What every VPE should know about accounting and margins
What every VPE should know about accounting and margins
Last week’s post went through some of the most common themes a VPE tackles with her Board of Directors; all based from my own experience. One of those themes was “margins” in which I said the following:
“In later stages, series-D and beyond, especially if the company is on track to IPO, margins and profitability will come under increased scrutiny. Engineering - more generally speaking R&D - impacts two critical profitability metrics: gross and operating margins. Your BoD and CFO, will be increasingly interested in the health of these margins and levers to improve them. “ Five VPE themes that come up in board meetings
Today, we’ll diver a little bit deeper into accounting and margins to better understand what these metrics are, how they relate to a company’s profitability and valuation and how the VPE influences both.
First, a very quick primer on accounting, specifically the income statement. An income statement summarizes the company’s profitability and loss (P&L) over a period of time, typically quarterly or annually. The income statement will summarize all income and expenses over a given period, including the cumulative impact of revenue, gain, expense, and loss transactions. In this article we will explore Snowflake’s quarterly income statement from its quarterly report dated 9/2022 to get a quick overview of its structure and how some elements are highly influenced by engineering (R&D).
One side note on income statements. These are accounting instruments and are subject to many accounting rules. They will also include cash and non-cash costs (e.g. depreciation and amortization). Therefore, a company can report a loss on its income statement yet still be able to generate a substantial amount of cash (cash flow, or free cash flow). If you want to understand how much cash a business generates over a period of time you need to read the statement of cash flows.
We won’t go through the entirety of the income statement, but will focus on revenue, cost of revenue and operating expenses.
Revenue, is as the name suggests, the revenue or sales that Snowflake attained during the three month period ending July 31, 2022. In Snowflake’s case the company reported revenues of $497M for that period relative to $272M for the same period last year. This represents a year over year growth of ~82% - pretty impressive!
The next line item on the income statement is cost of revenue. This item, also known as cost of goods sold or COGS, represents the expenses Snowflake incurred in order to manufacture and deliver its products to its customers. The structure of COGS will vary by industry. Most software companies, unless they build hardware, incur very low COGS relative to their revenues. For most software companies, especially SaaS, the two main cost items here are cloud/infrastructure costs and support.
The difference between revenue and COGS is known as the gross profit, or simply the money left after the costs of building and delivering the products have been incurred. The higher this metric, the better. Gross profitability will differ by industry, with software having one of the highest. In Snowflake’s case, its gross profit for the quarter ending July 2022, was $324M. This represents a gross margin of 324/497 = ~65%. For the same period last year, Snowflake’s gross margin was 166/272 = ~61%. Therefore, on a year over year basis, Snowflake was able to grow its revenue and gross margins.
We now move on to the operating expenses (OpEx) section, which in turn consists of three line items: sales and marketing, research and development and general and administrative. Sales and marketing is pretty obvious, and tends to be the highest cost item in operating expenses. It represents the costs incurred by Snowflake’s sales and marketing organizations. The next item is R&D, which again is pretty evident, although we will dive deeper into what it is composed of in the next section. General and administrative (G&A) represents the costs incurred by organizations outside sales, marketing and R&D. Those include legal, finance, CEO, IT, HR and so on. For the quarter ending July 2022, Snowflake’s operating expenses amounted to $537M, resulting in an operating loss of ($207M) which is derived from $497 in revenue - $173M in COGS - $537M in OpEx.
So how is any of this relevant to a head of engineering you might ask? Well for one, engineering is almost entirely responsible for two critical cost items: COGS and OpEx-R&D. Both of which impact profitability and ultimately the ability of the company to generate cash flows.
COGS
The interaction below between Snowflake’s CFO and a Barclays’s analyst from the December 2020 analyst call highlights the importance of COGS and gross margins. The analyst - Raimo - is trying to project Snowflake’s sustainable (long-term) gross margins. Notice, Michael’s response which indicates Snowflake’s desires to grow their gross margins beyond 70% and drive that number by better pricing from their cloud vendors. Recall that Snowflake’s SaaS runs on AWS and Azure, hence a substantial portion of the company’s COGS will be the infrastructure spent on both AWS and Azure. The more pricing power - discounts - they can obtain from these vendors the better.
There’s another lever, and one which is almost entirely in the engineering organization's domain. And that is to spend less on AWS/Azure. The intent is to be efficient and diligent with how the product is designed, its infrastructure requirements and always striving to optimize those.
This is obviously much easier to write in a blog than actually do, but nonetheless it is an engineering challenge. I wouldn’t be surprised if the leaders of Snowflake’s engineering organization derive a portion of their compensation based on attaining gross profitability targets.
OpEx & R&D
Snowflake, as do other companies, outlines in details what R&D expenses are composed of. Broadly speaking the main costs under R&D are employee salaries, infrastructure & cloud costs (for dev/test), computers & personal equipment and other SaaS tools e.g. Github, Jira, Slack and so on.
Research and development expenses consist primarily of personnel-related expenses associated with our research and development staff, including salaries, benefits, bonuses, and stock-based compensation. Research and development expenses also include contractor or professional services fees, third-party cloud infrastructure expenses incurred in developing our platform, and expenses associated with computer equipment, software and subscription services dedicated for use by our research and development organization. Source: Company filings
I highlighted one particular expense above - stock-based compensation (SBO). This is a non-cash expense, but is recognized as an expense on the income statement. It can be a large expense - ~$605M in 2022 - which will be reconciled in the statement of cash flows. SBO can be the main reason why a software company is unprofitable on its income statement yet is able to generate positive cash flows for the same period.
Much like COGS, questions on R&D spend and operating margins come up frequently during analyst calls. One of these interactions is below from the quarter ending July 2022.
I mentioned before that the margins conversations come to the fore as the company starts preparing for an IPO. That doesn’t mean that you shouldn’t be paying attention to these figures much earlier than that. It’s far easier to optimize these costs and how you run engineering organizations earlier on, versus trying to do so as you get closer to an IPO.
More importantly, the more cost effective you run your organization the better, regardless of IPO status. The less money you spend, the more profitable your company can be and ultimately the less money you will need to raise. All of that is money in your pocket!
Things I am reading/listening to
The AI unbundling I’m a big fan of AI and a user of some of the tools mentioned in Ben’s article. Are we on the cusp of content entirely derived by machines?
How SaaS performs in a recession Not to shabby IMHO; 15% growth isn’t stellar but it still represents growth
Speaking of accounting, this Twitter thread blew my mind. “a carbon accounting loophole is causing huge amounts of CO2 to be pumped into the atmosphere today that will take decades to abate using natural means”
