The Operating Model

Newport Beach, October 1, 2022

After describing the revenue model assumptions to Moore-Cash, Sleepless discussed the assumptions for the remainder of the operating model.

"ADS's cost structure includes cost of revenue - i.e., the direct costs of providing services, sales & marketing, research & development, general and administrative, as well as non-cash expenses such as depreciation and amortization.

The cost of revenue includes the cost of subscription revenue (principally hosting and provisioning), the cost of consulting revenue, and the cost of revenue for the SCB ("other cost of revenue"). Subscription COR is a function of the average number of subscribers. Exhibit 1 shows the expected year-end subscriber count for 2022. ADS expects the 2022 cost of subscriber revenue to be $225 per average subscribers, respectively. I think it is reasonable to assume that this cost per subscriber will increase at the general annual inflation rate of 2%. The COR per silver, gold, and platinum subs is identical.

Since ADS bills its consulting services at cost, we can project cost of consulting revenue to be equal to consulting revenue. Finally, I would expect the recently acquired Software Consulting Business, categorized under Other Revenue, to produce a gross profit of $11.5 throughout the projection period.

ADS's Sales & Marketing expense includes customer acquisition costs (i.e., commissions to our sales force and other expenditures directly attributable to acquiring, retaining, upgrading and downgrading subscribers), as well as other S&M costs including advertising, promotion, events, and marketing staff costs.

Regarding commissions, our plan beginning in 2023 is to increase the commission rate for new subscriber acquisitions from 12% to 15% of sales value to improve the incentive to close new deals. The commission rate for all retentions, upgrades and downgrades will be 10% or sales value. This difference in commission rates reflects the reality that retentions, upgrades, and downgrades require less effort to sell those new contracts. Even at the lower commission rate, the incentive to upgrade expiring subscriptions is significant because the sales force will be paid its commission upfront for the entire contract period. In other words, the sales reps would prefer to collect 10% of the value of a two- or three-year contract than 15% of the value of a one-year contract. All SACs, including commissions, are paid on average 30 days after the closing of a sale.

ADS capitalizes SAC and amortizes it over the life of the underlying contracts. Keep in mind that half of the SAC capitalized 2022 will be amortized in 2023 according to the half-year convention, which is the best assumption we have at this time.

For 2022, we expect non-commission SAC to be $98.50 per new subscriber acquired and half of that, or $49.25, for each retention, upgrade, and downgrade. These amounts should increase by the annual general inflation rate of 2% throughout the projection period.

We expect all other sales & marketing costs to equal 4% of total revenue for 2022 and beyond.

Regarding R&D costs, our general policy is to spend a constant percentage of total revenue on R&D. This ensures that our companies remain efficient and innovative. For ADS, we assume R&D costs will be 7.5% of total revenue for 2023 and beyond and that these costs are fully expensed rather than capitalized.

General & Administrative expenses include finance, legal, accounting, consultants, headquarter expenses and other costs not specifically attributable to a product line or department. G&A expenses include a fixed component (40% of 2022 G&A, excluding "Other G&A", i.e., excluding G&A attributable to SCB)and a variable component (60% of 2022 G&A, excluding "Other G&A"). The variable component is a function of average active subscribers. ADS expects to spend $67.2768 of variable G&A per average subscriber in 2022. The variable G&A per average subscriber should increase by the 2% assumed annual inflation rate for the remainder of the projection period.

The line-item "Other G&A" historically includes the G&A from the Frozen Banana Business and SCB after its acquisition. The 2023-2027 projections include only the G&A for SCB, which we project at $5 million per year.

Fixed G&A is so-called because it does not correlate directly with our subscriber numbers. The company has made significant investments in fixed G&A infrastructure in the past few years. Going forward, we expect this item to grow by 5% per year, 2.5x the annual inflation rate.

Depreciation expense is a function of capital expenditures. Capital expenditures can be categorized into maintenance capex (required to operate the business in its current form) and growth/success capex (required to acquire or retain customers and otherwise grow the business). In 2022, we expect to spend $45.15 per average outstanding subscriber on maintenance capex and $19.35 per unit sale (be they new, retentions, upgrades, or downgrades) on growth/success capex. We expect these ratios to increase by the 2% annual assumed inflation rate for the entire projection period. In addition, I am showing in Exhibit A, the projected run-off depreciation for capital expenditures incurred through the end of 2022, i.e., the depreciation from assets purchased before 2023. All capex is assumed to depreciate over seven years.

Amortization expense represents the amortization of capitalized deferred commission and other SAC and is included in Sales & Marketing expense. ADS currently pays a 7% interest rate on average debt balances. Average cash balances earn 0.5% annually in interest income ADS's effective tax rate is 28% and their dividend policy is a 35% payout ratio.

Regarding accounts receivable, ADS extends 45-day payment terms to its customers, so they collect subscription invoices and consulting and other revenue 45 days after invoicing. Regarding accounts payable, they pay their hosting and other suppliers (i.e. subscription and other cost of revenue) 35 days after incurring the expense.Regarding accrued expenses, they pay their consulting cost of revenue, commission and other SAC, other S&M expenses, G&A and R&D expenses an average of 30 days incurred. Tax payments are made an average of 45 days after provisioning.

Finally, ADS has accrued a $2 million restructuring liability on its 2022 balance sheet which is expect to pay-off in 2023."

Prompt

1. Construct an operating model with separate assumptions section, build-up schedules, and projected 2023-2027 income statement, EBITDA to Cash EBITDA bridge, cash flow statement and balance sheet.
2. For the above, assume that all CFADR is used to pay-down debt until the debt balance reaches 0.

NB: PE Firms focus on cash EBITDA when analyzing profitable SaaS businesses. While this is normally defined as EBITDA - change in working capital, in practice, PE Firms tend to adjust EBITDA by the change in the deferred revenue liability and the expensing of capitalized items. So, for the purposes of our model, assume that cash EBITDA = EBITDA + change in deferred revenue - commissions & other SAC expenditures.

Income Statement 2022E 2023P 2024P Projected 2025P 2026P 2027P $135.22 22.25 $184.09 $222.07 $247.31 14.29 29.29 14.29 32.89 $171.76 $227.66 32.06 $287.02 42.24 32.50 $322.05 12.2% $275.97 44.32 32.50 $352.79 9.5% $311.44 53.85 $355.28 $407.11 57.65 67.12 32.50 $397.79 12.8% 32.50 $445.44 32.50 $506.73 12.0% 13.8% Revenue Subscription Revenue Consulting Revenue Other Revenue Total Revenue Growth % 2020A Observed 2021A Cost of Revenue ($54.23) ($72.53) ($84.50) Other Cost of Revenue (6.29) (6.29) (13.46) Gross Profit $111.24 $148.84 $189.06 Gross Margin Sales and Marketing General and Administrative Research and Development Restructuring Expense Depreciation Operating Income ($33.63) ($44.74) ($53.68) (24.53) (28.87) (33.55) (12.88) (17.07) (21.53) 0.00 0.00 (2.00) (11.72) (11.08) (11.94) $28.48 $47.08 $66.36 Operating Margin % 16.6% 20.7% 23.1% Operating Income Growth % Interest Income $0.28 $0.33 $0.39 Interest Expense Pretax Income Tax Provision (2.45) (1.49) (1.04) $26.32 $45.92 $65.70 ($7.37) ($12.86) ($18.40) Net Income $18.95 $33.06 $47.31