I was recently listening to the 2022Q3 earnings call from $PAR and their CEO Savneet Singh provided such a beautifully succinct explanation of how to think about capital allocation. Here’s the excerpt (link):
Let’s start with looking at sales and marketing efficiency. If we look at the last 12 months, we’ve added roughly $24 million in new ARR to PAR.
During the same period, we estimate – we spent roughly $25 million in sales and marketing for those subscription services.
So for approximately every dollar of sales and marketing, we’ve added $1 of ARR. If we assume that our gross margin on that ARR is around 70% and our annual churn is around 5%, our payback period on this investment is 1.5 years. The problem of the payback period on off of gross profit is that ignores incremental R&D and G&A needed to support this customer.
So let’s assume for that $1 of incremental revenue, we also need $0.20 of incremental R&D and G&A. This is completely incremental to our existing expense base as I mentioned. And as I mentioned, we are not adding incremental R&D or SG&A, but for argument’s sake, let’s assume we do. The result is that the $1 of sales and marketing spend drove $1 of ARR and $0.50 of operating profit when you subtract out $0.30 for COGS and $0.20 for incremental R&D and SG&A. Simplistically, that is a two-year payback period, but we don’t look at it as a payback period. We look at it in terms of return on investment. If we assume that the $0.50 of operating profit degradates every year because of 5% churn, the IRR of just as one customer is in excess of 40% on the original $1 of sales and marketing investment, but I think that’s actually an understatement because our goal is to take the 5% churn and turn it into a 100% net retention, thereby taking the IRRs well beyond 50%. To make this a real example, let’s look at our payments initiative. In 2022, we estimate that we will have spent $5.3 million inclusive of all G&A allocations on our payments business. I’m including all costs here, not just sales and marketing, to ensure that we look at IRR covering all investments made. By the end of 2022, I expect our payments ARR to exceed $5 million.
It’s rare to hear software CEOs speak in such clear investment terms about inputs like SG&A and R&D and outputs like payback period/IRR. Most got to their role by being strong in product development or sales, and being able to tell a great story to inspire others to use or build their product.
But to build a truly great, long-term company, EVERY CEO should think this clearly about how capital is deployed. EVERY DOLLAR SPENT should be considered an investment with some expected return (financial or otherwise), especially as the days of easy money are at an end. The great capital allocator CEOs (like the ones profiled in The Outsiders) who outperformed the market through good cycles and bad focused on frugality and unit economics, and provide a great template for how to operate in today’s climate.
On another note, it’s great to hear Savneet’s focus shifting away from (short-term painful) paying down of tech debt and more towards new feature development. Like most things in life (markets, politics, Philadelphia sports teams), software development cycles between periods of rapid feature growth followed by significant refactoring, correction, and restructuring for the next marathon (and so on and so on). This is perfectly natural; I have yet to build a platform where we knew all customer use cases upfront and designed it perfectly in advance. Great companies understand how to manage this tension by building with simplicity and flexibility in mind, and seems like $PAR has been refactored with a similar philosophy.
Note: I do have a small position in $PAR (hoping to grow it over the coming weeks!)