From Xero to a Billion in How Long – Part 1

Posted by on Apr 20, 2018 in Growing with Confidence

The truth is in the cash flow

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.