A First Look at the Compliance Cloud

One of the more tedious aspects of e-commerce in the U.S. and globally can be dealing with tax collection and remittance. This is complicated by a web of regional regulations that must be addressed based on the location of each customer. Traditionally, sellers could ignore these requirements, as their business activities were largely confined to a local geography. However, the rise of online sales and new legislation have encouraged government organizations to become increasingly aggressive in ensuring they extract their due share of taxes. Further, as businesses of all sorts move online, other types of regulation and compliance enforcement is emerging. Left on their own, online sellers and service providers could expend significant resources keeping up with these requirements.

Fortunately, new technology providers have emerged that help companies navigate this situation. These services are often delivered through open APIs and integrated with popular e-commerce platforms. They handle the calculation of tax, filing and remittance to every required jurisdictional entity. In addition to sales tax handling, these services are branching out into other aspects of regulation compliance, including managing exemption certificates, business licenses and the bevy of new use taxes globally. One of the leading independent providers of these services is publicly-traded Avalara (AVLR).

As companies increasingly migrate offline business processes to new digital channels, consideration for tax payments and compliance must come along. This has created a large and growing opportunity for solution providers that make compliance management easy. With an increase in government activity to regulate tax collection, privacy, online behaviors and safety, we can expect compliance enforcement to increase. This blog post examines the history of taxation of e-commerce, along with future implications for additional oversight of emerging digital channels. Further, it reviews the leading providers of compliance automation services with a focused analysis of Avalara (AVLR), which is becoming the dominant player in the space. The goal is to provide investors with an avenue to capitalize on the growing demand for services that simplify regulatory overhead for online businesses.

History

In the early days of online commerce in the U.S., a seller of goods was only required to collect sales tax from customers located in those states where the seller had a physical presence. This generally applied solely to the location of their store or headquarters, with some companies spanning more than one state due to manufacturing or distribution facilities. This precedent was established by an obscure case that landed in the Supreme Court in 1992. The defendant was an office supply mail order business based in Delaware that only interacted with customers in other states through the telephone and mail service. The court ruled that this company was not required to collect and pay sales tax to customers in other states (like the plaintiff North Dakota) because the mail order business didn’t have a presence there.

As businesses slowly moved online in the late 1990’s, this same ruling was extended to sales over the Internet. Internet sales were treated like the mail order business. Without a physical presence in a state, the Internet retailer lacked a “substantial nexus” in that state as required by interstate commerce laws. For a long time after this, online businesses explicitly tried to minimize incurring “nexus” in any states, outside of their home state. Arguably, this helped many nascent e-commerce companies grow rapidly in the early days, by avoiding the payment of sales tax. After coming under immense pressure, the largest online sellers eventually cooperated and voluntarily collected sales tax. Amazon, for example, started to collect sales tax in some states in 2015. However, these were generally the exception.

This “voluntary” payment model persisted and some states even asked citizens to declare large out of state purchases on their own income tax forms. These approaches had little success. However, this situation was turned completely upside down in June 2018, by the landmark Supreme Court case of South Dakota vs. Wayfair. This effectively overturned prior law and allowed states to collect tax on purchases made from out-of-state vendors, even if that vendor has no “nexus” or physical presence in the state.

This opened up the floodgates of tax collection for online businesses of all types and significantly complicated compliance. Most states tried to mitigate the processing overhead for small businesses, by establishing minimum thresholds. In South Dakota’s case, this was either $100k in total sales or more than 200 different addresses for shipments to that state. Still, a large segment of online retailers was impacted and quickly needed a way to update their processes to meet these requirements.

Most of the enhanced state laws went into effect in early 2019, coinciding with the new tax year. Large companies with extensive resources and liabilities began adhering to the new rules. Small to medium-sized businesses dragged their feet. In most cases, the amount they owed to each state was small enough that it fell under the threshold for collection enforcement. At the same time, state tax departments were improving their ability to locate and track potential offenders.

With the COVID situation in 2020 and subsequent impact on businesses of all types, many states provided relief by declaring a temporary hiatus on sales tax collection. This further kicked the compliance can down the road. However, we know that state revenues are down across the board. I expect that once the post-COVID recovery takes hold, states will become more aggressive and sophisticated in tracking down retailers for sales tax owed.

This creates an onerous burden on any company distributing goods and services over the Internet. At minimum, the online vendor needs to know the amount of sales tax to charge for every customer address in the U.S. This is not a simple matter, as the total sales tax is a combination of state, county, municipal and other regional entities. It can also vary by type, materials and volume of product. No individual business (or at least any outside of the very largest) could be expected to maintain this data on their own. Even if they managed to collect it once, the tax rates, circumstances and jurisdictions are constantly changing.

Just to size the problem in the U.S., there are 45 states, plus the District of Columbia, that have a sales tax. Each of these is further sub-divided into over 11,000 local taxing jurisdictions. This extensive array of jurisdictions results in thousands of different tax rates, taxable and non-taxable products and services, exempt purchasers, shipping tax treatment, specialized tax rules (such as sales tax “holidays” and “thresholds” for different products), statutory definitions, registration and reporting regimes, record keeping requirements and filing methods. In addition to compliance burdens, companies are exposed to potential audit by every state and locality with a self-administered sales or use tax. And the number of taxing jurisdictions has continued to grow.

Second, even if a business accurately accounts for tax in every sale, they need to remit it to the taxing bodies on a prescribed basis. This can result in hundreds or thousands of tax filings, more than could be managed by the finance department of a mid-sized business. Filing dates and payment rules vary widely, again requiring the collection and maintenance of relevant requirements for each taxing jurisdiction.

Fortunately, software and automation can make this manageable for even small businesses. As online sales by definition are automated, outsourcing the sales tax collection and remittance is possible. API-driven services provide a way to calculate the sales tax on the fly at check-out, record the sale and then handle all the back-office processing and reporting necessary to remit payments to each jurisdiction.

These same requirements and processes apply internationally as well. Many U.S. businesses (and vice versa) sell goods and services to customers in other countries. These countries also have various sales tax rules, thresholds and mechanisms for payment. At a large boat rental marketplace where I recently worked, we had to consider tax implications for boat rentals not just in every state in the U.S., but also every country where we allowed transactions. This quickly escalated into a complicated system to maintain compliance, not just accounting for U.S. sales tax filing, but addressing VAT in multiple countries.

Given the complexity and ease of outsourcing, service providers have emerged to handle this tax compliance processing at scale. These generally consist of third-party companies, that provide an integration with popular e-commerce and accounting systems. For online services that custom built their sales and booking engine (like my boat rental company), APIs are available to make remote calls to retrieve tax rates and record transactions.

Historically, implementation of tax calculation and remittance have been handled in a few ways, generally determined by the size of the company. The largest online operators, like Amazon, have rolled their own systems and maintain large teams that handle just sales tax collection and remittance for orders of Amazon-sold products around the globe.

Small to mid-sized companies usually set up stores on e-commerce hosting providers, like Shopify, BigCommerce and even Amazon’s marketplace. For these companies, they can select from a few vendors to handle their sales tax collection and remittance. These providers are already integrated into the e-commerce platform.

Many native online operators have built their own custom applications for commerce. These use APIs to exchange data with a sales tax provider. This allows them to maintain full control over their online service. More and more online businesses do not involve standard retail sales of physical goods. They provide services that require payment, but don’t fit neatly into the product catalog of a typical off-the-shelf e-commerce solution. Examples are dating services, gaming, content streaming, subscriptions and marketplaces. As other personal training services move online, these would be similarly taxable (your local Pilates studio training clients in another state). These areas, in particular, are seeing a lot of growth as new types of businesses are being created from scratch on the Internet.

As more and more commerce moves online, the companies that provide tax compliance services are seeing an increase in demand. While some providers support online sales tax calculation and remittance as an extension of their core accounting and finance packages, the market has become large enough to support independents who specialize in just providing outsourced sales tax and remittance. The volume of tax data and complexity of collection rules has become too extensive to simply bolt onto an existing accounting package. The largest of the new independent service providers is Avalara.

The movement of many types of businesses online is creating demand for other types of compliance services. These all have a parallel in the physical world, but migrating their engagement to digital channels creates a requirement to provide the same level of regulatory oversight. Examples include lodging, insurance and alcohol distribution. Supporting the growth of these new online businesses provides a further opportunity for compliance automation.

Avalara Background

Avalara was founded in 2004 in the Seattle, WA area by Scott McFarlane. McFarlane had founded and exited a couple of companies prior to starting Avalara, including Lifecycle and MetaInfo, which was acquired by Checkpoint Software. After 16 years, McFarlene is still CEO and active in maintaining the vision and strategy for the company. He likes combining innovation with rigorous operational discipline.

Avalara was founded to address the mundane world of sales tax management. Businesses of all types have to address the overhead of calculating, collecting and remitting transactional taxes. Before the Internet, managing this process was much simpler. Businesses could just plug the local sales and use tax rates into their POS system for the store’s physical location. Tax remittance was similarly handled in the accounting system. For a business with a single physical location, the owner could just pay a single local jurisdiction. For mid-sized companies with multiple locations, this manual process could just be repeated for each jurisdiction by the finance team. More work, but still scaled linearly to the number of stores.

However, the Internet, and more importantly, the South Dakota vs. Wayfair court case, changed all this. Now, a business selling over the Internet effectively has a store in each of the 11,000 tax jurisdictions in the U.S. and a completely different set of requirements for international business. This makes automation a requirement for almost every business. No longer can a small or medium-sized business just set up a web site themselves or through an e-commerce aggregator and address sales tax management through the same manual process as their physical store.

Avalara provides an outsourced, scalable, full-featured solution to automate tax management. Their products contain a deep and broad store of statutory tax content and apply advanced technologies to allow businesses to import their product catalog easily. Recognizing that online transactions are often conducted through a bevy of third-party services for e-commerce, accounting and point of sales management, the Avalara team has built over 700 integrations. These allow Avalara’s service to inject the sales tax calculation into the e-commerce platform at customer check-out and record all sales for future tax remittance.

Avalara is well positioned to capitalize on this rapid shift towards automation of tax compliance, driven by a few technology trends. First, the obvious is that traditional brick-and-mortar retail sales are rapidly transitioning online. The often quoted acceleration of digital transformation during 2020 is a testament to this. Second, other types of business services, besides just physical goods, are moving online, creating new digital business channels that hadn’t existed previously. Finally, recent legal changes in the U.S. and internationally (like the EU) suddenly make manual management of sales tax untenable for all but the very largest companies. After the temporary hiatus on sales tax collection clears post COVID, we can anticipate more aggressive collection efforts by cash-strapped states and other jurisdictions.

In 2019, Avalara managed tax on $19B of sales during Cyber Week. For the full year, they remitted $8.4B in tax payments to collecting jurisdictions. They were involved in over 6B transactions that spanned 208 countries. The company’s ultimate goal is to have a hand in every transaction conducted over the Internet. Given the rapid shift of business to digital channels, the amount of commerce serviced by Avalara will likely grow significantly over the next several years.

Financials

Avalara (AVLR) went public in June 2018 and the stock closed at $44.94 on the first day of trading. Since then, it has more than tripled over the following 2+ year period, recently posting an all time high around $184 in December 2020. Since then, it briefly dipped to $150, following a similar pattern of other SaaS names, and restarted an upward trajectory in February.

Avalara didn’t experience as significant a jump in price during 2020 as other SaaS stocks. For the full year of 2020, the stock was up 125%. So far in 2021, it is even. Its market cap is about $14.5B with a P/S ratio of 29.

Earnings Results

Avalara’s most recent quarterly earnings were from Q3 FY20, released on November 5th. Q4 2020 and full year results are forthcoming on February 10th. For Q3, Avalara delivered significant beats on both revenue and EPS. They also provided guidance for Q4 that was above analyst projections. The stock closed up 4.6% on November 6th.

Q3 revenue was $127.9M, increasing 29.8% year/year. This beat analyst expectations for $116.2M. Analyst estimates would have represented only 18% growth, so they delivered pretty significant outperformance of almost 12% of annualized growth. Billings were $142.3M, up 31% year/year.

On the bottom line, Avalara is starting to see leverage. Non-GAAP gross profit was up 34.9% year/year (more than revenue growth), driven by an increase in gross margin to 75% from 72% a year ago. Non-GAAP operating income turned positive at $1.7M or 1.3% of revenue, compared to a loss of $3.1M in Q3 2019. Non-GAAP EPS was $0.02, which beat analyst estimates by $0.11. Finally, free cash flow was $25.8M, for a FCF margin of 20.2%.

On the customer side, Avalara ended Q3 with 14,180 core customers, up 4.6% from 13,560 customers at the end of Q2 and 24.4% from 11,400 customers in Q3 of 2019. The net revenue retention rate was 108% in Q3 2020 and has averaged 108% over the last four quarters.

With the COVID pandemic, Avalara has experienced headwinds to the business. These have taken the form of a slowdown retail activity for the SMB sector and a hiatus on sales tax collection. These have delayed some deal flow and disincentivized companies to migrate their sales tax management to an automated solution like Avalara. We can see the impact on customer growth and revenue growth during 2020.

The progression of Avalara’s revenue growth going back to 2018 provides some further insight into the broader story. After the IPO, revenue growth accelerated to a peak of 43% in mid-2019 and then stabilized in the 40%+ ranged for a couple of quarters. For the first three quarters of 2020, revenue growth dropped into a range of 27-31%. The growth rate ticked back up in the most recent quarter from about 28% in Q2 to nearly 30% in Q3 2020.

For Q4 2020, Avalara is projecting revenue of $132M – $134M, beating the analyst consensus for $125.1M by about $8M at the midpoint. This would represent annual growth of 23.6%. Given that Avalara beat Q3 revenue guidance by almost 12%, we could see further acceleration in revenue growth for Q4 to a range of 33-35%.

The big question for Avalara will be if this revenue growth acceleration can continue and push growth back into the elevated rate from 2019. Management has commented in the past that they are confident that Avalara can sustain elevated revenue growth at least in the 20% range for many years, given the secular tailwinds around the e-commerce opportunity. Near term, if a resurgence of customer demand hits in 2021, revenue growth could return to the 35-40% range. With gross margin expansion, Non-GAAP profitability and continued high positive FCF, AVLR could experience a rerating of the P/S valuation multiple from the high 20’s to the 30’s.

Product Overview

Avalara offers a number of solutions to address the different aspects of compliance automation. These primarily focus on sales and use taxes, as this represents the company’s historical base. As we will examine in a bit, several recent acquisitions telegraph Avalara’s intent to expand into other areas of compliance, including business licenses, insurance premiums and e-invoicing. I think this is interesting, as Avalara has the potential to provide a platform of services that online vendors can leverage to automate any aspect of legal compliance associated with running their business over the Internet. Avalara refers to this as the Compliance Cloud.

In some ways, this opportunity reminds me of DocuSign and its generic positioning as the Agreement Cloud. DocuSign doesn’t categorize themselves as strictly an eSignature provider. Rather, they recognize that more broadly, as digital transformation moves every type of business online, there will be a need to manage business “agreements”, whether they be contract execution, notarization, click capture, blockchain, etc.

Avalara may have a similar opportunity. Like DocuSign, they started in a specific niche. For Avalara, this was sales tax calculation in the U.S. However, managing compliance with government entities will likely become more complex over time, as jurisdictions of all types globally shift their revenue collection and governance to business conducted over the Internet. Sales tax collection for all jurisdictions connected to the Internet might just have been the first salvo.

Avalara’s product offering is meant to automate compliance processing requirements using cloud-based software, so that businesses don’t need to address them manually. For example, once a sales tax solution is configured by a customer, they don’t have to worry about ever-changing, impenetrable tax rates, applicable rules, geographic boundaries, exemptions, tax holidays, reporting requirements and filing deadlines. Avalara’s cloud-based software platform manages the complexity and simplifies the process of sales tax and other transaction tax compliance. This is delivered seamlessly over the Internet, often integrated with the e-commerce or accounting tooling already in place. Avalara’s cloud-based solution is available with consideration for high scale, speed, and reliability.

Tax Calculation

AvaTax is Avalara’s cloud-based calculation service for sales and use tax. It can be queried in real-time for every transaction as it is being processed. Often, this calculation is performed inline during the final step of an e-commerce interaction, like the check-out process. In this way, the latest changes to tax rates, boundaries, application rules, etc. are automatically applied and kept up to date. Tax calculations used to be much simpler, but as automation has emerged, tax jurisdictions have gotten more creative in expanding their rules and sub-dividing geographies. For example, two houses next door to each other might have different tax rates. These divisions don’t fall neatly along other geographic conventions like zip codes or county lines.

Beyond nuanced geographic lines, tax rates can be impacted by other factors. Again, jurisdictions are getting more creative. Many have introduced special tax rates for items based on the materials in a product, price points or product function (luxury goods taxed more). Some jurisdictions establish sales tax holiday periods to encourage local commerce periodically. These are all taken into account by AvaTax in making the sales tax calculation.

As transactions are processed, Avalara maintains a record of them and aggregates across jurisdictions. This information is used by the filing process. Many states apply minimum thresholds for incurring a tax obligation, often associated with the number of transactions or total value of commerce in a particular state. AvaTax keeps track of these totals over the associated time period and notifies the business user as they are approaching a threshold for nexus in each state.

Returns

After all the sales tax has been calculated and withheld, Avalara can help businesses file the returns necessary and remit tax owed to each jurisdiction. Avalara Returns identifies every jurisdiction that requires payment, maintains an updated version of their filing forms/process and then auto-populates each with the relevant transactional data for the filing period. Once the finance team has reviewed the forms, they can be submitted automatically. A copy of all filings is maintained in the Avalara platform for future reference.

Avalara can aggregate transactional data across multiple sources. Many businesses will maintain several online sales channels (Shopify, Etsy, Walmart Marketplace, Amazon), in addition to POS transactions. Avalara has integrations with all major e-commerce solutions as well as popular accounting packages. This greatly simplifies the overhead of sales tax management, as this aggregation and filing doesn’t need to be repeated manually across each sales channel. Records are available for retrieval at any time and the platform provides additional tools to manage an audit.

Registrations

As an online business is first getting ramped up, they may not even have a relationship with all the relevant taxing authorities. In the U.S., this primarily involves going through a registration process for each state. The applications and filing process for each state is different. Avalara simplifies this by providing a single form for the business to complete. Once submitted, Avalara then distributes the necessary information to each state’s licensing body.

As part of submission, Avalara can handle payment of any registration fees and then periodically checks the status of each filing until the registration is complete. Avalara then stores a digital copy of the registration certificate and uses this information for any future filings.

Exemption Certificates

When customers make bulk purchases from a business for resales, they may be allowed to claim that the purchase should be tax exempt. This might apply to a restaurant that is purchasing food supplies that it will then resell as food and charge sales tax on that bill. In order to forgo sales tax collection for a customer, though, a business needs to collect and store the customer’s exemption certificate. Certificates are issued by a local jurisdiction and have to be kept up to date.

Avalara’s exemption certificate service provides the ability to store customer certificates of exemption, apply those as appropriate to purchases and maintain all necessary records of compliance for audit from a taxing authority. Additionally, if a customer doesn’t have an exemption certificate, Avalara’s service can assist with collecting the information necessary to submit the request for one. Finally, it tracks the duration of the certificate and provides customers with a reminder when it is about to expire.

This can save the business substantial manual overhead. Managing these exemption certificates can be a full time job for one or more people at a large retailer.

Item Classification and Customs Duties

Cross-border selling is one of the fastest growth areas in e-commerce. It should reach over $1T in total sales by 2022 and is experiencing twice the growth rate of overall e-commerce. To take advantage of this, retailers have to account for customs duties and import taxes. These fees are required to be paid to the inbound country when product is shipped across borders.

Cross-border product delivery often experiences common problems. These range from shipment delays by being held in customs, added costs due to mis-categorization by shippers and poor customer experience due to unexpected add-on costs. The fees to import a product vary by country and are based on a number of factors, including item cost, materials, size and country of origin.

The custom duties and import taxes for each country are based on a classification system, called the HS code (harmonized system code). Over 200 countries participate in the HS code classification, but only the first 6 digits of the HS code are common among all countries. The other digits past the sixth are unique to each country. That unique HS code identifies the fee to import a product into a particular country.

Determining the proper HS code can be challenging for the individual retailer. Some rely on their shipper to add the classification and then pass the cost on to the customer. But, this can result in unexpected charges and returns. Often the shipper will select a code with a higher import fee, in order to clear customs easily.

Avalara’s Item Classification solution determines the correct HS code for a destination country automatically. A retailer can import their product catalog into the the Avalara platform for automated classification. The solution will scrape the product details from a retailer’s catalog, usually their online listings. Avalara’s solution can classify each product into the correct top-level product taxonomy. Then, it uses the item attributes (like color, size, material, country of origin) to further refine the HS code to assign. This matching is driven by Avalara’s classification system powered by AI. The output is the full 8-12 digit HS code for every country.

With the proper HS code, Avalara’s AvaTax solution can calculate the items’s fees for custom duty and import tax. These can be injected into the check-out experience in real-time. This on-the-fly calculation is enabled by running the product catalog through Avalara’s Item Classification solution in advance.

Marketplaces

One category of rapid growth is the emergence of online marketplaces that facilitate connection of buyers and sellers of goods and services. These are popping up for every business sector, both in the U.S. and internationally. As I mentioned previously, I experienced this first-hand working for the largest online marketplace for boat rentals. In this case, the company helped travelers in any destination globally get connected with a commercial boat owner (whether individual or charter) to book a personal boat trip. We would take a cut of the transaction cost for making the connection. Marketplaces exist for other types of rentals, like cars, RVs, tools, and of course, lodging.

As this represents a new type of commerce, which in many cases doesn’t clearly fall under a standard product sale, many government jurisdictions are imposing new rules to extract tax revenue from these marketplaces and enforce compliance rules. Marketplaces are under increasing scrutiny from taxing authorities around the globe, and noncompliance can generate fines or other penalties. In the U.S., states have passed Marketplace Facilitator laws, which require the marketplace itself to begin collecting tax on behalf of sellers (where previously marketplaces could claim they were neutral). And this doesn’t just apply domestically, other countries are getting in on the opportunity. The UK has new obligations for marketplaces taking effect in January 2021 which require the platforms themselves to collect and report VAT on behalf of their sellers. Similar rules are rolling out in the EU in July.

Avalara’s Marketplace solution automates this process for online marketplaces. The solution helps manage compliance documentation, calculates tax rates both domestically and internationally, and handles filing returns with all jurisdictions. The complexity for a small to medium-sized marketplace that is trying to do business internationally (like my boat rental company) would be significant. It would be challenging to manage this without outside help. The Avalara system makes this type of offering feasible.

Other Tax Types and Solutions

Beyond standard transactional sales tax on cost of goods, other types of taxes have emerged that have to be applied to digital business. These include consumer use, communications, excise and lodging taxes. Many of these are new taxes that apply to emerging business models. Vacation rentals is a good example, particularly as these businesses are moving online. Avalara offers an end-to-end solution for vacation rental tax management, called MyLodgeTax. This solution helps the customer get rental properties registered, determines taxes for rental transactions and facilitates payments to taxing jurisdictions. Given that all types of traditional businesses are getting duplicated online and taxing jurisdictions are looking for incremental revenue, I can imagine these types of new tax requirements will continue to proliferate.

Beverage and Alcohol sales over the Internet are increasing as well, experiencing a sustained burst during the pandemic, as consumers were locked down. Like other restricted products, alcohol sales include their own set of requirements for licensing, tax collection and local jurisdiction filing. Beverage alcohol industry regulations and tax rules exist at the federal, state, county, and city levels — with little or no consistency between jurisdictions. Additionally, licensing is required at the federal (Federal Alcohol and Tobacco Tax and Trade Bureau), state (DORs) and local level (Alcohol Beverage Control departments). These licenses must be filed and maintained, or businesses risk revocation of sales privileges. Finally, alcohol sales must be filed periodically and tax paid, which is often separate from standard sales tax.

Avalara’s Beverage Alcohol solution automates all of this, by handling regulatory compliance for suppliers, distributors, and retailers. The software service automatically calculates tax rates using the latest tax information, obtains and renews licenses, registers products at federal and state levels, and generates shipment reports and tax returns. This is all done in adherence to the specific requirements for alcohol distribution and integrates with major platforms used by retailers. 

Pricing

Pricing for Avalara’s services is generally usage based. It scales with volume and is designed to grow with a business. The price formula is based on few factors, including the products purchased, the number of business application integrations, volume of sales transactions and the number of jurisdictions (usually states) where sales tax is being collected. Pricing is determined by going through a quote request process and engaging with sales.

Integrations

Tax calculation and returns management is most naturally applied through the e-commerce package or accounting system used by the retailer. In order to support this, Avalara has over 700 pre-built integrations to accounting, ERP, e-commerce, shopping cart and business applications. These span all the major providers and allow customers to make full use of Avalara’s services within these tools. Avalara claims to have the largest network of integrations of any tax software provider.

Avalara also offers a full-featured API for customers with a custom-built web site that has its own payment workflow. The API includes full documentation, integration guides, an API explorer and SDKs for most popular development languages. New software vendors can easily add Avalara’s capabilities to their offerings through the API.

Accounting Firms

Avalara recognizes that many businesses still rely on their accounting firms to handle sales tax remittance on their behalf. To capture a share of this market, Avalara recently launched their Managed Returns for Accountants (MRA) product. MRA enables accounting firms to drive efficiencies in their practice with automated sales tax preparation and filing services. This allows them to provide clients with the benefits of a fully managed returns service, but reduce manual overhead of filing in hundreds or thousands of locations. With this service, Avalara hopes to extend their filing service to a broader set of customers.

Acquisitions

As Avalara is expanding their compliance reach beyond simply collecting sales tax, they are leaning on acquisitions to rapidly add new capabilities, talent and customer segments. Recent acquisitions have focused on addressing emerging areas of compliance and gaining more penetration into the enterprise segment. The acquisition pace in 2020 was aggressive, spanning four companies. This was in addition to Avalara’s own internal product development efforts. Let’s take a look at each of these acquisitions.

INPOSIA

Avalara announced their intent to acquire INPOSIA Solutions GmbH in December 2020. INPOSIA is a German software company focused on e-invoicing, digital tax reporting, and business and data integration to address real-time compliance requirements for companies worldwide. Financial terms of the deal were not disclosed. The transaction is expected to close in the first half of 2021.

Tax authorities around the world are transitioning to requiring real-time compliance as a means of collecting tax revenues faster, with more transparency and less fraud. E-invoicing and associated live reporting requirements move the exchange of purchasing and tax information between business and governments to near real-time. These requirements represent a meaningful global shift to upgrade technology systems to facilitate this real-time compliance. These enhanced requirements are spreading across Latin America, Europe and Asia.

INPOSIA helps its customers send and receive legally compliant invoices in more than 60 countries. Their technology solutions integrate business processes and data directly between other B2B partners, governments and across the multiple digital business systems used by operations and finance teams. Avalara plans to leverage these capabilities to expand their product offering to meet the growing need for real-time tax compliance globally through e-invoicing.

TTR

In October 2020, Avalara announced that it acquired Transaction Tax Resources, Inc. (TTR) for approximately $377M in cash. TTR, known as the tax answer company, primarily serves enterprise businesses and their internal tax teams, offering U.S. sales and use tax rates, laws, software, and customer support required for the biggest and most complex companies.

This acquisition was primarily about adding depth of content and expanding the enterprise customer footprint. TTR brings Avalara more than 1,400 customers, including blue chip customers that represent more than 30% of the Fortune 500, the largest or second largest company in each of 40 industries, 9 of the top 10 healthcare companies, 8 of the top 10 telecommunications companies and 5 of the top 10 IT services firms.

With TTR, Avalara will now have the opportunity to build the most robust compliance content library available through a cloud-based, integrated automation platform. Since its founding, TTR has focused almost exclusively on tax content. As a result, they have amassed a large database of content that expands Avalara’s existing database. It adds to some of Avalara’s most important vertical markets such as retail, telecommunications, food and grocery and manufacturing, and contributes new categories including automobile, construction, and financial services.

Finally, TTR’s core business is a subscription service for tax professionals in mid- and large-sized businesses to determine and validate tax decisions and avoid costly mistakes. In the largest companies, internal tax teams within the finance department make their own decisions around tax obligations and product classification. This is done in an effort to optimize for savings and sometimes results in a tax rate calculation different from what the automated Avalara system might provide. By offering both a content subscription and a tax calculation service, Avalara can now cater to the largest enterprises, which are moving to a semi-automated approach to tax rate management. They will leverage the automated calculation in many cases, but override it in some, where they feel their interpretation of the rules are uniquely beneficial.

Impendulo

In December 2020 as well, Avalara announced the acquisition of Impendulo. Impendulo offers insurance premium tax compliance management, specializing in support for multi-national insurance companies. Impendulo helps its clients in several ways, including acting as the required in-country tax representative and agent, handling rate calculations, filings, returns and audit support.

Similar to many other types of indirect tax, regulations vary by country. For example, in the United States, insurance brokers often file and pay taxes on behalf of those purchasing the insurance. However, in Europe, insurance companies mainly have the legal obligation to file and pay directly. Tax rates on insurance premiums can vary by type of insurance and who supplies it.

Impendulo gives Avalara access to the global insurance compliance business, where emerging rules are creating a new market for tax automation. Insurance sales are also increasingly moving online, making automation and integration with customized sales platforms necessary. Terms of the acquisition were not disclosed.

Business Licenses

In November 2020, Avalara acquired the operational assets of Business Licenses, LLC (BL), a company that provides software and services for the research, acquisition, and management of business licenses, registrations, and permits for businesses of all types. The transaction was valued at $97M in cash and stock.

Nearly every business must obtain some type of license, permit, or tax registration and keep it current. Like tax compliance, licensing requirements can create complexity for businesses that operate on the Internet as the regulations for licensing and registrations vary by jurisdiction and industry. Business activities such as opening or closing locations, moving locations, changing names, changing ownership, or launching products can all trigger the need for licensing or registration. Business Licenses has built up an expansive database of licensing and registration content. It also stood up automated software and outsourcing services to support U.S. businesses in licensing compliance.

With this acquisition, Avalara will be able to address end-to-end tax compliance for businesses. Obtaining a business license and sales tax registration are often the first step for a new business in compliance efforts. Avalara can now guide and automate this process for businesses. This also applies to large enterprises, which span multiple jurisdictions. The aquisition includes Business Licenses’ subscription-based SaaS license management solution that enterprise customers use to store, manage, and renew registrations, licenses, and permits. For example, a national home improvement retailer uses Business Licenses’ software and services to manage more than 8,000 licenses. Business Licenses has nearly 200 enterprise customers, with a significant number of those customers in the Fortune 1000. These should further expand Avalara’s penetration into the enterprise.

Addressable Market

Avalara’s vision is to be part of every transaction in the world. The Internet has driven a substantial increase in digital commerce and made shopping across borders as easy as a mouse click. These trends have caused government organizations to respond and ensure that their tax base and oversight are maintained. This has resulted in constantly shifting taxation and reporting obligations imposed by a global patchwork of local, regional, state and national taxing authorities. This compliance burden extends to any business operating on the Internet, regardless of size.

While many businesses previously processed transactions using traditional financial packages such as accounting systems, ERP, point of sale (POS), or even CRM systems, most of these include rudimentary tax calculation capabilities. They are generally not sufficiently comprehensive or current to provide accurate tax determinations and compliance assurance for the new global landscape.

This has created a significant opportunity for companies that can accumulate enough tax compliance data to facilitate every type of transaction in the world. The Avalara Compliance Cloud provides an advanced database of broad, deep, and up-to-date tax content. That is combined with software services that execute compliance processes, including tax calculations, certificate management, returns filing and tax remittance.

Avalara estimates the total addressable market for their services to be about $8B in the U.S. This is based on the number of businesses in each of three varying segments by size, multiplied by Avalara’s average revenue per customer for each segment. Roughly, they size small business at $2B, mid-market at $4B and the enterprise segment at $2B. Mid-market is currently where Avalara focuses most of their effort.

This does not account for business outside the U.S. or for future product expansions beyond tax compliance. Avalara estimates the international opportunity to be several times larger than in the U.S., particularly as the amount of tax collected tends to be greater per transaction in jurisdictions outside the U.S., like the EU.

Competitive Landscape

In 2019, IDC published a MarketScape report for Worldwide SaaS and Cloud Enabled Sales Tax and VAT Automation Applications. This was the first analyst report that highlighted the market opportunity and identified the major providers in the space. They highlight many of the drivers for tax automation solutions that we have discussed and see this as a large, emerging market opportunity, primarily driven by the rapid adoption of e-commerce and cross-border transactions.

The process of managing the collection, calculation, and filing of taxes has been growing increasingly difficult as enterprises and their markets have grown in scale and complexity. Companies are selling more products and services in more places (regionally and globally) and in more ways (B2C, B2B, and B2B2C) than ever before. Growth in the digital economy has made the process of managing sales and use taxes more difficult as each sales location may have its own tax reporting obligations. For digital commerce companies, sales and use taxes are the most complex areas of tax management because of the constant rate of change in tax regulations.

IDC Marketscape, Sales Tax and VAT Automation Report, 2019

Per their standard approach, IDC surveyed vendor solutions and solicited feedback from end users on how tax automation vendors lined up relative to current capabilities, future product strategy and relative penetration in the market. They identified Sovos and Avalara as the clear leaders, with Thompson Reuters and Vertex close behind. In the Major Players category, they included Intuit, TaxJar and TaxCloud.

This survey skews towards enterprise level customers, as a consequence of IDC’s customer base and perspective. These rankings have likely changed since 2019, particularly given Avalara’s rapid expansion of its product and content coverage through acquisitions in 2020.

G2 provides a different perspective, generally based on feedback from users at small to mid-sized companies. They maintain an up-to-date grid comparing Sales Tax Compliance solutions. They score products and services based on reviews gathered from their user community, as well as other online sources and social media. Similar to IDC, they rank vendors based on two axes, but measure signals of customer satisfaction and market presence versus pure analyst research.

G2 has ranked Avalara highest on market presence and second on customer satisfaction. The market presence ranking is particularly telling for investors, as it combines 15 data points from various online sources that G2 tracks and reflects Avalara’s claimed position as the market leader. Also noteworthy is that G2 allows the viewer to narrow the grid by size of customer. For small and mid-market customers, Avalara is far and away the leader. For the enterprise segment, Vertex is first, Avalara is second and Sovos is third.

From Avalara’s perspective, they differentiate their solutions from competitive offerings along three factors.

• Breadth of coverage. The Avalara platform extends compliance solutions beyond just sales tax, to offer treatment for other tax types like use, excise, VAT, GST, communications, lodging, alcohol sales, insurance premiums, etc. Additionally, Avalara’s coverage extends globally versus just the U.S.
• End-to-end. Avalara goes beyond tax calculation to provide tax return preparation, filing and remittance. They also handle exemption certificate management. Competitive solutions might provide point solutions for just calculation or filing.
• Easy to implement. Tax software is easiest to manage when it is integrated with transaction data residing in other business applications like e-commerce platforms, accounting software, ERP, POS, recurring billing or CRM systems. Avalara has over 700 integrations with these types of third-party applications and a complete API for custom transaction engines. Also, as a cloud-based solution, all updates to tax rates are automatically incorporated into the next request in real-time without requiring software upgrades.

Even with competitors in the space, Avalara leadership claims that do-it-yourself, manual processes represent the largest share of the market currently. As the sales team lines up new customer deals each quarter, they are primarily “lost” (really postponed) due to a decision by the target customer to maintain the status quo. Based on Avalara’s internal sales data, only 3% of deals are displaced by a competitive solution.

In their Investor Day presentation in June 2020, Avalara leadership said that while some customers do delay tax automation, 50% of new deals close within 3 months of first contact, 70% within one year and 85% within 3 years. The adoption of an automated solution like Avalara’s is usually triggered by a change in the target customer’s business. Typical triggers are expanding online sales, opening new locations in other jurisdictions, international sales or a broader product catalog.

With that background, let’s conduct a brief examination of the primary competitive solutions identified by industry analysts and Avalara’s own internal tracking. These are Sovos, Vertex and TaxJar. Sovos and Vertex primarily target enterprise customers, while TaxJar has the most penetration with small business.

Sovos

Sovos offers the most comprehensive solution as compared to Avalara. They were founded in 1979 as Taxware and have grown through acquisitions and mergers to the present. The company is privately held, owned by London-based private equity firm HG Capital.

The platform is branded as the Sovos Intelligent Compliance Cloud. It provides a complete solution for sales, use and VAT tax determination, e-invoicing compliance and tax reporting for government entities around the world. They also offer a few specialized solutions like insurance premium tax and cryptocurrency exchange tax support. With recent acquisitions, Avalara covers most of these (except crypto).

They offer an API for external connections, with a basic developer guide. While useful, this developer integration support isn’t as extensive as Avalara’s developer portal. They list integrations with a few major financial and commerce systems like SAP, NetSuite, and Magento. They claim to have other integrations, but I couldn’t find any listed.

Sovos has over 8,000 customers, including half of the Fortune 500. The team of 1,100 employees is spread throughout North America, Latin America and Europe. They tend to perform well with large, multi-national enterprise customers. IDC lists some of Sovos’ challenges as being general awareness and limited number of integrations, particularly with ERP systems. We don’t have data on financial performance, but as a private company under the umbrella of a large private equity firm, I suspect growth will be limited.

Vertex

Vertex has been in the tax business for a long period as well. It was founded in 1978 and has its headquarters in Pennsylvania. The company went public in July 2020, but is controlled by a single family that descended from the founder. They have about 1,100 employees in offices through the U.S. and overseas. They claim to have over 4,000 customers, including 50% of the Fortune 500.

The Vertex platform provides support for a broad array of taxes for both the U.S. and over 130 countries. These include similar tax types to Avalara, including sales and use, VAT, consumer use, communications, lease and lodging. The solution can be delivered both on-premise and through cloud delivery. The platform lists 228 integrations with third-party software packages. I couldn’t readily find references to an API or other developer tools.

The company trades under the ticker symbol VERX. Shares initially closed around $24 a share at IPO in July 2020 and have appreciated to about $34 recently. The company’s market cap is about $5B. In their most recent quarter (Q3 2020 reported on Nov 10) , they reported revenue of $94.6M, up 14.8% year/year. Their NRR was 108%. They are profitable on a Non-GAAP basis with about a 21% operation margin. For Q4, they are projecting revenue of $94M at the midpoint, for annualized growth of about 9%. Full year revenue is estimated at $369M representing 14.8% growth at the midpoint.

Compared to Avalara, Vertex is more profitable, but growing revenue at about half the rate (15% versus 30% for Avalara). This is on a smaller base of about $95M versus $128M for Avalara. Vertex’s Q4 estimated growth rate with a marginal beat would represent deceleration from Q3 and is even less than half Avalara’s Q4 estimate for 24% growth. The market reflects this trajectory in valuation, assigning VERX a modest P/S ratio of about 13. Given their slower growth and family-owned configuration, I suspect Vertex will lag Avalara over time.

TaxJar

TaxJar is a cloud-based sales tax automation solution. The platform facilitates calculation of sales tax, filing with taxing jurisdictions and remittance. Their service is delivered primarily through an open API and is geared towards online sellers. Their scope is currently limited to sales tax processing within the U.S. TaxJar provides integrations with the major payments, accounting and e-commerce platforms for small businesses, but the total count of these appears to be less than 100 (versus Avalara’s claim to 700 integrations). They cite 20,000 online sellers as customers.

Founded in 2013, TaxJar is a privately held company. The workforce of about 160 employees is completely distributed. They raised a $60M Series A round of funding in early 2019. There are no plans for a public offering at this time.

Take-Aways

The overhead of managing tax collection and regulatory compliance for online sellers is not going away. In fact, it will likely intensify as COVID restrictions lift and governments scramble for tax revenue. This applies not just in the U.S., but also internationally. Additionally, the Internet has made every purveyor of goods and services a click away, driving a rapid increase in cross-border sales. Further, traditional physical goods aren’t the only category being subjected to new Internet taxes. Lodging, beverages, communications services, marketplaces, insurance premiums (and more coming) sold over the Internet are all subject to taxation and new regulations.

Few providers exist that offer an automated solution, delivered at scale and covering the full lifecycle of tax compliance across all categories in all countries. This limitation of providers is probably because the category requires the accumulation of an immense database of tax rates, rules, processes and regulatory expertise. Also, it is a mundane category, lacking the buzziness of other software services like observability or AI. However, it is a necessary component of every online business, that is best managed through automation. Of the modern compliance providers, Avalara offers the most complete solution and is publicly traded. It is also growing the fastest.

The addressable market for tax automation by itself is large, estimated by Avalara at $8B domestically and several times that overseas. This will increase as more business shifts to digital channels. Additionally, we will likely see expanded regulation for new types of online business that didn’t exist before. This will create demand for other compliance management services.

Many potential customers postponed tax compliance automation in 2020 as a result of COVID, both to mitigate costs and in reaction to various government efforts to deliver a hiatus on tax collection. These factors created a headwind for Avalara revenue growth in 2020, driving deceleration. However, this situation should reverse in 2021, as businesses double down on digital channels and commit to meeting expanded regulatory requirements.

Looking forward, Avalara is a leader in a growing technology segment that is becoming an increasingly necessary component of every online business. They are expanding into other product offerings beyond sales tax, capitalizing on the wave of activity by government entities to extract their share of tax revenue and to apply oversight to protect their citizens. Cloud-based compliance automation is emerging as a formal service category, which will further solidify its share of IT budgets.

Avalara’s annualized revenue growth rate re-accelerated to 30% as part of their Q3 earnings results. For Q4, growth could push back over 30%, if they deliver a beat of a similar magnitude to Q3. Avalara is driving operational leverage as they expand, with a 3% year/year improvement in Non-GAAP gross margin and a transition to positive operating margin.

These trends could continue in 2021, both in terms of higher annualized revenue growth and improving profitability, providing upward support for AVLR’s valuation multiple. Over the long term, Avalara leadership is confident that they can deliver sustained revenue growth, riding the long tail of business migration from offline to online channels. AVLR stock could offer investors a safe way to harness long term compounding of growth at a reasonable valuation.

Investment Plan

Avalara has been on my radar for a while, and I wanted to dig into the story for my own understanding. My intent has been to share this research with other investors, so that they can make their own evaluation. While I like the opportunity and execution uncovered thus far for Avalara, I want to see the outcome of the upcoming Q4 report before opening a position. If Q4 results demonstrate continued progress, I will set a 5-year price target.

NOTE: This article does not represent investment advice and is solely the author’s opinion for managing his own investment portfolio. Readers are expected to perform their own due diligence before making investment decisions. Please see the Disclaimer for more detail.