The Story:

The once-bright subscription economy pioneer just got a kick in the side. The firm's investors ran out of patience and decided it best to sell the company to tech PE firm Silver Lake.

Zuora, a robust subscription management platform, was on the forefront of the shift from license-based to subscription business models. A little-known pain point for B2B software companies transitioning to a subscription model is the structure of complex enterprise contracts. The Hulus and Netflixs of the world have the general public thinking subscription is an easy once-a-month charge for the company to handle. Though this might be true in the consumer space, B2B subscription works drastically differently.

Instead of operating off of just two or three standard plans, selling enterprise software on a subscription basis is more of an art rather than a science. If you’re lucky, your enterprise customer agrees to a monthly subscription, but that’s rarely how it works. In reality, perhaps your customer requires to be billed on the 3rd Thursday of every other month, needs up to 7 days after receiving the invoice to pay you back, operates on a flat fee + usage-based plan with overage costs, and wants a contract long enough to last them until the end of their own Fiscal Year. This is just one configuration tailored to that specific customer’s needs. Creating a tool to dynamically accommodate plans like this would not only take a stellar in-house technical team, but also outstanding communication between the technical and the FP&A/Compliance team to figure out the financial nooks and crannies that must be taken care of with regards to revenue recognition.

This is where Zuora filled the gap. They built a dynamic playground that could bill any subscription pricing model you please, and handle all revenue recognition tasks automatically. Instead of requiring fragmented technical and finance teams communicating at a high clip just to send an invoice to a customer, B2B SaaS companies could now run their business through a purpose built subscription management tool. This was the company’s value proposition, and considering the subscription economy was just getting up and running, the outlook was bright. 

It was 2018, and the company was positioned beautifully to capitalize on this trend: acquire customers of any size who operated subscription models, and just as subscriptions were insular revenue streams for the Zuora user, it was also an insular revenue stream for Zuora. They could sit back, relax, and ride off into the sunset as they watch their customers grow, and their subsequent payments to Zuora grow as well. 

Fast forward 6 years after the company IPO’d in 2018, the textbook silicon valley story was just becoming more textbook. The company was only ever profitable on an EBITDA basis for 3 quarters, and has never officially generated a single dollar of GAAP net income to this day. Early signs of a stall were apparent, with revenue growth slowing to just 11%YoY 2 years after IPO. For reference, Zuora’s Rule of 40 score was -23 in the quarter ending January, 2020. Even though the company’s financials for a growth stage SaaS company were objectively pitiful, there was still some hope the “Subscription Economy” could be their saving grace. Morgan Stanley aptly titled their FY2020 Q4 research report “Waiting for Subscription Economy to Kick Into Higher Gear” and assigned an equal-weight rating.

Morgan Stanley might still be waiting. The subscription economy definitely came, but Zuora’s product held it back. Though extremely powerful, it required professional services from Zuora to implement, and specialized training to operate. One user complained on Quora:

“Everyone gets stressed when they have to do even the smallest changes in the system. Why? It is very hard to communicate with the system. The UI is slow and heavy and not intuitive. We had to train every single person that worked on it, and they were not happy because things just did not make sense for them.”

Implementation services being a significant part of revenue is excusable for a high growth company who is quickly acquiring new customers. In this case, it seemed Zuora was implementing any customer it could into its ensnarement of a product, just to try keep their growth numbers above water. The company has since offloaded some professional service tasks to third party implementation partners like Accenture; But prior to the outsourcing, professional services accounted for approximately 25% of total revenue, and had negative gross margins. Zuora could honestly take a 100% loss on these implementation services, as long as the money would show up on the subscription side, but this was not the case. A complex and hard to navigate product necessitated costly professional services that made each deployment cycle longer, thus limiting Zuora’s growth. Then, once customers were supposed to be accustomed with the product, its complexity continued to stump administrators. 

The lack of growth, profitability, and insane spending on professional services were the first clues at Zuora’s demise. How come no one identified these alarm bells? To begin with, Zuora was very savvy when it came to engineering their numbers. A KPI that SaaS companies are extremely tied to is NRR, net revenue retention. In Zuora’s case, NRR was always in the 100-110% range, which is passable/good. However, with revenue growth barely surpassing NRR numbers at times, one might suspect that these NRR numbers were potentially inflated using coercive techniques. Zuora could offer discounted software cross-sells to customers, and then send their professional services team to make a deployment which they’d eventually have to service. This way, NRR trends up in the short term, but in addition to the marginal add in revenue, Zuora would now have to shell out on professional services to support that deployment for the following years. Another way Zuora could have massaged their NRR numbers is with their land & expand strategy in recent years. The company has stopped whale hunting, and instead turned their focus to landing smaller customers they think will grow usage eventually. Acquiring small customers that are growing fast would explain the lackluster topline growth but decent 106% NRR in 2024.

Eventually reality caught up with Zuora, and the market realized the company would never grow to utilize their operating leverage anytime soon. This prompted a slew of activist investors to establish large stakes within the stock like Scalar Gauge Management, Praesidium Investment Management, and Pleasant Lake Partners. (Source: Refinitiv) Looking back though, perhaps the most important development with regard to the recent acquisition is the $400M issuance of convertible bonds to Silver Lake in 2022. If the stock options were exercised, this could leave Silver Lake with almost 30 million shares of the company, representing a quarter of total shares outstanding at the time. This investment not only gave Silver Lake plenty of voting power in the company, but also came with a board seat for managing partner Joe Osnoss. Another notable development was the entrance of Scalar Gauge Management. The fund’s AUM is just $200M, yet they piled $55M into Zuora over the past year. The company is their largest holding by far, and luckily they were also able to acquire a board seat for partner John D Harkey Jr in May 2024, notably after the company announced they’d be exploring sale opportunities in April.

Before Zuora announced it was exploring a sale, the signs were already coming together. There was an activist investor piling all their AUM into a company with no runway to FCF positivity, and a MF tech buyout firm holding a board seat and equity derivative. These both look like obvious signs that the company would soon be headed in the direction of exploring a sale. If one had identified these signs early in the year, they would have bagged an easy 20% gain by May. The May appointment of Harkey to the board should have been the nail in the coffin. Unless Scalar Gauge’s vision was for the operational genius of Harkey to guide the company towards profitability, it was safe to assume their activist strategy was intently focused on getting the company acquired.

Even with these parts in place, the market began discounting the odds of a transaction by September, and the price of the stock fell back to the $8 per share range. Perhaps investors wrongly thought that acquisition talks had gone stale after radio silence for 5 months. Harkey and Osnoss were hard at work behind the scenes though, and it was revealed that Zuora had entered into an agreement to be acquired by Silver Lake and Singapore sovereign wealth fund GIC in mid-October.

Now that the acquisition is being finalized, there are two pressing issues that I think shareholders must be reminded of. Even though the purchase price represented an 18% premium to the current share price at the time, Silver Lake and Scalar Gauge’s board seats may have been of questionable value to the shareholder. On the point of Silver Lake, one might say that having board seat influence in addition to the option to quickly acquire 30% voting rights to the company might have given Silver Lake leverage to negotiate for a lower purchase price. From the perspective of the acquirer, of course they’d want to acquire the company for the cheapest price possible. Yet, as a board member, considering their fiduciary duty, they need to try and fetch the highest possible price during acquisition talks. In addition, with their stock options from the convertibles, they would have been granted immense voting rights had negotiations not gone in a favorable way for Silver Lake. This set of perverse incentives was partially mitigated by the fact that Osnoss was not included in the “Special Committee” during deliberations for board approval of the acquisition. This was not the case for Scalar Gauge Management. Upon the initial agreement for Harkey’s appointment, there was a special clause that stated Harkey be included in any special committee formed during his time on the board. This status on the special committee most likely gave Harkey access to material non-public information in terms of how negotiations for the merger were going. This is crucial because Scalar Gauge continued to pile into Zuora during the time Harkey was on the board, increasing its stake from 3.8 million to 6.5 million shares.

What can Middle-Market PE learn from the Zuora acquisition?

Silver Lake’s strategy in this instance revolved around the thesis that cash was Zuora’s largest constraint to growth. Perhaps Silver Lake thought that given enough cash, Zuora would be able to hire and deploy as many professional service teams as they could. With human capital no longer a limiting factor, Zuora could saturate every ounce of demand that came their way. Eventually, the company would grow itself into FCF positivity. This is why Silver Lake invested $400M into convertible PIK debt. Zuora had a PIK toggle, where it could either pay interest on the $400M at a rate of 3.95%, or pay the interest “in-kind” which then adds the interest due back onto the principal at a rate of 5.50%. This essentially gave Zuora $400M with no obligation to pay interest when they don’t want to. Zuora could use the cash from the foregone interest payments in the short term to grow and develop the product, which Silver Lake thought was a more value accretive use of cash for the company at the time. When Zuora had grown to a reasonable size and level of profitability, they could begin repaying the loan, whose principal had been growing at the PIK rate of 5.50% for all these years. This would prove extremely profitable to Silver Lake, as the principal accruing nature of PIK debt exponentially increases the total repayment that Silver Lake receives over time. If Zuora had done incredibly well for itself during that period, then Silver Lake could also consider exercising their stock options on the convertible bonds.

In the end, this bull thesis for Zuora never materialized. Silver Lake is now buying the company, and will try to turn it free cash flow positive. I anticipate that Zuora’s professional services segment will continue to dwindle as Silver Lake changes gears and moves towards outsourcing with the thesis that it will be cheaper and also allow the company to focus on its core product. The fear that third-party implementation teams will have trouble implementing the product will be mitigated by the larger focus on product driving ease-of-use and simplicity improvements. After the core product is in a better position, and the professional services team substituted for implementation partners, the company would be in a good position to begin raising prices. Due to how a customer’s entire business has to flow through Zuora, price increases would be unlikely to cause significant customer churn. Companies won’t want to migrate away from software like Zuora that is embedded so deeply in their core operations. After leveraging as much pricing power as possible on customers, and continuing to trim headcount at the company, Zuora is likely to be in a free cash flow positive position, the company only needs to save or generate an additional 11% worth of margin in order to achieve profitability on a net income basis.