Hey fellow monkeys,
Wanted to ask all the folks who are in software investing -
I've been through several interview processes for buyout shops (non-software focus), where I've been tested the typical technical questions including...
- what are key drivers in LBO
- walk me through calculation to FCF
- what is one financial metric that is most important when assessing business
- walk me through credit metrics
- etc.
However, I have an interview coming up with a software-focused PE firm (think top 3 software investors), and have never been through an interview process with software-focused firms. I wanted to ask if and how technical questions for PE software investing companies may be any different (e.g., do you prefer high gross profits vs. operating profits, what are key metrics in software business [LTV/CAC, Net ARR, etc.]), and any other questions that may be key to focus on studying.
Would really appreciate any inputs here from all the software investors!
Not on the buyside (yet) but have worked on a good amount of software. I think you should be familiar with the terms you mentioned, plus the below:
1) Difference between Gross and Net Retention
2) Walk though a customer vintage analysis / retention analysis (renewals, churn, new customer growth, expansions/upsells, downsells)
3) Walk through how you would project revenues. (you might have to look this up. I've done this differently every time I've built a SaaS model as each firm is kinda different...)
4) Why would you have increasing renewal rates but decreasing expansion/upsell? Which would you prefer?
5) Difference between billings and revenue and how these flow through the statements with deferred revenue
6) TCV vs. ACV vs. ARR
7) Do SaaS companies typically have positive or negative working capital? What does it mean if it's growing in either direction?
8) What kind of operating expenses would a SaaS business incur? How would you model it? (focus on sales & marketing, salesforce productivity & ramp, etc.)
EDIT: Also you should probably brush up on industry trends so you don't say something super generic or wrong, I think too many people just randomly throw out buzz words like cloud, edge computing, AI, 5G, etc....
This is super helpful - thank you!
Thank you so much for the in depth post. I feel pretty good about most but having trouble with this one: Why would you have increasing renewal rates but decreasing expansion/upsell? Which would you prefer?
This is btw not really a common question, but more so a case type of question that could be thrown it. I just remember getting it once. It happens when you start losing momentum or winding down a growth strategy, so you aren't getting many more customers but the ones that are left are stickier. Obviously having both be high is optimal, but if the S&M costs for expanding/upselling outweighs the ACV you gain, you may prefer focusing on customer service/experience for renewals. You could also pursue renewals with legacy products for an old target customer base that doesn't have a lot of growth runway while pursuing expansion/upsells for new products you are trying to get to market.
Anyway you could provide a brief run through on answering these? Thx
Some are basically answered in my other comments. See below for the rest. Not answering #2 because it takes too long and im celebrating a national holiday today...also easily Google-able.
1) Gross Retention is essentially renewals. Net Retention includes expansions & upsells
3) See my comments below
4) See my comment above
5) Billings is how much you actually invoice the customer, while revenue is only recognized revenue. If you have a customer with a 3-year contract of $100 ACV paid at the start of the term, you could have $300 in billings, but $100 in revenue for first year. The rest goes into deferred revenue.
6) TCV = $300 in the example above = total value of the contract over its term. ACV and ARR are similar and alot of companies tend to use them interchangeably but the nuance is ACV includes ancillary revenue that may not necessarily be subscription, so like additional services tied to a contract
7) Negative because of deferred revenue. If it is shrinking, it could indicate that the company is switching to shorter term lengths, and vice versa
8) See previous comments
Could you please give brief answers these questions of your list?: - what is the most important financial metric when assessing businesses ? —- margin? growth rate?
THANKS
Key drivers in LBO: Purchase and exit multiple and amount of leverage used; secondary drivers are revenue growth, ebitda expansion, reducing capex, etc.
Walk through to FCF: net income + D&A / other non cash expense - capex - increase in NWC (this represents levered FCF)
What is most important financial metric: FCF is the lifeline of a LBO; it determines how much of the principal debt and interest you can paydown
Key credit metrics: Total debt / EBITDA (typically within 4-6X); Total interest / EBIT (typically ~1.5-2X)
Hope that helps
you mean EBIT / Interest?
OPs answer covers most of the fundamental aspects in LBO. For software in particular, given the nuances of the top-line and how important it is in the industry with a lot of companies valued on revenue multiples for better or worse, understanding the revenue related metrics is pretty critical.
So if I had to boil it down, for SaaS companies, most important metrics are: (1) gross/net retention rate (2) CaC (3) New customer growth rate (4) ARR (5) % recurring revenue
Margins often fall more onto the sidelines, especially as you go earlier in the company lifecycle, with the rationale being that even if they have negative 50% operating margins, if there are customers being signed up for year or multiyear long subscriptions with 90+% gross retention and 20% new customer growth, it's not hard to see that they can reach profitability.
With that said, the biggest cost is largely going to be related to R&D or S&M, with S&M being the more significant one (since R&D often is done in sprints). For S&M, the key metrics are related to sales force productivity like ramp time for new reps, quota attainment %, etc. On a more general level, the S&M as % of revenue. With these metrics, you can do an operating model seeing how much each rep gains in renewals vs. new customers vs. expansions & upsells, model out hiring plans, and model out the new reps ramping up to the average attainment% which forms the basis of the revenue build.
Credit metrics are the same as any other. The one unique dynamic here is cash flow for servicing debt, which is often dependent on contract term mix which influences deferred revenue balances in working capital. So if a business has 5-year contract terms with the amount paid upfront, that company will have higher cash flow since they receive more upfront vs. a business with 1-year terms even though their ARR is the same.
Hey Yasuo -
Quick question on modelling for software businesses (assuming SaaS model).
Is the topline in software-related models typically driven by # of salespeople (assuming $ sales / salesperson), or do you typically assume a revenue % growth based on simplifying assumptions of say historical bookings?
Generally speaking, wanted to gauge whether you build models based on tying back to certain key inputs (e.g., salespeople) or if you typically use simplifying assumptions such as % of revenue, etc.
If you had a software specific model template, that would be so helpful!
I interviewed at 2 of the top 3 PE software investors and got an offer with 1. One was extremely focused on interest and knowledge of the space, the other was deeply technical. The latter was the type of questions you see above, but also one about contract value that blew my mind.
Let's say the date is 1 Jan 2018. You are a business with one customer, a 2year software contract with $100M ACV. The contract starts 1 Jul 2018. Walk me through the 3 statements for this year. Now walk me through 3 statements assuming the date is 1 Jan 2019.
Now, walk me through the three statements assuming the date is 1 Jan 2018 and the contract starts 1 Jan 2018 as well. What are the differences based on contract start? Why does that matter?
.
The question is designed to get at the differences in annual cash flow based on whether something is recognized mid or beginning of year based on contract date, and that the rest is couched in deferred revenue. This can affect valuations for unsavvy investors. You should really get comfortable with this question because this was the hardest one I had over tons of interviews.
Do you mind providing the answer to this by any chance? I'm trying to study software as well with regards to interviews and wasn't sure how to approach.
I'll do my best. It's been a while. Here’s a simplified version.
Today: Jan 1, 2018
Contract Value: $200M
Contract Duration: 1 Year
Margin: 50%
Tax: 40%
----- Section Break -----
Contract Start: Jan 1, 2018
Revenue: $100M
Gross Profit: $50
Taxes: $20
Net Income: $30
Deferred Revenue: $100M
----- Section Break -----
Contract Start: Jul 1, 2018
Revenue: $50M
Gross Profit: $25M
Taxes: $10M
Net Income: $15M
Deferred Revenue: $150M
----- Section Break -----
Look at the above two examples.
In example one, Net Income + Deferred Revenue = $130M
In example two, Net Income + Deferred Revenue = $165M
The contract is the same value though. Why?
The reason is because you don’t tax affect something that goes straight into deferred revenue.
Hey MG,
Taking a stab here, but wanted to get your guidance on how to actually calculate the impact across 3 statements -
Ultimately I think the timing of contract start has to do with revenue recognition and impact on cash flows.
For first scenario where contract starts mid-year of 2018, cash flows would be lower since you account for full S&M cost to acquire account, but only recognize half a year's worth of revenue. Deferred revenue I'd think would be $150M here
In the second scenario where contracts starts Jan 2019, while 2018 cash flows would be 'most negative' (recognize only S&M acquisition cost and book no revenues), the 2019 statement would show stronger cash flows ($100M revenue from ACV, with no acquisition cost booked for that year). Deferred revenue in this scenario would be $200M in 2018, but 100M in 2019
In the last scenario where contract starts Jan 2018, cash flows would be least negative so to speak since you are recognizing both ACV ($100M) and whatever the acquisition cost for that year to be. Deferred revenue in this scenario would be $100M by end of 2018.
I'd suppose that Scenario 2 would produce the "lowest valuation" for unsavvy investors while scenario 3 would produce relatively higher valuation assuming valuations are based on EBITDA in 2018 although there is no difference in the actual company itself. Is this heading the right direction?
Quite a question. I'll take a stab. In the second scenario, to clarify, do you mean the contract still starts Jul 2018, it's currently Jan 1 2019, and you want the walkthrough for end of year 2019? (this is what I'm assuming below)
Scenario 1 On Income Statement: >Revenue goes up $50M (6 months of recognized revenue) >Net Income up $40M (assuming 20% tax)
On CF Statement: >Net Income up $40M > + Net Increase in Deferred Revenue of $150 ($200M TCV less $50M recognized) >Cash up $190M
On BS: >Assets: Cash up $190 >Liabilities: Deferred Revenue up $150 >Equity: Retained Earnings up $40
Scenario 2 On Income Statement: >Revenue: $100 (full year of recognized revenue) >Net Income: $80
On CF Statement: >Net Income: $80 > less Decrease in Deferred Revenue: ($100) >Cash down ($20)
On BS: >Assets: Cash down ($20) >Liabilities: Deferred Revenue down ($100) >Equity: Retained Earnings up $80
Scenario 3 On Income Statement: >Revenue up $100 >Net Income up $80
On CF Statement: >Net Income: $80 > + Net Increase in Deferred Revenue: $100 >Cash up $180
On BS: >Assets: Cash up $180 >Liabilities: Deferred Revenue up $100 >Equity: Retained Earnings up $80
Differences / why does it matter: The difference appears in cash with $190 in the first scenario vs. $180 in the second scenario. The difference is due to tax which is higher from more recognized revenue in the first scenario.
Looking at it from an LBO (or any investment with debt) context, in the first scenario, you are receiving a larger sum of cash for the year because you are only taxed on the recognized portion, so you can use that cash to paydown debt sooner and reduce interest in the second year, which can increase your IRR.
Is this the basic idea?
>
Why wouldn’t the net cash effect be the same, given that the contract starts in the same year under each scenario and taxes are paid on cash flow rather than GAAP income? Wouldn’t both scenarios incur the same cash tax bill and DTA?
Love this question. Need to fill in some assumptions:
One, we need to assume 100% of the TCV is billed up front. (If not, this question gets even better and more complex).
Margin / Tax assumption: See the 50% margin / 40% tax in comments above so will just use those to stay consistent
ACV is $100 and TCV is $200 (2 year contract * $100 ACV)
If you start July, 6 months of a $100 ACV contract is being recognized this year: Revenue: +50 Less: Costs (25) Less: Taxes (10) Net Income: 15
Net Income: 15 Add: NWC 150 (remember we billed the full TCV up front so $200 less the recognized $50) Cash: +165
Balances with Deferred Revenue +150 and Retained Earnings +15
If you start the same contact in January it looks like: Revenue: +100 Less: Costs (50) Less: Taxes (20) Net Income: 30
Net Income: 30 Add: NWC 100 Cash: +130
Balances with Deferred Revenue +100 and RE +30
This is omega helpful -
Thanks so much SG. Quick question for you on side note as I recently received this question, and wanted to get your thoughts.
If you have 2 companies that are exactly the same where one has high gross margins but low operating margins, and another with high operating margins but low gross margins, which as an investor is more attractive? - I ultimately defended my answer as high operating margins with lower gross margins with the rationale that EBITDA would be higher in scenario 2, which is a good proxy for cash flow / ability to pay down debt and reinvest back into the company. However, I think this would be true for financial engineering firms, while perhaps software investors might prefer the former given SaaS firms have 80%+ gross margin. What would you say in this case for why scenario 1 might be preferable for a software investor?
Thanks so much in advance!
Kind of a classic PE question and, as always, with all of these questions the best answer is to usually lay out the framework to demonstrate you know the concepts and then take a step back to apply them to a/some situations.
What does a gross margin tell us? The difference between a product/service's price and its cost. This is important because if gross profit is too low, then even if you slash all your R&D/S&M/G&A you can't turn a profit.
Operating margin and its relationship to gross margin tells us what level of supporting costs are needed to maintain the business. The two margins taken together tell us how profitable a business is absent financing/tax considerations.
Which would an investor want? It depends. If you have high gross margins, then you know the business is insulated from price deterioration. It's important to diligence why the operating margin is so low then. Bloated R&D? Inefficient salesforce? A sophisticated investor could see an opportunity to improve these. They can then buy at a lower EBITDA (lower operating margin), make some operational changes, and exit as a company with a higher margin. Your returns benefit not only from operational improvement increasing the quantum of your EBITDA via margin, but also the multiple off which that is valued (people pay more for higher quality businesses). However, another investor could prefer the other option if their thesis is much more centered around generating cash, recapping, etc. Or maybe they have a good M&A target lined up, and the transaction synergies would enable them to pay up.
What we're looking for is your ability to understand the concepts at their core to such an extent that you can understand how they could contribute to the development of multiple theses / styles of investing.
For software the answer is mostly going to be the same.
Thanks so much for going through it makes a lot of sense now. I had a quick follow up question based on your assumption, where you said we assume "100% of TCV is billed upfront." If this weren't the case, how would you go about revising the 3 statements financial figures below? Thank you!
So you have three moving things: Recognized revenue, deferred revenue, and future contracted revenue that hasn't been billed.
The unbilled contracted revenue (bookings) won't show up on the balance sheet until cash is received, but you will have a separate build in your model for bookings and will ultimately build a schedule for how bookings roll into revenue over time. It gets messy (especially when factoring in conversion rates, implementation schedules, etc). I probably wouldn't ask it in an interview because I'd be worried about getting jumbled up in my own head myself =)
That being said, it's fair game on a model/case. (Although even this will be simplified. But you can see how real life operating models can become laborious.)
Thanks everyone. This is a classic discussion. Does anyone have exposure to Cloud/Telecom focused PE/growth equity firms and how their interview process looks like? I would imagine Software shops doing Cloud/Telecom as well and if anyone is coming specifically from Cloud background interview? I would imagine a lot of overlap with SaaS based since they are related industries but still would like to hear some thoughts.
Thanks for this thread and all the answers. Saving this for later use.
I have been and have asked most the following in some shape or form. Not LBO specific
Model out a cloud conversion i.e. perpetual to SaaS and explain resulting impact on growth and cash flow and return. Then tell me technically what it means and whether it could be done and the benefits. This is the most fundamental question as most large cap tech LBOs are conversion cases.
What metrics do you use for your CLTV and CAC calc and why? Practically speaking - walk me through it - what sources and what calcs?
Back of the envelope, what multiple would you apply to SaaS or other maintenance streams and why? What are your assumptions?
To test a sunset case, what do you need to know if you only have 3 questions about a business.
As brain teaser: if you are mature non growth business - is a "SaaS" business better than a 100% maintenance old perp business? What exactly is the dif? Why would multiples differ?
Talk to me about the software ecosystem and explain to me how infrastructure and application software differ and how that should impact me as financial investor. Pick one subsector and tell me your favourite company as well as highlight 2-3 key trends
Which software sectors are most crisis proof?
What are the typical levers to improve a software company? If you became CEO and had a 3-5 year time horizon, what would you look at first?
Thanks. Would love to hear your perspective on the questions you listed. These are all great and very useful so knowing briefly how you think is going to be of much utility
Thanks for these. Would you be willing to run through your thoughts on how you approached these questions?
Same; Would love some answers is possible.
Same here, following
What are the names of the top PE software shops?
Not software-specific, but the top tech-focused PE shops out there (off the top of my head, I'm definitely missing some) are:
Silver Lake, Vista, Francisco Partners, Vector Capital, Thoma Bravo, Siris.
All of the above have done lots of well-known software deals. Vista's exclusively software, but the rest invest across tech verticals.
Of course, that doesn't include lots of MFs with tech sub-groups like Warburg, TPG, Apax, etc. and growth equity-focused shops like Insight, TCV, GA, Spectrum, etc.
Hi guys,
Could anyone please help me with the below.
I am practicing an LBO model for a software company. I have picked a few drivers, such as New customers, Sales& Marketing expense and Average Revenue per Account (ARPA). I chose these quite randomly, as not sure what is the best way to tackle this. But the question i now have - how do you project Deferred Revenue on Balance Sheet? Given i have forecast of revenue - should i simply apply historical margin (saying hey historically 60% of revenue was deferred revenue), or is there a flaw somehwere?
Also, is there a specific way to forecast Accounts Receivable? Is it simple days calc based on historical data or smth more fancy?
It's the first time i am working with software LBO and i am completely lost, therefore appreciate any help.
Thanks!
Depending on the level of information you have available, you can project with historical % of revenue. However, if you have information on contract term length and average ACV/TCV of the contract, you should be projecting deferred revenue based on that.
For example, say the company has 3 5-year contracts with $100 ACV with TCV billed upfront, but they are planning to change future contracts to a 3-year term instead. Say they get a new customer on this contract at the start of year 2.
Year 1: Revenue $300, Deferred Revenue $1,200. Year 2: Revenue $300 + $100 = $400, Deferred Revenue $1,200 - $300 (recognized) + $200 ($300 TCV - $100 recognized) = $1,100
.
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