'd be curious, how much of the framework do you still use internally? And how have you tried to adapt it for internal uses with access to perfect information?
On my side, I quickly realized, the framework helps, but then you run into more issues, because now you have 19 inputs instead of two. And you're guessing the future on many different things instead of one input.
Stan Zlotsky:
Again, as you know, the SaaS X-Ray is a very crude exercise. And in looking at the companies from the outside in, and trying to figure out how profitable they can be. Now that we're on the other side of the wall, you do have a ton more information. So you can do a lot of slicing and dicing. And what I've seen as the biggest challenge is an overload of data and making sure that the data makes sense and that the data quality that you're looking at makes sense and that the approach makes sense.
I think that the most eye-opening thing is, you and I grew up in Morgan Stanley as spreadsheet jockeys. But it's one thing to put together analysis, and it's a completely different thing that's a hell of a lot more challenging is: how do you now take that analysis and turn it into the real world? How do you operationalize all this spreadsheet math that you just did, that is truly where the rubber meets the road. And when you listen to earnings calls and you hear the executives say “we executed really well this quarter” or “we didn't execute well this quarter”, what they're really saying is, we did better or worse than what we first planned out on paper. The actual process of taking things from a spreadsheet into the real world, why we either did better, or we did worse than what we initially set out to do.
Thomas Robb: That's so interesting. It reminds me of a meeting where we were discussing an issue where person ABC should be communicating with person XYZ and while they fall under the same executive, they report to different VPs so there was no natural touch point. But its super important to the customer these 2 people align internally but it's dropping off and negatively impacting the customer.
Stan Zlotsky: And customers are frustrated, and they leave and all of a sudden, it's like, Hey, why did my gross retention just drop? Well, there it is.
Thomas Robb: Yeah, it's super fascinating going from the spreadsheet that looks amazing and explains everything perfectly and tells you exactly what you need to do to the messy real life of operations and working with people across geographies, different teams, different orgs different, and different priorities
Question from the audience: Cisco acquired Splunk today in a massive acquisition, which was one of the largest software acquisitions of all time, which particularly stands out this year. What are you seeing broadly in the M&A market? I know bankers come to us all the time with ideas and many smaller companies are trying to get acquired, but are running into many of the same issues we discussed where their business quality is just not that great.
Stan Zlotsky:
So today has been a fascinating day, and I'll tell you why. So obviously, Splunk is being bought by Cisco in a huge acquisition and it's been rumored for a very long time that Splunk is for sale, but when the news hits it's still surprising. But I think what this announcement really showcases is that the strategic acquirers are ready. They're ready to come in and start the M&A engine. Through 2023, you've seen a lot of PE shops buying software companies, but the whole strategic game has really been quiet.
From the strategic side, I understand the hesitation and you need to look at it through a human lens. You are the corp dev guy sitting in large technology company XYZ, and you're seeing software multiples compressing on a weekly basis, you never want to be the guy who everybody's going to remember that you just did a large deal and shortly after could have bought 30%, lower, right? That's your entire job and you just did an absolutely crappy job, right?
And when these strategics start buying, that's when it tells me that hey, even they have realized that multiples have stabilized, right, that they're probably as low as they're going to get. And then it's okay to step in. So what that has done is, typically, if you look historically, the multiple that a strategic buyer will be willing to pay for an acquired target is meaningfully higher than what a private equity firm would be willing to buy that same target for, right. And the private equity guys looked at the deal today. And they just panicked. They panicked, because holy crap, if the deals of this size are being done by strategics, that signals that most SaaS companies are now on sale, because every strategic is going to be looking at all these smaller software companies. And if I am a private equity guy, if I wanted to buy somebody, the multiple and the premium that I now need to pay for that company just went up probably 10% today.
We're supposed to be at Morgan Stanley conference in LA in early October. And all of a sudden today, I kid you not I got 10 requests from private equity shops to meet with us. Because they're like, maybe they're for sale? You never know. Right. And it was just really fascinating to see the real-time evolution of markets unwind in one day.
Question from the audience: So we were talking about the pendulum swinging from growth to profitability. Interest rates seem to be the big macro factor impacting software valuation right now which seems to be indirectly impacting real-life operations. What are some of the impacts you see from interest rates right now?
Stan Zlotsky
Thinking mechanically through a DCF model, say you have a software company, and you built out this really cool 10-year DCF and year 10 the company's generating a billion dollars of revenue and then you think they're gonna have 30% free cash flow margins, so they're gonna make 300 million free cash flow. How much is that free cash flow worth? Using interest rate logic to come up with the discount factor that you're going to put on that 300 million and derive the present value of that 300 million. And when interest rates go up, mechanically, your discount rate goes up as well. And so instead of applying an 8% discount rate to that 300 million of free cash flow, you are now applying a 12-14% discount rate to that same cash flow.
So for you to justify paying a certain amount for each share of that company, you need that FCF number to be $400 million, maybe even $500 million depending on what discount rate you're now going to use. And that's why all of a sudden, all of these investors swung the pendulum so rapidly in the direction demanding more profitability, because their DCFs are spitting out dramatically smaller numbers.
Thomas Robb: On the operational side, what were the impacts? Put yourself in the CEO position. You hear interest rates are rising, you think that's bad for the economy and start to reduce spending which obviously causes a trickle-down effect. Likewise, we saw some VCs experience the valuation impact in their portfolios and responded by deciding to invest less which required the entire software ecosystem to conserve cash. Did you see some of these third-order impacts as well?
Stan Zlotsky:
The impacts were across the board. And it started in the public markets, and then very quickly trickled down into the private markets. And just to piggyback on what I said a second ago, in times of uncertain macro, investors want to see management teams that are controlling the aspects of their business that they can truly control. So if you think about a company, where do you have more control? On the expense side or on the revenue side? Expenses are fairly knowable and therefore tremendously more controllable than the revenue side of the equation. And so that's why investors during this macro uncertainty that we were going through, they demanded that all these companies swing the pendulum so rapidly towards profitability. It's because you're going into this uncertain macro. Public companies responded quickly and then in turn, all the VCs said “oh wow, I gotta go tell all my portfolio companies that they have to conserve cash”.
We definitely saw some challenges from selling into these smaller VC-backed companies. much more than a large customer.
Thomas Robb: Another thing we’ve seen recently is the late-stage, pre-IPO market shaking out. This market got much more influential over the last 2-3 years as it’s designed to get you through that extra bump just before IPO. And this market really dried up because all the people who are crossovers are like “Oh, everything is down and I'm extremely illiquid now.”. And so the expectation that Tiger Global would come and give you $100 million with just a phone call or text message is no longer an option and it seems like this is another direct impact from higher rates.
Question from the audience: What are your thoughts on the state of IPO markets in terms of where private companies really need to be before they can IPO? Is it 100M ARR? 200M ARR? And what are expectations for pathway to profitability? 2 years? 5 years?
Stan Zlotsky:
The threshold to become public has once again stepped up. I was reading a book over the summer called, The Hard Thing About Hard Things by Ben Horowitz. And the company that he founded during the.com era went public with like 30 million of revenue. And that was shocking.
If I wanted to have a successful IPO today, I think it needs to be at least 200 million of ARR. And, do you need to be profitable? Probably not. But you need to show a very strong path that you've already taken towards profitability and continue to outline the path for investors for how you're going to continue to improve your profitability down the line. But the key there is you need to show that you've already went through that path of dramatically improving profitability and cash flow generation.
Thomas Robb: Investors always like to just be shown the numbers instead of having to forecast significant changes vs. trends. If you can show margin improvements for the last two quarters, plug in my NRR, and now drag it forward. That becomes an easy, powerful story for investors.
Stan Zlotsky: One thing I noticed during my time on sell-side research, is investors are really good at spotting trends and spotting patterns. So pattern recognition for a buy-side investor is paramount. Because when you think about what a buy-side investor does, say they're covering the software sector, they're looking at 200 different names in the tech sector. So they don't have the luxury of “I'm going to spend the next three weeks diving into this one particular company”, because there are 199 others that they need to also be looking at. So what instead they do is they look at trends very, very quickly. And the easiest way for you, as a company going public, to fit into their pattern recognition, is showing what you've already done. And then you give them a point A and point B and they'll draw a straight line through it, And that's why it's so important to show the work you've already done. And then they'll be able to extrapolate forward.
Thomas Robb: The range of understanding the SaaS business model is very broad as well. It feels like the top 5% of investors know customer economics, and if I know your growth and your account executives, I can model it out myself. And then the rest of the 95% of people are like, I kind of get it, but none of my other companies act like this so I don't really trust them. But to Stan’s point, as soon as you show it, they can draw the line and continue it.
Question from the Audience: When you think about incorporating SBC into a DCF, how do you consider diluting the share count vs. incorporating the actual expense?
Stan Zlotsky:
One thing that really stood out to investors over the last 18 months, is stock-based comp. I remember when I started in 2010, I remember talking to my analyst at the time, and I was like, Hey, how can we just take out stock-based comp [from our analysis]? That's how people get paid, how don't we care about that? Oh, no, no, no, no, no, no investors don't care about stock-based comp, pretend it doesn't exist, we'll just just focus on growth. And that worked for a while and then it stopped working. And now investors have become tremendously more sensitive to dilution.
Splunk at the time of IPO was one of the most egregious companies as far as stock-based comp. At one point post IPO, something like 50% of their revenue was in stock-based comp. That percentage trickled down over the years, but that was insane. And that was the peak egregiousness of stock-based comp.
Nowadays most investors are willing to stomach something like 3-4% share dilution because they do understand that you need to pay your people, and that engineers and finance professionals come to work for these tech firm because of the potential upside around equity.
You can get as creative as you want with accounting for it in a DCF. For me personally, I find the most straightforward way to do it is just to model out for share count. So in our example of a billion dollars of revenue with 300 million of free cash flow. You model dilution from today, 10 years forward and there's your free cash flow per share. There are more esoteric ways to do it, but to me that feels like the most straightforward one.
Thomas Robb: I'd say that's how we look at it internally as well. Since most companies are just valued on a revenue multiple, if you are thinking about a forward share price, you have to divide it by the correct share count. The downside of just using just EV / Sales is you actually ignore it all together.
Question from the Audience: How do you forecast ARR and revenue as an operator versus an investor?
Stan Zlotsky:
Super top of mind for me right now as I’m driving our calendar 2024 planning process. What I will say is, as far as transferable skills from equity research into the corporate world, and for that matter, investment banking, venture capital, or private equity, the transferable skills are the ability to tell a story with numbers and the ability to look at historical trends and identify patterns for the future. When you're on the outside you're creating a model for a company based on public disclosure. Ideally, you’d base it on number of customers, times ASP per customer, and you come up with an ARR number or an ACV number, and then you'd waterfall out to revenue. that’s probably as sophisticated as we can get in the public markets with what companies usually give you.
I remember back in the day, Salesforce when they first went public, because they were kind of like the icebreaker for the SaaS universe, they actually would give you the number of seats that they had, the amount that their customers were paying per seat. So you could actually truly get to an ARR number from Salesforce back in the day, obviously, they stopped (around like 2011 or 2012) and everybody was really sad.
But on the corporate side, you can get super, super granular. So you look at how many accounts there are in a given geography or for a specific segment. And what the ASP that you could get, on average per account in a specific geography. How many account executives do I want to have in that geography going after those accounts? And I view that as almost like a sanity check. If you really talk to sales leaders and CROs, they think about everything, from a human lens. How many bodies are they going to have? And they know the salary plus variable commission expense per each one of my sellers is going to be 300,000. The typical industry best ratio for quota amount, versus how much the seller makes is, let's call it 5x. So this person needs to carry a one and a half million dollar quota. And now one and a half million dollars of quota, how many of these sellers do I need to have? And how many can I afford? Because for every company now, it's not just grow, grow, grow, grow, but it's grow efficiently. So how many of these sellers can I afford in order to still hit my profitability targets. So you can't get too wild in the hiring because then your profitability is going to be out of whack. It's a system of equations that you need to solve, but it's a fascinating science, and as far as I look at it, there's certainly a lot of art to it, as well.
Thomas Robb: We're also going through our long-range planning so all of my capacity equations and assumptions behind the scenes are fresh in my head as well.
But Stan, we're on the hour. Once again, really appreciate it. It’s been great to catch up and hear your thoughts on everything SaaS, moving to corporate, and the comparisons between the two. Thanks again for joining us.
Stan Zlotsky: I’m glad I was able to make it and thank you again for the invitation. If anybody has any questions, channel them through that man right there, and we can go from there. Thanks, everybody.