Cornerstone OnDemand – a case study in SaaS vendor maturation

At first blush, the recent $300 million convertible capital financing deal that Cornerstone OnDemand (CSOD) recently struck might seem like so much ho-hum equity news. But, this deal marks a turning point in the company’s evolution.

CSOD is no longer a startup and its size puts it more frequently in the big league/big boy category. Moreover, there were interesting side aspects of this deal that warrant discussion. What’s this new equity deal?

CSOD raised a $300 million block of capital from a combination of Silver Lake Partners (a technology investing concern) and LinkedIn. Yes, that’s the LinkedIn of Microsoft fame and the LinkedIn software firm with something like 500 million people’s employment history in their database.

The gist of this transaction is that CSOD gets $300 million of debt that comes due in 2021 (just 4 years from now). Some of these proceeds may go to retiring approximately $253 million of prior debt over the next two years while the remainder may go to a stock repurchase program.

The old debt was also convertible and was scheduled to be repaid in 2018. That debt cost CSOD 1.5% per annum while the new debt costs them 5.75%. Was this a good deal?

A while back Workday, Salesforce, and other larger software firms did similar deals with 0.5 to 1.5% coupon rates. Other HCM firms that had been carrying debt with a cost of 8.5-12% have been refinancing this at every opportunity. Some low-interest deals are more costly as the debt is offered at a discount to par thus raising the effective interest rate.

The deal may reflect rising commercial lending rates but some may see this debt as expensive.

Some tech companies like this kind of debt. In the short term, they avoid stock dilution and get access to capital. Longer term, if their stock price rises, then debtholders will convert their debt to equity at a pre-determined conversion rate. When conversions occur, the debt is erased although dilution to equity will occur at this later date. This works well for growing firms with rising stock prices. It doesn’t do much for slow-growing firms and is deadly to firms with declining revenue.

Note that the conversion price for this deal is around $42/share while CSOD was trading at a bit over $37 on 11/22/2017. CSOD stock has fluctuated between $32.88 – 44.25 the last 52 weeks.

For declining firms, the debt must be repaid in a short time and there’s little money to do so. A sale of key assets or the firm itself might be the only options to pay off the debt. For the other investors, the sale often means that the bondholders are the first to be repaid, then VCs (if they have preference rights and/or preferred stock), and, if anything remains, then the common stockholders (like employees) might get a penny or two (or nothing at all). So, the lesson is: don’t do this kind of deal unless you’re sure your firm’s fortunes still have positive runway.

Before this deal…

It’s important to note that this deal wasn’t the only thing CSOD executives contemplated. A little over 6 months ago, the company started to investigate its ‘ strategic options’. They explored whether they should go private (the company is currently traded on the NASDAQ under the symbol CSOD), be acquired, or do an acquisition themselves.

The company settled on a PIPE (private investment in public entity) transaction.

But why did CSOD want to explore these options? CSOD is a good-sized HCM provider with approximately $480 million in revenues and a $2+ billion valuation. It has a fairly complete HCM suite with Payroll its one big functional hole (see this detailed and current review of CSOD and its products).

The place where CSOD sits today is an interesting one. There aren’t many firms like CSOD. It’s too big and expensive for many firms to consider acquiring and many potential acquirers (e.g. big ERP players) already have a lot of similar functionality. A lot of investors push tech firms to get acquired earlier in their lifecycle while they’re smaller and digestible. If you wait until the company becomes bigger and middle-aged, the liquidity event options are much narrower. One famous Silicon Valley VC once told me that the mid-sized tech company often sits in a no-mans-land: too big to acquire and not big enough to be a category killer.

I suspect CSOD is in this space. Going forward, it must grow to be a far bigger firm.

Going deeper

This deal is not a typical capital raise. Just look at the partners involved, the two additional board seats offered them, the expected changes in spending that CSOD will make, etc. This deal marks a transition point in the company’s life.

Silver Lake/LinkedIn essentially gets two seats on CSOD’s board of directors. CSOD will get to work with LinkedIn on two new joint efforts. These joint initiatives will not be exclusive though. However, given LinkedIn’s goldmine of employment data, synergistic opportunities could be accretive to both parties.

Remember also that LinkedIn acquired the learning content firm Lynda.com a while back. Marrying that content with CSOD’s Learning module will be beneficial. Interestingly, I recently saw some Lynda.com content on a recent Virgin America flight as part of its onboard entertainment. I guess training is not just done in the workplace anymore.

The importance of The Rule of 40 (R40)

This deal is also about a new metric that is changing SaaS vendors everywhere: the Rule of 40 (R40). Simply stated, a well-run SaaS firm should have growth (CAGR) and profit percentages that add to a total of 40 percentage points. If your revenues are growing at 25% per year and profits are holding at 15%, you’re good. Different firms have their own take on R40 with some using net margin or non-GAAP net profit. Some firms count revenue, while other firms count bookings. Some firms alter the target of 40 combined points to 35-38 if the company has almost no churn. Regardless of the tweaks, R40 is making many SaaS companies change their ways.

In particular, fewer SaaS firms can get access to an infinite amount of capital unless they can show they’re growing top-line revenues at a 40+% CAGR. Overspending on sales and marketing cuts into profits and when high sales costs are paired with modest growth, investors rebel.

What R40 is doing is bringing a new spend discipline to many mid and large sized SaaS companies.

In CSOD’s case, the company had very good combined annual growth in revenues and bookings (see below). But, it’s the recent trend in CAGR that caught activist shareholders attention. By my calculations, CSOD’s revenue growth in its early years was often well north of 50%/annum. Now, that growth is closer to 15-30% per year. Yes, the absolute growth in dollars is still solid but the slowing relative growth is a common occurrence as companies grow in size and scale. It’s easy to show 100% CAGR when you go from 1 customer in year 1 to 2 customers in the second year. But CSOD is no longer a startup.

However, when these revenue/billings growth rates are netted against profits (not margin), the Rule of 40 might have been in jeopardy. Earlier this month, Bloomberg columnist Gillian Tan developed this graphic detailing CSOD’s R40 compliance challenge.

CSOD revenue can sometimes be lumpy. For example, CSOD recently won their biggest customer to date, the U.S. Postal Service, and that changes the metrics for a time. Secondly, it’s the forward-looking, not past, growth trend that matters. CAGR numbers from the beginning of the firm’s history can skew one’s assessment. Massive growth gains over a relatively small base can distort the CAGR. Often though, as companies acquire mass, it becomes harder to pull in net-new customers at the growth rate of the past. That scenario may be where CSOD is now.

A recent William Blair note said:

… overall deal activity seems somewhat down; management speculated that part of this could be driven by Workday freezing the market.

That nugget was an interesting one to see as it validates the continuing maturity of large suite players in the software market and highlights many customers’ preference towards vendors that offer full HR, Finance and other solutions (e.g., CRM, ERP) instead of those providing functional mini-suites or best of breed applications. (Caution: Just because a vendor offers a full HCM or ERP solution set doesn’t mean all modules are offer the functional depth of best of breed competitive offerings).

In a November 9, 2017 report on CSOD by the investment firm William Blair, Justin Furby and Vinay Mohan wrote:

In conjunction with the investment, the company announced a three-point plan that it believes will allow it to reach the “Rule of 40” by 2020. This plan centers on 1) a renewed focus on recurring revenue, with lower-margin services revenue to be increasingly pushed to the channel; 2) rapid expansion of non-GAAP operating margins; and, 3) aggressive expansion into the learning content business. This plan makes sense to us, though it arguably should have been done earlier, and we continue to worry that the sales and marketing inefficiencies are less about the operations of the business and more about competitive dynamics.

That paragraph packs a wallop. Let’s dissect it.

Dissecting the numbers

CSOD will shift more of its services revenue to its channel partners. When I recently spoke with Jason Corsello of CSOD, he said that while the company has done plenty of services related work, it has also used Deloitte and others to fill a number of service needs or projects on CSOD’s paper. One should expect to see more of Accenture, Deloitte, and others doing CSOD implementations going forward. Investors may see some decline in top-line revenue during this transition period but this should be offset by markedly higher gross and net margins.

Rapid expansion of non-GAAP margins. Typically, SaaS companies spend a lot of money on sales and marketing. As a result, investors tend to watch CAC (customer acquisition cost) and churn rates. They want to see that the cost to acquire a net-new customer is reasonable and that the customer remains a subscriber for a very long time. Investors will forgive a higher CAC if the churn rate is very low. Investors also love it when the company can cross-sell additional products to the same customer as in-fill sales often come with less competition and lower sales costs.

It should have been sooner. CSOD is now adjusting to a new reality. I heard CSOD speak to this point at the summer analyst event and CSOD’s Jason Corsello recently re-confirmed it. They’ve already been adjusting plans for 2018 and will be making spending cuts in some marketing activities. Mostly though, it sounds like they’ll keep many cost areas (e.g., R&D) and headcount at similar levels today instead of continuing to increase budgets as revenues increase. That approach should mitigate any service level issues, maintain product investments and deter attrition. William Blair figures CSOD must expand the CAGR/Profits spread by 25% to hit R40 levels. I suspect it will take CSOD 1-2 years to achieve this.

Assessment

In some ways, this isn’t a really big deal. Capital isn’t free and growth is not without its challenges. Many software firms would kill to have CSOD’s problem because achieving an almost half-billion in annual revenue is quite a feat. The fact that CSOD has to rein in its spending/capital appetite while continuing to grow isn’t a bad thing. This is what responsible firms do as they achieve mass or face a maturing market. CSOD is going from adolescence to full-blown adulthood.

The backdrop of the deal does make me wonder what other potential options emerged in the bigger assessment process and what those potential investors or acquirers thought. We’ll likely never get the answers.

The LinkedIn aspect could go either way. Is this a foothold for Microsoft to get its hands on a major HRM vendor and drive more synergies with LinkedIn? Or, will Microsoft/LinkedIn continue to play the field with many HR vendors while expanding its own solution organically? I suspect the latter.

How does CSOD circumvent any market freezing by Workday? CSOD has no Payroll module nor Financial applications. Both CSOD and Workday covet large enterprises yet also face formidable competition from the likes of SAP, Infor, and Oracle. This is likely an on-going conversation at CSOD executive committee and board meetings.

Should CSOD seek a partnership or acquire a complementary technology software solution? It’s a great idea but I can’t think of a great candidate at this time.

Similarly, could CSOD become a takeover candidate? The company has some great assets and could be a great deal for some firm. However, I’m not sure anyone will come running. A potential buyer would need to see if CSOD’s technical architecture fits their solutions and whether CSOD would complement or be redundant with their own. I don’t see this happening.

Will this deal impact morale at CSOD? I don’t see this having any material impact for now. Management must do a great job of managing costs without layoffs. I suspect they’ll ease into R40 and keep morale high. There is one major morale risk factor though and it involves CSOD CEO Adam Miller. If new or existing board members don’t think Adam is going to make progress against new R40 goals at the pace they want, then they could force him out. Should that happen, employee morale would almost certainly suffer, with other key executives choosing to pull out.

In the really big picture view of things, remember that most HCM solutions on the market today were either created or reinvented around 2007. That’s when multi-tenant cloud HCM solutions really got underway. In the ensuing decade, many firms have either fallen by the wayside or been acquired. A select few have grown materially and have now reached a material size/mass/market share.

It’s this maturation that will require firms to revisit their role, space, policies and more. Workday, which has already added financial applications and more, has chosen a constant invention mode to maintain competitive parity (or advantage) with firms like SAP and Oracle. CSOD will need to do some introspective soul-searching to identify its next path. I hope it chooses a fun one…

Image credit – via TechVentive, Bloomberg and CSOD Disclosure – Infor, SAP, Workday, and Oracle are premier partners at the time of writing.