I think we'll go ahead and get started here. With me, I have Ken Stillwell, CFO and COO of Pegasystems. Thanks for having me.
Good to be here. Thank you.
So I thought maybe to level set, can you just give maybe a brief overview of the company, the products you offer, and kind of the value prop?
Sure. So Pega, Pega does end-to-end workflow automation, and, what does that mean? It is typically used for transactions, events, that where it goes kind of across a series of steps to accomplish a specific activity. It might, or likely will, integrate with other systems.
It will, you know, be used by someone like a, like a CSR at a client interacting with consumers. Increasingly, it's becoming more automated in terms of that interaction. Common use cases are things like, you know, financial services, healthcare, insurance, telecommunications, consumer manufacturing, public sector.
Those are all industries that have a very big B2C presence or even a B2B2C presence, where you have significant amounts of transactions that need to be done quickly, that you might even then wanna analyze or use the data from those transactions to be able to drive intelligence and kind of a closed loop improvement of the process. Our clients, you know, we don't have, we have less than 1,000 clients, and the top 200 clients, you know, drive about 75%-80% of our ARR.
Mm-hmm.
We believe every client that we have, I would say 95% of our clients, you know, should be and could be spending $10 million, $20 million, $30 million a year with us. Most are not, and so that's where the opportunity is.
Yeah
... that we're focused on.
So, you know, I think in this space, you know, there's a lot more than just low code, right? I think Pega focuses on very mission-critical use cases, intelligent workflow automation. So, maybe-
Yep
Just break down kind of where you're positioned competitively, where you're maybe different than, you know, what people traditionally think of as low-code. You know, some of the vendors like Microsoft, Salesforce, so, like, how you're kind of uniquely positioned.
Sure. So when you think of the concept of low code, I typically kind of refer to low code as there's low code the concept and low code the product. And when you think about companies like Pega or Salesforce or ServiceNow, not so much Microsoft, but the bigger, they're typically more kind of low code the concept versus a low code simple platform.
What does low code the concept mean? It means that when you build an application, an enterprise-grade application, you want to build it in a way that you can evolve it, change it, without having to write new code, without having to have lots of check-in, check-out. It's something that typically the configuration can be done in the screen with a low level of hard coding. It's not no code, because there are some cases where you do need to write, you know-
Mm-hmm
Some level of custom code, but you want to try and minimize that, because every time you write a piece of custom code, it just means it's that much more complicated to change it in the future. Then there's low code the product. Well, low code the product typically is something where the use case is simple, where you're trying to do things like, you know, I want to build a badge swipe application for my doors to the office.
And you're going to say, "All I'm going to do is take an RFID, take a scan, and say, 'Is that person on the list or not on the list?' If they're on the list, I click open. If they're not on the list, I click a red error message." That's it.
That's all you're building. So, there's lots of low code use cases out there that Pega would be an overkill for that use case because it's really not... It's really just very simple, open/close type activities. By the way, so would all the competitors that we mentioned as well. No one—you wouldn't go out and spend $10 million or $20 million or $30 million to manage a very simple, like, you know, like notify when a desk is open or something like that-
Mm-hmm
If you were hoteling in an office. So there's a real misunderstanding in the marketplace that it all gets lumped in together. And so when you hear, like, well, how is Salesforce low-code? Well, they're low-code because they try to build their applications in a way that they can be scaled.
Now, how is Pega different? The reason why Pega is very different than any of the companies that you might think of as competitors is that Pega's entire platform, the architecture, the approach, everything that we've done for 40 years has all been based on building something that can easily be changed, can easily evolve.
Things like what we call the Situational Layer Cake, which is this concept of dimensionality, where you can build one application that can solve similar use cases in different parts of the world, where there might be slight changes or even material changes. Other companies would go and they'd copy the applications and create maybe a version for each state, a version for each country.
So the concept of Pega has always been to be able to serve enterprise, enterprise clients with enterprise-grade applications and significant volumes in a way that you can future-proof that application and change over time.
And I think our retention rates really speak large to of how sticky our product is and how clients have taken applications that they used from 1985, and they're still using those applications today, except in a more modern environment. They've evolved that, maybe even every year, they've made changes to that without having to write code. So that's kind of our—that's one of our, one of our differentiative powers.
Yeah. No, that's great. And then maybe on that topic, Pega Infinity just launched a new version. The latest version, I think it just came out. So maybe, you know, talk about some of the new features that have come out and kind of the impact to the customer base.
So, yeah, Pega 2023 or Pega Infinity 2023, which is the one we talked about at PegaWorld, is kind of in the GA phase. And what's different? You know, well, Gen AI, right? A big, you know, we've hooked in AI capabilities to be able to leverage. And we always had something called customer decisioning, which was a form of AI that we used at Pega.
It was something that essentially it took a rules database and created kind of almost a spider diagram of, like, figuring out probabilities and analyzing information so that it could give you a prediction. Like, I think the next offer you should do, or I think the next action you should take.
Gen AI goes to a different level, more on the conversational AI side, and with voice AI, where it can actually simulate a voice interaction, right? It can. You can call into someone, think you're talking to an operator, and it will actually understand what you're saying, run through all of the information that you put in the LLM, and be able to say back to the person, you know, something that might be helpful in them solving that issue. That's something we did not have before Gen AI.
Another big feature is we've really made the designer experience. So when you go into Pega and you wanna configure, You wanna start from scratch, you wanna configure, you want to evolve, you wanna improve, whatever, the designer experience of how you would do that is really quite modern and very easy.
I would draw the, you know, I'm gonna date myself a little bit, but I would draw the analogy of the way workbooks used to operate before Excel, right? Where you could, you know, if you knew all the codes, and you could do backslash W, you pull out. Like, it was... You could do it, but you had to literally know how to figure things out.
We went to the point where you can hover over, using the Excel example, you can hover over, and it says, "This is a sum, and here's the formula that you do." And we've made it so that you don't really need to have the knowledge of Pega or even the developer acumen to be able to evolve. And so we have, the, you know, the Designer Studio kind of, feature function.
We've also have a lot more of the actual configurations and rules, standard rules in the library, so that when you're building something, you don't actually have to start from scratch. You can say, "Hey, I wanna build a loan origination process." And now you can use AI, and you can say, "Well, get me something to start.
I wanna build a origination process." And it will, within a matter of, I mean, literally in a matter of, like, 3-5 seconds, it'll pop up and say, "Here's an example of a workflow for loan origination." You can use that, you can, you can, you can, kind of configure off of that. You can say, "That's good to know, but I'm gonna start my own." You can add steps and stages, create integrations.
It can actually even tell you, "Here's the common integrations, FICO and TransUnion, and Experian." I mean, it can, it can get you to the point where it's, it's kind of almost building the application on your own.
So I think what you're gonna see with our clients more and more is that they're looking to Pega and saying, "I get all the enterprise, enterprise-grade, the workflow automation and intelligent workflow automation, but now I don't have to spend so much time to actually build out the application, because I can leverage AI to do that." I think that's gonna be transformative for our clients.
Yeah. So maybe a few more questions on Gen AI.
Sure.
So I believe all the new features and functionality will be provided to cloud customers. So maybe talk about that. You know, why, strategically, why kind of push it out to the cloud customers and potentially the implications to, you know, cloud mix over time as you, you know, push out more features to that set of customers?
Sure. So, the version, 2023, is available for our Pega Cloud clients. Now, the beauty with that is, one, Pega Cloud is really the modern application environment that we want our clients to operate in. That doesn't mean that we will treat our clients that may have purchased previous versions on, you know, either they're managing on their own cloud or maybe, you know, managing it on premise.
We will still support them. They will get all of the new technology innovation with all of the releases. But when you think about Gen AI, we wanted to start with a very controlled group of clients that were already on Pega Cloud. You know, we're leveraging Gen AI on this.
We didn't wanna have to deal with all the firewall and security protocols of trying to actually... Now, if a client wants to actually go use their own AI tools on Pega, they could certainly do that. But for us to offer it, and we are offering it to our clients, it's Pega Cloud. When we get to 2024, we'll reevaluate whether there's different delivery models for Gen AI, but we haven't really made that decision yet.
What that also does is that- so clarify one thing. When we think about Pega Cloud, most of our clients have a version of Pega Cloud. Even though our Pega Cloud is only about 40%-45% of our total ACV is Pega Cloud, if you look at the number of our clients that have Pega Cloud, it's 75-
Mm
...% plus of our clients. If you look at our top 200-300 clients, pretty much all of them.
Mm-hmm.
So if you think about the clients that kind of, I would say, matter, all of our clients matter, but the larger clients, more influential to our business, they're all gonna have access to this. If a client doesn't have access, there's a very simple way to get access, which is they can actually get kind of a sandbox for Pega Cloud, and they can actually start to test and import rules into there and start to run some of the analysis. So there will be no reason why any client couldn't get access to it if they want it.
Yeah. Is there a kind of... I thought I saw that there's maybe a seamless cloud migration path. Is that, you know, would that will that change potentially kind of the incentives for some folks to kind of shift over?
Yeah, that's a good, that's a good point. So we really announced maybe a doubling or tripling down on moving clients to Pega Cloud. And you might say, "Well, why now versus why not 2 years ago?" If you go back about 5 years ago, our clients were you know, sporadically on the current version. I would say, you know, some were, some weren't.
We didn't really force them to. We were, you know, we were coming off of a perpetual model where, you know, clients, you know, paid a significant amount upfront, and they paid maintenance, and they got all the technology, but we left it up to them when they wanted to upgrade or to move to the current version. Fast-forward to today, we have the majority of our clients on Pega Infinity.
I mean, the overwhelming majority, probably 90%+. So now is the perfect time to go to those clients because the migration from Pega Infinity, non-Pega Cloud to Pega Cloud, is quite straightforward.
Some clients, it will be more complicated because their applications are just so powerful and they've do so many things that we might need to modernize certain aspects of how they do things, but for many clients, it will be a more simple migration. So given that, and we have so many clients wanting to move to Pega Cloud, we feel like it's the time to really kind of push for more focus on it.
Yeah. That's great.
And then that also opens up GenAI.
Yep, exactly. So a question I get often is around, you know, what are the plans on monetizing all these new features? And then, you know, part of that is kind of pricing, right? Like, maybe just give us an update on, you know, how you think about pricing, how much is seat-based versus, you know, usage-based, and cause that comes up pretty often.
Yeah. So I've. That's a very common question because we are including GenAI for 2023 with our clients. And so the immediate question that people ask is, "Well, why would you give it away? How are you going to monetize it?" We don't license on a seat. Companies that license on a seat have no other way but to increase the seat price to monetize AI.
So companies that, you know, and I won't name, but some of our competitors, which I'm sure you've seen, will take the seat price, and they'll increase it by 40% or 50% or 60% because there's no other way to monetize it. We typically contract with our clients based on activity, based on volume.
So because most of our contracts are activity-based, GenAI should, if the client's getting the value, push more volume to the platform, which then would mean that we would get a bigger wallet share with those clients. So that's not something that we're hiding from our clients. They're very. That's very clear to them.
So we really are encouraging clients to leverage AI because that should move more workloads. And by the way, if it doesn't move more workloads, then the client's not getting value from GenAI, and they shouldn't pay for it. But if they move more workloads, they are getting more value, then we should have a revenue share, so to speak, from that, and that's how our contracts...
I think that's one of the very good question, but really what you have to layer back is that licensing, 'cause the second part of the question you asked, which is: How do we license? Our view is that the value of Pega is not limited to the number of users that you have. And quite frankly, if you think about it, our goal should be that the users drop, not increase. If someone deploys Pega, they should need less customer service reps.
Quite frankly, they should need none, right? The system should be able to interact with the consumers. So then you get into this complicated, well, what do you charge for a, you know, an interaction that involves no human interaction versus... So we've just kind of reverted back to that's not the way to generate value.
The way to manage value is what's the number of transactions that the system is actually running? And that's been... Our clients are very on board to that level of contracting. And as the client volume goes up, which means they're automating more transactions, then the commitments that they make to us go up, and our clients are completely aligned with that.
Versus the user model, where the client basically says: "Well, I bought 2,000 users, but I only use 1,200, so I don't want to pay for it." And you say: "I only want 1,200." Normally, the conversation is, "Well, if you only buy 1,200, your price has to go up." It's kind of a... It really makes clients have to buy more than they need, and they feel very frustrated with that.
Yeah.
You'll hear that about the licensing models from of other vendors.
Yep. Okay. That, that's super clear. I do want to ask about, you know, a lot of, lot of talk about GenAI, but when do you believe that maybe starts impacting the pipeline? You know, when do you think that's going to start impacting kind of ACV growth, right? That's a pretty important metric for Pega. So maybe some context there.
I don't think we'll see anything in 2023. I think the first part of 2024, I think there's probably a chance that you start to get some momentum from that. I think when we get further into the beginning of 2024, I think we'll have better visibility of that.
Yeah.
We don't see a downside from it in terms of the, the amount of transactions that go through our platform. The question just is: How much upside is there? I think we're still trying to figure that out. So we are, we are optimistic that it will drive more automated, you know, straight-through processing, so to speak, transactions. But it will also do two other things for us. It will speed up the amount of time that it takes to start a new application-
Yeah
... and that will then move more workloads on. So we're very optimistic about that, and it will reduce the upfront implementation costs. It should make it so that if you're designing, building, or improving an application, much of that work should be able to be done leveraging, you know, some levels of AI, and so that should reduce... And the more that you reduce the time to value, the time to production, the cost to change, I mean, that's all, that's all accretive to the amount that we should receive in licensed revenue-
Yeah
... or cloud revenue.
Yep. I did want to quickly ask about Launchpad. I think it's been about a year since Pega announced that, and so just curious on kind of early customer testing, how that's progressing, and-
Yep
... you know, if possible, maybe frame kind of the opportunity. Like, is this incremental to your long-term kind of targets? How do we think about the incremental kind of opportunity?
So Launchpad, so for those of you that don't know, Launchpad is our multi-tenant version of Pega that is being delivered through ISVs, partners, or other software companies. So we are essentially licensing our platform to other companies so that they can sell workloads to their ultimate clients. So an example would be, I use this example because it's a simple one, Boston Scientific sells equipment to hospitals.
They want to actually sell a subscription service that those hospitals can use to manage, you know, charging of their clients, consumable things, but they don't have it. They're not a software company, neither is Boston Scientific necessarily, so they go and they leverage the platform. In that model, Pega is not selling in the traditional way.
We are actually supporting the ultimate client that would sell and leverage our platform, and we get a revenue share. That's Launchpad. We have Launchpad was GA in early part of this year. We've got our kind of our first cohort of service providers that would manage that.
We've got, you know, kind of in the kind of under 10 number, and we we do have some commitments from it. Any any activity from Launchpad is currently not factored into any of the numbers that we've talked about in our guidance or any of our long-term plans. So we feel like, we feel like we didn't want to put a number on what that opportunity is until we had a better idea of what's there.
I think so far, I'm very excited about the feedback that we're getting from the companies that are actually building, and some of the names of the companies that are actually in that first cohort are pretty names that you would, yeah, we'd be pretty happy to have in that group.
I did also want to ask a demand question.
Sure.
Maybe just an update. Like, most of you know, most of your net new ACVs from the existing customer base.
Yes.
And so just curious, kind of what, you know, what the appetite is, you know, for to undergo some of these larger kind of projects. Anything you can kind of share in terms of kind of the incremental macro?
Sure. So our growth, our growth comes primarily from two different mechanisms. One is clients pushing more workloads to the applications that they've already purchased, and new workloads. So if we just make it simple and call it those two. Activity and volume increases with existing workloads, I would say, is relatively unfazed from-
Mm
... you know, the economic climate that we're in. You know, naturally, there might be slightly less transactions than there would otherwise be, but I would say that's less of an impact. Net new workloads, I think that we've definitely seen enterprise buyers be, you know, a little bit more skeptical with scrutinize-
Mm-hmm
... and more pressure and maybe even a little bit more discerning in terms of starting and engaging in those new projects. And I think that's relatively consistent with what we've heard from Gartner and Forrester and lots of our partners, and many of our competitors have said something similar.
What I can't put a direct... I can tell you that there's a connection, I just don't know how material it is, is the AI connection. So I think AI has had a little bit of a freezing effect on spend in the enterprise space. It, you know, temporarily, but it's because people are, like, kind of so distracted, I would say, with AI.
In some good, some bad, where they're really trying to do, you know, set up these test pilots and really trying to figure out what AI even is for them. But I do think that's kind of pushed a little bit on some of the normal projects they would have done. Now, whether that will just rebound, and they'll start those projects in Q3 or Q4, Q1 or Q2, like, that's. I would say that's TBD.
Mm.
Because I just don't know, I don't know how long this AI hype will continue. But I definitely don't think it's going to shut down those projects because AI is not a replacement for those. But it, that- so that's a part of it. Some of it's been the economic climate, definitely is less... It's more, I would say it's more skeptical in enterprise buyers now than it was a year ago. And couple that with a little bit of the AI risk, and we're seeing that, and we're feeling that.
Yeah. So Pega recently announced a restructuring of the workforce. I believe that 4% of overall headcount was impacted. So maybe just walk through the changes-
Yep
... in general, and then in particular, kind of, you know, the go-to-market sales organization, what's changed and, you know, how do you see that kind of headcount growth evolving?
So I'll start quickly with about five years ago, when we started the subscription transition, we said that when we exited the subscription transition, we were going to see a, you know, a pretty radical inflection of free cash flow and, and margin improvement. We have begun to see that. We also said that we are committed to Rule 40, and if we see that the sales capacity that we've invested in the business is not yielding the return, we will calibrate that.
At the beginning of the year, in December, we actually did a, an action of similar size to what we just did, and that was really to align our organization focus, meaning the clients that we were covering and targeting, and making sure that we really rationalize that to being focused on existing clients.
Not exclusively, but materially on existing clients, because that's where we get our growth anyway. This most recent one was really a connected but follow-on to that process, which was really around looking at the role clarity and the complete capacity that we have covering more organizations, and making sure that they were closer to the client, that there was not the overlay, a specialist, things that were not kind of primary quota carrier or directly connected to primary quota carriers.
So this was not a surprise to us. We had planned on phase 1, phase 2. And July, in our, when we released earnings, I even mentioned in my prepared remarks, and in, and I think it was even in the quote in the earnings release, that this was coming. So it was not a surprise to our management team, et cetera.
So now what we have is, we basically have made significant progress in addition to the progress we already made, to set ourselves up to, you know, be on, be on track to be a Rule 40 company in the near- very near future.
Yeah. So maybe, to follow up on that, wanted to talk about free cash flow.
Sure.
So the first half of the year was pretty strong. I think you delivered $123 million in free cash flow. And in your June Analyst day session, you increased guidance from $150 million to $180 million. So maybe just walk through kind of the strength there you're seeing on the free cash flow side. I know it's been a 5-year journey to, you know, get here, so just walk through maybe the levers there.
Sure. I mean, well, so our profitability levers were, you know, very, very kind of, you know, connected to the free cash flow improvement, which was we wanted to get our gross margins up. We wanted to maintain, you know, G&A and R&D as being a, you know, a significant amount of investment, but a reducing percentage of revenue.
We wanted to make sure our professional services grew at a slower pace than our overall growth, and we wanted to really focus on the sales optimization. And what you've seen is, originally, we were trying to get Pega Cloud gross margins to 70%, then we changed it to 75. Now we're targeting 80. We're at, you know, we're approaching 75% already this year. So I think we've, I would say we've... I don't want to say I checked the box.
I would say good progress there. We've maintained our R&D and G&A. Our professional services come down as a mix of total revenue. Really, the thing that we've been really working hard on is the sales productivity which we're not there yet, right? And we still have work there. But what that's all done is that's actually been the recipe for us having such a strong free cash flow start to the year and really sets us up.
I mean, you know, our free cash flow of, you know, the, of the, even the $180 that we guided is, you know, is a reasonably big improvement over last year, but still nowhere near where the business has the potential to be. Like, we should, you know, we at steady state, we should have margins much higher than even what that would, you know, as a percentage, what that would indicate. So I think we're on our journey. I think we've made good progress.
I think, you know, probably people want to see us continue to do that. B efore it becomes something where you really kind of believe it's something that's anchored. But, we're very committed to it, and I think you've seen it in our results, and I think you've seen it in the actions that we've taken, and I think we've got a lot of operating leverage in a business of like ours to get margins even higher.
Yeah. You know, the $180 million guidance of free cash flow, I mean, I think you're running, based on historical seasonality, you're probably running ahead of target on that. So just curious, is there, you know, further upside there, or is there anything we should know about kind of the seasonality, you know, throughout the year?
So the one thing, the one thing that's different about how we thought about guiding on that number is. And I didn't mean to be cute with my wording on this, but we said at least 150 and at least 180. So we really created a floor-
Yeah
And said, like, "We will at least get there." Now, does that mean it's 180, 181, or does that mean it's something different? I mean, naturally, we want it to be as high as possible. The other thing is that we are not doing anything unusual with our free cash flow in this year that would be repeated. Like, we're not going out and telling clients, "Hey, we'll give you a 5% discount if you pay us everything this year." Right? Because that's not.
That serves no purpose, right? If we can't actually make this sustainable and embedded in the company. So there's nothing unusual. Like, if you look at our. We look at a metric called Days Billed Outstanding, which is the amount of time that it takes to collect from the date an invoice is sent. If you look at that, that metric, it's been pretty much the same for the last three years.
Mm-hmm.
So we're not squeezing anything, and we're not delaying vendors either, right? It's not... You know, we're not changing the way we pay commissions. So there's nothing that we're doing that would be a one-time thing. So I'm optimistic. I mean, naturally, being at 123 through 6 months is, you know, that's where you want to be. The question is just, you know, how fast can we get to a real, good, steady state number that's, you know, much higher than where we are now?
Yeah. So, the other part of the Rule of 40 equation is top line, right? So moving to ACV, which I know is a pretty important metric-
Yeah
... key metric at Pega. Maybe just to start, because this has come up a few times. I guess, you know, typically, I think Q1 to Q2, you saw a little bit of a dip sequentially.
Mm-hmm.
So, maybe just walk through kind of the puts and takes there. That's not- you don't typically see that. So, maybe that's part of one of the ACV questions.
Sure. So what happened... If, if you would, if you would have just looked at the end of Q2, we probably wouldn't be having this, you know, this, this curiosity, you know, because the... And it's totally valid, right? Which is, if we would've just said, "You're gonna be a 13% constant currency grower at the end of the midyear period," which is kind of what we ended the- I think everyone would have said, "Well, that's right in line with what you thought for the year." Because Q1 was kind of an outsized growth and kind of, you know, admittedly shocked people, I think, and probably surprised us a little bit, Q2 is kind of a- it was a little bit of a contrary to the Q1.
And so what happened in Q2 was a combination of, you know, a handful of anomaly things, like, you know, the timing of when renewals are, the timing of some of our consumption, kind of resetting. We actually had a little bit of churn in Q2, which typically we do have churn through the course of the year.
It's not significant, but it typically doesn't happen in a linear fashion. It kind of happens when it happens. So we had these. And quite frankly, when you have a Q1 that added that much ACV, invariably, you probably stole some deals. Either deals slip from one quarter, or you sometimes pull them in. So I think that there is kind of a reality of that being a factor.
So, I think, you know, we're focused on, you know, our ACV growth. We think that 2023, you know, 2023, and then the beginning of 2024, we think is kind of like a growth trough, right? A little bit of that is, you know, a distraction to our sales team and the changes that we made. A little bit of that is the, you know, the general economic climate.
A little bit of that is just other things that we've been dealing with as distractions. And I think that, you know, we've kind of built the business around assuming that that growth rate wouldn't be as strong as it has been in other years. I don't think that changes anything around the growth prospects, right?
You know, the market growth rates admittedly have slowed for all of the, you know, for pretty much everybody in tech, but I think there's a tremendous amount of opportunity for us, even just with our 100 or 200 largest clients.
Yeah.
Just, there's. As I mentioned before, I think all of them could be spending orders of magnitude more than they're spending now.
So maybe continuing on that thread, you've put long-term targets out.
Yep
... around, you know, ACV, I think around kind of mid-teens, 13%-14% over the next 3-5 years.
Yep.
So maybe just, you know, contextualize kind of the assumptions, you know, that you're using to kind of, you know, forecast that. Is that mostly existing customers? You know, do you expect macro to ease a bit? Just, you know, some color around the longer term targets.
Yeah, great, great question. So, we're assuming that, retention rates stay largely the same, gross retention rates. That CPI or kind of inflation stays somewhere in that 3%-5% range, right? We don't-- we're not assuming a 7%, 8%, 9%. We're also not assuming we go back to one or two.
We're assuming that, we get the majority of our growth from our existing clients, which majority for us is we're talking 85%, 90% of our growth comes from existing clients, but that we will get some new logos. You know, probably, you know, I'm saying handful, it's probably more like, you know, 10-25 new logos a year.
But those logos may not be big dollar contributors, but they'll create some fertile ground for continuing to grow. We are assuming that the economic climate is, you know, not... I wouldn't say boom times, but I would say slightly improved over what we're seeing in 2023.
Yeah. Any questions from the audience?
Hey, how's it going? Alex, say hi as well from Luxor. Yeah, I guess the only question that I had, I know, you know, it's a topical conversation right now in software. Generally speaking, just stock-based compensation. And a lot of investors, I think, are thinking about free cash flow and SPC in tandem.
So I think you guys have done a great job at not letting that sort of balloon out of control in terms of the sequential year comparisons. But I just wanted to ask that question, is how, how should investors expect that line item, just overall, to grow over the next, you know, 2-3 years as you guys approach that $500 million free cash flow target that you set out there in the Investor Day?
So yeah. So right now, our, our, you know, our Stock-Based Compensation is probably order of magnitude, like 10% of revenue or something like that, 10%-11%, which is lower than our- lower than some of our peers. That's not to say that that's the right number. It's just, you know, it's, it's not... I would say it's not out of control, but, I would, I would anticipate that that percentage should not go up.
And the only, the only difference with us is that we have, we have a, a potential up or down side on dilution because we give 50% of our grants as options. So naturally, many of the... The accounting is one thing, but the actual dilution is another. The accounting is kind of my first point of thinking about that low, you know, 10, 11, 12% is probably a reasonable kind of peg for the future.
But to be honest with you, you know, we have to be realistic about that as a percentage of market cap, and the shares dilution as a percentage of market cap, because, you know, our market cap is much lower now than it was a few years ago, and we have to be really thoughtful about the dilution impact to shareholders that, you know, that we, you know, we work for. The one thing that I would say is our leveraging of options does help us with that, because naturally, you know, our employees only benefit if shareholders benefit over longer periods of time.
So, we are very conscious of that. We're also very conscious of the overall dilution and flow. One thing that helps us a little bit is the new calculations that Glass Lewis and ISS do now, which is they never – they only looked at your shares outstanding. We really got hit hard on dilution versus the in-the-money on the option.
So that'll actually help us, because when you actually look at the new calculation from a dilution and overhang, we'll look much better than we did. One last point. Last year was a little bit of an anomaly year. With the stock – we had the stock price drop, we had the Appian litigation.
We really wanted to make sure we didn't have retention risks with some of our employees, and so many of their grants were underwater, that we did a special option grant in November as a retention tool. That was unusual, and that would not be something... You know, we're not doing that this year, for example. So that was a, so last year has a little bit of an anomaly to it. Yep. Which, by the way, will carry for a few years as those vest.
Yeah.
Yep, yep.
Let me kind of last question here, but to close things off, you've set a free cash flow target of $500 million over the next 3-5 years. So you've kind of touched on it a little bit, but maybe just to summarize, you know, the key levers, you know, level of confidence you have in kind of achieving that goal.
So this is very high level, but if we're a $2 billion company and we have 25% free cash flow, that's $500 billion. You know, that's just the-- You know, just kind of think about that framework. In order to get to that, we really need gross margins to be approaching 80%, and we need R&D and G&A to not be any higher as a percent of revenue than they are now. We don't need to, we don't need to have them dramatically reduced, but they need to kind of stay in line, and then the big lever is sales.
I think that what I said before is we are very committed to that model, and I think we've made, you know, a surprising amount of progress, and quite frankly, progress that you can't really even see yet, because you have to see the quarters kind of play out to see some of the changes that we've made. But I'm very optimistic. We're very committed to it. I'm very optimistic on getting to that.
The question just is, this, the trade-off between sales productivity and growth opportunity and sales capacity is a tricky one, right? It is one that we just have to make sure that we don't... You know, you can't cut your way to prosperity, but you also can't accept, you know, inefficient selling at some level. That's the, that's the one that we just have to really work hard at calibrating.
Yeah. Well, I think we're out of time. Thank you, everyone. Ken, thanks. Thanks a lot for joining us.