Lesson 7 of 7
Reading a software company
A software company is read on revenue recognition, remaining obligations and retention, because stock pay can move its profit in either direction.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- Remaining performance obligations show revenue already contracted but not yet recognised, billed or not, which a subscription business books over time rather than at sale.
- Retention, how much of last year's revenue renewed, matters as much as growth, because new sales can mask a business quietly losing existing customers.
- Stock pay is a real cost, and adding it back, for an "adjusted" profit or for free cash flow, makes the same company look more profitable than GAAP does.
A software company is read on how it recognises a subscription it has sold but not yet delivered, on how much of last year's customers stayed, and on where the cost of paying engineers in stock actually lands across three different figures.
From GAAP operating income to an adjusted figure
- GAAP operating income$50
- Stock-based compensation added back+$80
- Adjusted operating income= $130
- Capitalised software costs−$20
- A further-adjusted figure= $110
Revenue recognition and remaining performance obligations
ASC 606 recognises revenue as the promised service is delivered, not when cash is collected. A one-year subscription paid upfront is booked as revenue across the year it is used, with the unearned portion sitting on the balance sheet as deferred revenue. Remaining performance obligations, disclosed separately, are the value of contracts already signed but not yet recognised as revenue: a forward look at revenue the company already has a contractual right to, distinct from bookings it is still trying to close.
Retention, the number growth can hide
A software company can grow total revenue every year while losing a large share of its existing customers, as long as new sales replace them faster than they leave. Net revenue retention, the change in revenue from the same cohort of customers a year earlier including any upsells and cancellations, answers a different question than growth does. It asks whether the business the company already built is getting stronger or weaker, independent of how much it spent finding new customers this year. Upsells to the customers who stay can hide the ones who left, which is why gross retention, which leaves out upsells, is read beside it.
Stock pay moves the income statement both ways
Both adjustments move the same direction, upward, which is why an "adjusted" software company margin is often a large distance from its GAAP margin, and why the direction of every adjustment has to be checked rather than assumed.
Where GAAP understates
- Sales and marketing spent to win a multi-year subscriber is expensed up front, not spread across the contract.
- Most research and development is expensed as incurred, even when it funds a product sold for years.
Where adjusted figures overstate
- Stock-based compensation is added back, raising profit without the cost disappearing.
- Some development costs are capitalised under ASC 350-40, shifting cost into future amortisation.
Read GAAP, adjusted and cash figures side by side.
Do it on a real 10-K
- Open the revenue note and find remaining performance obligations, split between the amount expected within twelve months and after.
- Find net revenue retention, or the closest disclosed cohort metric, in the earnings materials, and check what it includes.
- Add stock-based compensation back out of the non-GAAP reconciliation to see the GAAP operating margin underneath.
Check yourself
A software company sells a one-year subscription and collects the full year's payment upfront. Under ASC 606, when is that revenue recognised?
- All at once, when the cash is collected
- Across the year, as the service is delivered, with the unearned portion held as deferred revenue
- Only at the end of the contract term
Show the answer
Answer: B.
ASC 606 ties revenue to delivery of the promised service, not to when cash changes hands, so an upfront payment is recognised over the period the subscription runs.A software company's total revenue grew 20 percent this year. What does that number alone not tell you?
- How much the company spent on marketing
- Whether existing customers are staying or leaving, which net revenue retention measures separately
- What its GAAP operating margin was
Show the answer
Answer: B.
Total growth can be produced entirely by new customers while existing ones churn away underneath it. Retention isolates what happened to the customers the company already had.A company adds back stock-based compensation to report an adjusted profit above its GAAP operating income. What has actually happened to the cost?
- It has been eliminated, since it is non-cash
- It is still a real cost, borne by existing shareholders through more shares outstanding, even though no cash left the company
- It has been deferred to a later year automatically
Show the answer
Answer: B.
Stock-based compensation is non-cash, but it dilutes existing shareholders' claim on the company. Adding it back raises the reported figure without making the cost disappear.Sources
- ASC 606, Revenue from Contracts with Customers.
- ASC 718, Compensation, Stock Compensation.
- ASC 350-40, Internal-Use Software.
What this leaves out
- Remaining performance obligations exclude contracts a company is not required to disclose, such as those with an original expected duration of one year or less, so the figure understates total contracted revenue for companies selling mostly short-term deals.
- Net revenue retention is a company-defined figure: some measure it on annual recurring revenue, some on revenue, some only for larger customers, so a comparison needs the same definition on both.
- The waterfall and free cash flow table use round invented numbers so the arithmetic can be checked by hand.
- Nothing here is advice about any security.