Five Reasons Why Box's Big Spending Will Continue - And Why That's OK

David Paul Morris/Bloomberg via Getty ImagesBox CEO Aaron LevieBox has finally started trading on the public market Friday and things are looking good. On its first day of trading, Box is up more than $9, showing an impressive first day pop of nearly 70%.

It's been a tumultuous past year for Box after delaying its IPO for nearly 10 months. Critics especially pounded on its high sales and marketing costs, which at one point was higher than its total revenue.

But as warned in its S1, Box "does not expect to be profitable for the foreseeable future." Box plans to keep spending until it reaches scale.

And if today's big market debut is of any indication, the market seems to be OK with Box's long-term strategy. The company is now worth almost $2.9 billion, higher than at any point in their pre-IPO days. This should serve as somewhat of a victory for Box CEO Aaron Levie and his management team.

But there still seem to be a lot of question marks surrounding Box's sales and marketing costs, so we've put together five reasons why Box will not cut spending any time soon, and why that actually makes sense for the company:

Business is growing: Box had $153.8 million in revenue in the first nine months of 2014, a healthy 80% growth from the previous year. That, of course, came at the expense of spending $152.4 million in sales and marketing. But it's important to note that in a subscription model, sales expense gets recognized immediately while revenue only gets recognized when the service is actually delivered. In other words, the current revenue doesn't fully represent what current sales expense is going to generate down the road.

A more accurate measure for cloud companies is something called annual recurring revenue (ARR), which is the value of the total subscription contracts expected to recur for the next 12 months. Box claims its ARR stands at $225 million.

Users are staying and revenue will compound: Subscription models become high margin businesses once users start renewing contracts. And Box is proving to be a "sticky" product, meaning customers tend to stay as long term users. It has a 130% retention rate (net of churn), which means most of its existing customers are renewing their contracts, and on top of that, they're spending another 30% on upgrades and other features. So if Box had $1,000 sales in year one, those same customers will spend $1,300 the next year, and $1,690 in the third year. That means Box could shut down its sales and marketing now and be profitable - at the expense of growth.

"If people were actively replacing Box, those numbers would decline. But that's not happening, and that's an indication that the product is stickier than people may think," Battery Ventures' Roger Lee told us. (Battery was not an investor in Box.)

Enterprise sales cycles are long: Box is going after big enterprise customers, which take much longer to acquire than small businesses or consumers. As noted in its roadshow video, Box spent nearly four years to sign up 15,000 users at Bechtel, one of the largest construction companies in the world. It's because Box usually starts out with a small number of users and then gradually increases the number of renewing seats. But once you get to scale, again, Box doesn't have to spend a dime to generate sales from them, as their contracts would just renew.

"Typical sales cycles are 18 to 24 months (for the enterprise). But when you do close those deals, you're closing 10,000 or 100,000 seat licenses - and they're multi-million dollar, yearly contracts," Social+Capital founder Chamath Palihapitiya told us in an interview.

Storage and collaboration is a competitive market: Box is in a highly competitive market where it needs to fight big companies like IBM, EMC, and Microsoft, and upstarts like Dropbox for market share. That's what's causing them to spend so much upfront, as Levie told us in an interview, "The scale of the competition is far greater, which means we have to have a significant level of investment in our product or technology or sales and marketing to be able to actually go out into the market." But the return has been pretty good, too, as Box signed up 48% of Fortune 500 companies as paying customers, including General Electric, Eli Lilly, and Toyota. And with such a high retention rate, the financials are only going to get better.

Box has been trying to differentiate itself by creating a storage platform where collaboration, workflow, and security all happen in one place. It's too early to tell if this strategy is working, but prominent cloud investor Jason Lemkin writes, you become a "true platform" once you get to $100 million in ARR. Box is at $225 million ARR and has more than 1,300 apps built on top of it, so things aren't looking too bad.

We're in a "once in a life-time" market transition period: Levie told CNBC Friday morning, "We're in one of these 'once in a lifetime transitions.'" All of these cloud software companies are investing a lot to displace legacy software makers that once dominated the multi-billion dollar enterprise software market. It's why companies like Salesforce still remain unprofitable, even after going public in 2004. In fact, Salesforce has grown its sales and marketing cost every year, and it still accounts for more than half of its total revenue.

Tien Tzuo, an early Salesforce employee who now runs a subscription management software, tells us, "In the new, modern enterprise, cloud companies are only scratching the surface." According to Salesforce CEO Marc Benioff, 90% of enterprise software is bought in just seven countries, meaning there's still a huge untapped market for these companies.

Roger Lee of Battery Ventures adds: "These opportunities come up pretty infrequently, and when they do, you want to spend into it at the front end to ensure market share. Once you have market share, that creates a lot of long term profitability and equity value."

Now, the big hanging question is: "How do you guarantee users will continue to renew contracts and stay with Box?" As in any business, it's impossible to guarantee any future business performance, but based on historical numbers, like its retention rate that has consistently stayed at or above 130% over the past three to four years, it's fair to say users like Box's product. And most importantly, keeping that good customer relationship is what Box will have to work on moving forward.

"You can't guarantee it, but that's the work," Tzuo says. "How does Salesforce guarantee their customers will recur? How does Uber know you'll continue to use Uber? They're working for it, and they're going to earn their business every day."