When theory is the way to go: Why subscription companies should understand SEC Regulation S-X
Sometimes in finance, long and complex ways actually take you somewhere.
Although the SEC (Securities and Exchange Commission) does not regulate the financial reporting for your privately held company, you will benefit greatly from understanding, and maybe even adopting, their regulations. When serving in a Strategic Finance role, I ensure that the P&L follows this format and then use the historical data, as well as comparable company metrics, to develop company models.
This guidance is actually a very basic concept that defines the formats for financial statements. By adopting this definition for your subscription company, you will present your financials in an easily consumable format. This format also allows for comparable company comparisons that will help you refine your business model, identify KPIs and manage your business performance. Using comparable company comparisons will help you to better forecast your business and add credibility to your forecasts.
Income Statement Format
The regulation calls for what’s known as a “Two-Step” format, in that “subtotals are used to show decision-useful line items such as gross margin and operating income separately from non-operating income and net income or loss,” as stated by CFR Title 17.
Below is the specified two-step format customized for a subscription company. I’ve defined the resulting ten steps as follows:
- Net sales and gross revenues. State separately product and service revenue for each business line which accounts for more than 10% of total net revenue.
- Costs and expenses applicable to revenues, stated separately according to the net revenue categories. These expenses are known as Cost of Revenue for subscription companies.
- Gross Profit and Gross Margin
- Operating expense defined as Selling, General and Administrative expenses, or SG&A, and other general expenses relevant to your business, such as R&D or Operations. Subscription companies typically use R&D, Sales & Marketing, and General & Administrative.
- Operating Income, which is Gross Profit minus Operating Expense.
- Non-operating expenses, such as Interest, Taxes and Depreciation & Amortization (D&A) expense, if relevant.
- Net Income, which equals Operating Income less Non-operating expenses. Use if #6 is relevant.
- Earnings Before Interest, Taxes, Depreciation & Amortization, or EBITDA.
- Change in Working Capital
- Free Cash Flow
In my experience, early-stage, venture-backed companies typically have little or no Interest, Taxes and D&A expense. Most have convertible debt, but do not used debt lines. Most are in loss positions, meaning that they do not generate profits. Also, most are capital-light, meaning that they do not buy equipment above the $2,500 amount typically set for capitalizing purchases. Without non-operating expenses, Operating Income will equal EBITDA. In this case, use Operating Income in lieu of EBITDA because the latter implies that ITDA expenses exist. Free Cash Flow is the cash-based profitability of the company and should be added along with a liquidity metric such as bank balance.
The example in the call-out presents a typical format that I use for subscription clients. Please note that all numbers are entirely fictitious and presented solely to illustrate a financial reporting format. Any resemblance to an actual entity’s results would be coincidental. Additionally, these fictitious results do not indicate any view or opinion on the performance implied by this illustration nor do they suggest the size of the business that should adopt the recommendations herein.
Advantages of this Presentation Format
There are three main advantages you will achieve by adopting this format for your subscription company.
First, anyone who worked in finance will be intimately familiar with this format and can quickly grasp the financial performance of your business. You can skip the time needed to explain your custom single-step P&L and move straight into the performance.
Second, this format will allow you to analyze your performance with respect to comparable public companies. The comparison gives insight into key financial metrics such as gross margins and operating expenses, especially when shown as a percentage of revenue. You can back into R&D headcount using salary and overhead assumptions. Using multi-period financials, you can derive estimates of SaaS metrics such as Magic Number, CAC Ratio, and LTV/CAC. This insight will help you refine your business model, identify KPIs and manage your business performance.
Third, your finance team will use comparable company comparisons to better model your business. Actual revenue growth, gross profit and operating expense margins, cash flow and operating metrics combine to set parameters for the forecast. And this gives you credibility in discussing both the short-term and long-term forecast.
Useful and insightful for CEOs
The SEC directives in the case of subscription companies are quite relevant because they are useful and provide CEOs with great insight into the numbers. I’ve seen this approach work well in fundraising and for financial reporting. Feel free to contact me if you would like to dig deeper on the topic. firstname.lastname@example.org