The truth is in the cash flow

Jargon – Just a Thought

The other day I was at an accounting breakfast.

There was a lot of jargon being thrown around.

It got me thinking…why do we use jargon?

I think it is sometimes to project power over people.

At other times, it is to exclude people from the conversation.

Used well, it is a short form of communication between “insiders”.

This video is a light-hearted swipe at some of the common jargon running around the accounting industry.

In my work as a Virtual CFO, I try very hard not to use jargon.

When unavoidable, I make sure I explain what it means to my audience.

We already live in a world full of uncertainty.

It seems to me it would be better if we said what we meant, and meant what we said.

Just a thought.

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The Power of Connecting – Just a Thought

A chance encounter at a busy melbourne intersection had me reflecting on the value of human connection.

How different could our lives and businesses be if we smiled and connected a bit more.

I hope you enjoy the story.

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From Xero to a Billion in How Long – Part 3

From Xero to a Billion in How Long – Part 3

When last we met we had determined it would take another 2 to 3 years for you to achieve your goal of $1bn in Revenue.

The actual timeframe would be dependent on growth in ARPU, Subscriber Numbers and Employees.

Today, we’re going to consider the factors that could derail your growth plans.

I think there are five:

  • Technology stability;
  • Technology change;
  • Overseas expansion;
  • Customer Clarity; and
  • Behavioural biases in your partner programme.

Ok, from the top then:

Stability of Technology

Do Business, Beautifully is your tag line.

Invoice on the run, reconcile as you go, reclaim your time are your promises.

These promises rely on stable technology.

As subscribers increase, you will need to invest greater amounts in hardware and software to maintain up-time, and plan new releases / updates of your software with increasing care.

Protection from malicious hackers will be a relentless focus.

Earlier this year, you had an outage that lasted a little over a day. It was keenly felt.

These are rare events for you, but if that changes then you will degrade your promises and your brand.

Your focus on finding SME clients through their bookkeeper and / or accountant, and encouraging bookkeeping and accounting firms to switch their entire client base to your software, means that if your technology becomes unstable you risk losing entire firms of clients, not just individual SMEs.

Instead of a few pebbles rolling down a hill you could be facing an avalanche.

The stability of technology is a present, ongoing risk requiring constant attention.

Technology Change

In your own words, only a few technology companies have spanned a technology generation.

So, you need to be continually looking at new technology, developing better ways to deliver your technology.

But, as your business grows, servicing the existing client base will make increasing demands on your time and focus.

Your clients are your cash flow and underpin your ability to invest.

Keeping your existing technology stable will reduce the time needed to serve the existing client base.

Avoid “buying” technology. Take-overs seem an easy way to build scale, skills and knowledge quickly.

They rarely work.

Your hiring strategy is key to how successfully you manage and anticipate the impacts of changing technology on your business.

This is a risk that is both near term (hiring particularly) and long-term (tech changes and developments).

Overseas Expansion

Your business is active in numerous markets, chiefly Australia, New Zealand, United Kingdom and the USA.

To achieve your growth goals, you will have to expand beyond your home markets of Australia and New Zealand.

Not too many businesses do this well.

Fonterra recently wrote off $405m on an investment in a Chinese infant formula maker.

Westfarmers just wrote off their $705m purchase of UK-based hardware retail business.

ANZ’s push into Asia and NAB’s purchase of banks in Ireland, England and the US were all disasters.

Even though these companies stuck to their knitting, their strategies failed.

These were all investments in established businesses.

Your success has so far come from organic growth…don’t change.

Focus on the UK next. With your antipodal heritage there is more in common with English than the Yanks.

Once you’ve built momentum in the UK you can switch focus to the USA.

This is near term risk requiring active management.

Customer Clarity

Your customer is the party that ultimately pays the subscription to use your software – the SME owners.

Yet, it seems to me your focus is on Accountants and Bookkeepers.

Your marketing, social media, even key positions within your business are geared to accountants and bookkeepers.

I understand these two groups are an important means of accelerating your growth.

But if they ultimately don’t pay the bill then they are not your customer.

Why is this important?

Being clear on who is your customer will help you focus your attention on the things in your business that matter most.

Every decision you make needs to have your customer at the front and in the centre of your thinking.

Right now, it looks like you’re trying to have a bob each way. You need to make a choice.

Behavioural Biases in your Partner Programme

This is related to customer clarity.

Partner Programmes are the accounting industry’s dirty little secret – the nicely alliterated euphemism for a kick-back.

If you go to any accounting conference you will find a bunch of vendors pushing their partner programme at accountants and bookkeepers in the hope they will refer their clients to them, in return for a commission or some other reward.

You run one of these as well and it has been super successful.

70% of your new business comes through this method.

So, what’s the problem you ask? It works brilliantly for us, and is accepted practice in the industry we serve.

Partner programmes are built on encouraging particular behaviour(s) that can lead to poor customer outcomes.

Imagine what SME owners would think when they discover you offer your partners a discount on subscriptions.

Imagine if that discount is not fully passed back to the SME owner.

Imagine if your partners are pricing their services to the SME owner without full transparency, obfuscating the discount they receive and the fee they charge for the service provided.

How will your customer feel, and what will they think of you?

It’s your programme after all.

It won’t be beautiful.

Am I over-reacting?

Well, I’d invite you to think about the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry.

The banks designed a remuneration structure, with behavioural biases, to incentivise Finance Brokers.

Loans from this “channel” were larger, for longer terms and more expensive than loans from the branch network.

The commission paid to brokers drove this outcome – a broker got more for larger, longer and fully drawn loans.

Financial advisor behaviour is also impacted by commissions.

In this case, particular classes of investments received a higher commission.

Unsurprisingly, these products were recommended over others, irrespective of whether it was the right option for the client.

Recent press on superannuation has highlighted opaque reporting making comparison of fund performance impossible.

Poorly performing fund managers are rewarded and the savings of the superannuant diminished.

I reckon there is a wave of community revulsion coming about these commissions and kick-backs.

You need to be in front of this issue, lest it dump all over you.

My advice to you is to scale back the partner programme and ultimately disband it.

In the meantime, ramp up your direct marketing to the SME owners and convert them based on the quality of your product.

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From Xero to a Billion in How Long – Part 2

From Xero to a Billion in How Long – Part 2

When we last met, we’d determined that you needed 1,795,000 new subscribers to reach your target 2.9 million subscribers which, based on your current Smoothed ARPU of $343, will generate $1bn in annual Revenue.

In Part 2, we’ll look at how quickly, and what it’ll cost, for you to achieve this outcome.

We’ll be balancing a matrix of key business drivers to achieve the best outcome for your business:

  • Market Share and the need to grab it as quickly as you can.
  • The risk of new technology rendering your business obsolete.
  • Sticky subscribers will underwrite your profit.
  • Shareholders with deep pockets to fund growth.

Let’s start with taking a look at your current growth rate. The graph below shows the growth in subscribers on a 6 monthly basis.

It is clear from this graph that the rate of growth in subscriber numbers dropped significantly in the 6 month period between March 2017 and September 2017.  We’ll need to reverse this as quickly as possible.

What happens if you increase Average Revenue Per User (ARPU)?

Building on the work already done, let’s take a look at what happens if you increase the subscription payable for using your software.

First though, we’ll start with the position if we do nothing.

The graph below shows the nexus between the compound rate of growth and time needed to reach your target of 2.9 million subscribers.

It assumes there is no change to the Smoothed ARPU of $343 as at September 2017.

It’s a Speed graph, which tells you the compound growth rate needed to reach 2.9 million subscribers in a specified number of years – for example, if you grow your annual subscribers at a compound rate of 21%pa it will take 5 years to reach your target number of subscribers.

Ok then, now what happens if we increase the Smoothed ARPU?

The graph below shows the different outcomes from increasing Smoothed ARPU by 5%pa, 7.5%pa and 10%pa for each year over a 5 year time horizon.

As you can see, a 5%pa increase in Smoothed ARPU speeds up by a year (from 5 to 4) the time needed to reach your target (at 21%pa growth in subscribers, the same rate as the base case).

Conversely, a 7.5%pa increase in Smoothed ARPU speeds up by two years the time needed to reach your target (at 22%pa growth in subscribers). If you can get a 10%pa increase in Smoothed ARPU then you can reach your target in 3 years at 17%pa growth in subscribers.

So, we can see that increasing ARPU every year has a material impact on speed.  But, how realistic is a 7.5%pa or 10%pa increase in Smoothed ARPU? Well, the average increase since 2013 has been about 5%, when they are made.

We know that a key driver of your business is happy (and sticky) customers. Churn, which is what happens when you lose a customer, is like a slap in the face to your growth plans.  It takes momentum away.

It seems to me that without a step change in your offering, there’s a real risk of higher churn if you increase subscriptions by more than what you’ve conditioned your customers to expect. I think 5%pa is possible but not 7.5%pa or 10%pa.

What about Investing for Growth?

The alternative then, is investing in the resources you need for growth.  In your case, this means hiring more people to drive your growth and investing in Marketing.

Staff Costs and Marketing are two of the major costs in your business. If we can work out targets for these, then along with the Revenue and Subscriber targets, we’ll have a good chunk of your future profit and loss statement worked out.

Let’s take a look at the recent trend in these costs.

The first graph looks at Staff Costs to Revenue.  You can see in the graph below that Staff Costs have fluctuated between 68% and 104% of Revenue.  Considering the drop in subscriber growth in the September half, I am going to invest in new employees to drive growth, but will set a cap of 80% of forecast Revenue as the maximum investment in any given year.

The next graph looks at Marketing Costs relative to Revenue:

You can see that Marketing Cost has fluctuated between 15% and 27% of Revenue. In this case, I am going to use 20% of forecast Revenue as the cap for the maximum amount I will spend on Marketing in any one year.

Ok, having established some guidelines, we need to turn out mind to the number of staff you’ll need to support your growth ambitions.  And then we’ll need to runs a cross check on the cost of these employees to the business.

Let’s take a look at some employee related statistics.  We’ll begin with the trend in Subscribers per Employee.

At September 17, you had 1,853 employees in total, representing 1 employee for every 604 subscribers.  You can see that even as employee numbers have increased, so too has the number of subscribers per employee.  In other words, since 2013, there has been a trend of increasing efficiency.

What about Revenue per Employee?  Here is the graph:

So, just like Subscriber/Employee there is an increasing trend in Revenue/Employee.

Ok, we can use this information to help understand the number of employees we need to support 2.9 million subscribers, or the number of employees we need to generate $1bn in Revenue. You’ll see the outcome in the two graphs below:

Right then, if each employee can support 604 subscribers then you will need 4,825 employees to support 2.9 million subscribers.

Similarly, if each employee helps your business generate $183k of Revenue then you will need 5,451 employees to generate $1bn in Revenue.

By now I reckon you’re asking yourself the “How much will this cost” question.  Let’s find out, shall we?

We can see from this that average Salary per employee was $125k at September, and had been consistently around that level since FY16.

If we bring this information together we get the following graphs:

So, now we have both trends over time and a range of that covers employee numbers required to support either $1bn in Revenue or 2.9 million in Subscribers and what it will cost to employee this number of people based on the current average Salary in your business.

But, which do we use.

Well, remember in Part 1 we discussed that until growth stops it is very hard to get a true picture of your actual ARPU.

The same issue applies with Revenue per Employee.

So, I think Revenue per Employee at Sept 17 is understated because of growth, and hence, the number of employees needed to support $1bn in Revenue overstates the actual requirement.

For that reason, I would prefer to use the number of employees needed to support 2.9 million subscribers as my benchmark – 4,825 employees.

I still think this will be more than we need, because we’ll be targeting a greater proportion of employees to drive and support growth in subscriptions, but not head office employees engaged in Company admin and support services.

So, let’s call the target 4,250 employees, an increase of ~2,400 from present levels.  When we apply the current average salary of $125k the total cost is about $530m, about $300m more than your current cost.

Bringing it all Together

I thinks it time to summarise this conversation and work out where we’re at and what we want to measure.

The things we measure are not absolutes, but they are drivers of growth that we can check at any time and use as guides as to how we’re going.

I think we need to set the following goals:

  • Subscriber growth of 15%pa in FY18, which is on the low side.
  • This reflects the slow down in subscriber growth experienced in the September 17 half-year.
  • To compensate for FY18, a higher growth rate of 25%pa in subscribers in FY19, FY20 and FY21.
  • Increasing ARPU each year has a material impact on the speed at which you can reach your goal.
  • For that reason, I will be forecasting an annual increase in Smoothed ARPU of 5%pa.
  • Total employees of 4,250 to be reached by the end of FY20 (ie: over a 2.5 year time frame).
  • We will add 800 by the end of FY18 and then another 800 in each of FY19 and FY20.
  • A cap on Staff Cost, set at 80% of Revenue.
  • A cap on Marketing Cost, set at 20% of Revenue.

What will this Cost?

Using these goals as my guide, I have built a three-way financial model to work out the funding needed to support this growth.  The key details are set out below, but for now, the main things that stand out are:

  • You need $250m in new equity to fund this growth.
  • By the end of FY21 you will have 2.3m subscribers, generating $969m of Revenue.
  • Both Staff Costs and Marketing Costs are well within the caps we established.
  • But, Revenue/Employee and Subscribers/Employee are either flat or go backwards.
  • Perhaps we can achieve this growth with fewer additional staff than originally thought.

The main driver of these different outcomes is the impact of increasing Smoothed ARPU by 5%pa. It means you need less subscribers than initially thought to get you to your $1bn target and, as a consequence, less additional employees than additionally thought to support that growth in subscribers.

So, let’s now look at what happens if we can reduce the number of additional employees, and move our Subscriber per Employee back to around the 600 mark more quickly than under the base case. Again, the details are set out in the dashboard below, but the main outcomes, compared to the base forecast, are:

  • Your business is profitable a year earlier, by the end of FY20.
  • You generate a cash flow surplus a year earlier, also by the end of FY20.
  • This reflects lower Staff Costs, driven by lower staff numbers.
  • Subscribers/Employee trend up from the FY18 low, but do not exceed the 600 level again until FY21.
  • Consequently, the equity funding you need has reduced to $100m.

The power of this analysis is that it makes crystal clear that the key drivers of your business is ARPU, Subscriber Growth, Subscriber Numbers and achieving an efficient Subscribers per Employee outcome. As the business owner, you now have a road-map you can use to easily keep track of how your business is performing.

In addition, you also know the levels of each that you need to reach and the time-frame to achieve those goals.

Well, it’s been a long meeting, and we’ll wrap it up here. But, when next we meet, in Part 3, we’ll look at some of the risks in your business, how these could derail your growth plans and what you can do to reduce these risks.

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From Xero to a Billion in How Long – Part 1

From Xero to a Billion in How Long – Part 1

This blog is an invitation for you to come on a journey with me.

On this journey, you need to imagine that you are the owner of a business called Xero.  You’re on a high growth path and you’ve just employed me as your virtual CFO.  In your last financial year your revenue was $290m.  The 12-month revenue run-rate at Sept 2017 is ~$340m and your plan is to triple this revenue to $1bn.  You’ve just reached break-even on your earnings.

What follows is an example of how I’d go about helping you.

Setting the Scene

Ok then, the first thing I do as your virtual CFO is talk with you about your business. I want to understand the qualitative factors that drive it.  From that discussion I will distil the key drivers of it. I do this even before looking at the numbers.

Here’s what those discussions reveal:

  • Xero is a fast-growing software as a service business. You build and sell accounting software.
  • Technology has a notoriously short life-cycle.
  • Software as a Service is a winner take all game. Market share is vital. Grab it as quickly as possible.
  • But growth at great speed is expensive and you need shareholders with deep pockets to fund you.
  • Your future profitability is dependent on happy, and hence, sticky customers.
  • You sell your software globally, with major markets in Australia, NZ, the UK and USA.
  • Your find the end-user of your software primarily through accountants and bookkeepers.

Market Share

Right then, the first thing I am going to do is a little bit of work on your market share.  To reach your goal of $1bn of Revenue you can either increase subscriber numbers, increase subscriptions or do a combination of both.  Understanding which options are feasible requires an understanding of your market position.

So, let’s look at how things stack up for this business of yours.

In the graph above we have your major markets, ranked on the vertical axis in terms of number of subscribers whilst the bubble is a measure of the relative size of each of those markets.  The market size info (in blue) has come from various government sources in those countries.

We can see that your business has its highest number of subscribers in Australia, the 3rd largest of its markets. At 23%, you hold a strong share of market.

Its second highest number of subscribers is in NZ, the smallest of its markets. At 51%, you have a dominant share of market.

Its third highest number of subscribers is in the UK, the second largest of its markets. At 4.6%, you hold a niche position.

Its smallest number of subscribers is in the US, the largest of its markets. At 0.4% market share, you only just have a beachhead.

The initial conclusion I draw from this, is to meet your goal of $1bn in Revenue, growth in subscriber numbers needs to come from Australia (to a dominant position), UK (to a strong position) and the US (to a niche position).  I would suggest that you need to increase your subscriber numbers to over 1,000,000 in each of those markets.  This would bring your business to a dominant position (near half) in Australia, a strong position (20%) in UK and a niche position in the US (5%).

In round terms this means another 500,000 subscribers in Australia, 750,000 in the UK and 900,000 in the USA for a total of 2,150,000 additional subscribers.

But will this be enough subscribers to meet your Goal?

Naturally, like all successful business owners, you have a strong sense of curiosity…also, you just want to test out whether I have thought through the 2,150,000 number I’ve just lobbed on you.  The following discussion ensues:

You already know that your subscriber numbers were 1,119,000 at September 2017.  You also know that these subscribers were paying you $31 per month in subscription revenue, for an annual amount of $373 of subscription revenue per user.  You call this Forward Looking Average Revenue per User or Forward Looking ARPU.

But, when I look at your most recent 12 months of Revenue ($340m at 30 Sept 2017) and the subscriber numbers at that time of 1,119,000 I get an Average Revenue per User (ARPU) of $304, well short of the $373 outlined above. Looking back in time we see a trend of ARPU underperforming Forward Looking ARPU as shown in the graph below.

Although ARPU is always less than the Forward Looking ARPU on this graph, the gap is shrinking, from 75% of Forward Looking ARPU at the end of FY13 to 89% of Forward Looking ARPU for the 12 months to Sept 2017.

I suspect this phenomenon reflects the pace of growth of your business.  Whenever you’re growing, ARPU will always lag the Forward Looking ARPU.  It reflects that a full 12 months of Revenue from each subscriber is required before you can get a proper read on ARPU and you will never get that outcome whilst growing.

To test this premise, I look at the growth in Subscriber numbers.  Here’s what that looks like:

As the business gets bigger, the rate of growth in percentage terms, slows and that is what we’re seeing the graph above.  If we bring these two previous charts together we get the chart below:

It’s clear that as the growth rate in subscriber numbers slow that ARPU moves closer to Forward Looking ARPU, but at 89% of Forward Looking ARPU it’s not close enough to be useful yet.

Now, if rate of growth is the issue creating the gap between ARPU and Forward Looking ARPU then what happens if I smooth that rate of growth? I’ll do this by using the average of Subscriber numbers over the course of the year as my denominator for working out ARPU, instead of the year-end Subscriber numbers.  I’ll call this new measure Smoothed ARPU.  The graph below shows its correlation to Forward Looking ARPU.

This approach yields a much closer match and will be usable for forecasting.  So, using Smoothed ARPU, I can now derive the number of subscribers required to reach $1bn in Revenue at different points in time, as set out in the graph below:

Righto then, in round figures, your business needs 2,914,000 subscribers based on the Sept 2017 Smoothed ARPU to meet the goal of $1bn in Revenue.  This is an increase of 1,795,000 million subscribers from the September 2017 position.  It also confirms that if you reach the Market Share and Subscriber Number goals then you should also meet your $1bn Revenue goal.

This is the end of Part 1.  In Part 2, I will look at how quickly you can reach your growth target if you continue to yield a Smoothed ARPU of $304.  I then look at how this timeframe is affected by increasing your ARPU or, alternatively by investing in additional resources to support your growth ambitions.  I’ll also compare the cashflow consequences of following each of these paths.

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