Three envelopes

Three envelopesCan there be any subject more boring than revenue recognition for software? If you listen to the conference calls of the public EDA companies, you’ll either hear them discuss or get asked about how much of their business is ratable versus term. What does this mean? Should you care? Also, what does it matter how long the term is, isn’t longer more money and so better?

When Jack Harding was CEO of Cadence, he lost his job because of these details. Cadence had been selling permanent licenses (for historical reasons I’ll maybe go into at some point, EDA had a hardware business model). The sales organization had come up with the concept of a FAM, which stood for flexible access model. The basic idea was great. Instead of selling a permanent license valid forever, sell a license valid for only 3 years for not much less. Then, three years later sell the same license again. The lifetime of a permanent license had proved to be about 6 years in practice, so this was almost a doubling of the amount of money extracted per license. This was then scaled up into “buy all the licenses you will for the next three years today”, with some flexibility built in by throwing extra licenses into the mix. This was done in a way that meant all the revenue, or most of it, could be recognized up-front.

There turned out to be two problems with this once it was scaled up. Firstly, the customers didn’t really know what licenses they needed in year 3 although they had a pretty good idea about years 1 and 2. So to get them to go for this, the third year discount had to be huge. The second and bigger problem was that in two years the Cadence sales force closed three-year deals with every large account they had. The combination of these two things mean that every customer acquired all the licenses they needed for the next three years, but it was all booked in two years (and for not much more than two years’ worth of money). Numbers looked great for two years but in year three there were no customers left. The wheels came off and the numbers cratered. Jack Harding was CEO at the time and a couple of days after the quarterly conference call he was gone.

There’s an old joke about a new CEO starting his first day and being left three envelopes by the outgoing CEO. He is told to open them when things get really bad. Things go OK for the new CEO for the first few months and then there is a downturn in business so he opens the first envelope. “Blame your predecessor” is on the card inside. So he makes speeches about how he inherited a company on the brink of ruin from the old CEO and the analysts and press give him a break. The second time things look bad, he opens the second envelope. “Reorganize.” So the newish CEO takes all the business units and carves them up into functional divisions. That seems to fix business for a time. But eventually the future is not looking so bright any more and the now-not-so-new CEO opens the third envelope and read the card: “Prepare three envelopes”.

So after Jack Harding left, Ray Bingham came in, opened the first envelope, and said Jack Harding and FAMs were bad, Cadence would henceforth book ratable business. Depending on details of the wording in the license, FASB (Financial Accounting Standards Board, a bunch of academic accountants from the east coast who’ve never run anything, but that’s another story) forces the revenue to be recognized up front (like a FAM) or quarterly (“ratably”) over the three years of the contract. With ratable business almost all of a quarters revenue comes out of backlog so it is very predictable, and there is a lot less pressure to close business at the end of a quarter (because only 1/12 will drop to the bottom line) which should lead to better discounting behavior.

However, there was pressure for Wall Street for growth and one way to provide that was to start to mix some term FAM-like business in with all the ratable stuff, since it dropped to the bottom line immediately. That was why smart analysts were so focused on what percentage of business was ratable. If you don’t know that, you have no idea if the numbers are good or bad, or if they are sustainable.

[Full disclosure: Cadence acquired Ambit, where I was working, towards the end of Jack Harding’s tenure. I then worked for Cadence for three years including working directly for Ray Bingham for a period. I left before Mike Fister came on board.]

Eventually the board brought in Mike Fister as CEO and Ray became Chairman. Mike Fister hadn’t heard the joke, obviously, since he omitted to open the first envelope. He had a perfect opportunity to take a big loss, switch to ratable business and generally blame anything he wanted on Ray. Instead, he kept going on the same treadmill. To all of us observing from outside it was clear that Mike Fister wasn’t going to make some new and interesting mistakes, he was going to make the same old mistake all over again. So it was no surprise when it turned out that the rate of growth was not sustainable, that they were booking ridiculously long-term deals of 5 or more years. The reason that this is bad is that a 5 year deal is not a green-field deal with a virgin customer, it is a 5 year deal with a customer who already has a 3 year deal, and customers don’t pay much for a deal to buy software for years 4 and 5, let alone 6, 7, 8; they are not under any pressure. So eventually the wheels came off again. There was even some restatement of revenue associated with, surprise, whether some deals were correctly recognized as term or ratable.

So Mike Fister got to prepare his three envelopes and now we know it is Lip-Bu Tan who will open them. Watch for a big reset, blaming Mike for all the terrible deals he left behind, and lots of talk about starting with a clean sheet.

This entry was posted in eda industry, management. Bookmark the permalink.

Comments are closed.