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Zoom, one of the most anticipated tech IPOs of the year, has one key profit driver: engineers in China

Key Points
  • One key driver for Zoom’s profitability is its large engineering team in China, where average tech salary is relatively lower than in the U.S.
  • “Our product development team is largely based in China, where personnel costs are less expensive than in many other jurisdictions,” Zoom wrote in a regulatory filing.
  • Zoom spent $33 million on R&D, or just 10 percent of total revenue, which is a much smaller share than other business software makers.
Zoom Video Communications CEO Eric Yuan.
Courtesy of Zoom VIdeo Communications

Unlike most tech companies preparing to go public, video-conferencing startup Zoom is profitable. One key driver of Zoom's profitability: a large engineering team in China, where average tech salary is relatively lower than in the U.S.

Zoom's large R&D presence in China, which is likely made easier by CEO Eric Yuan's Chinese background, is turning out to be a major cost saver for the video-conference software maker — and reflects an increasingly popular strategy among fast-growth tech companies.

Zoom disclosed in its IPO prospectus last week that most of its product development personnel are based in China. Zoom employs over 500 people across multiple R&D centers in China, which accounts for roughly 30 percent of its total workforce and 70 percent of its non-US-based employees, according to the prospectus.

"Our product development team is largely based in China, where personnel costs are less expensive than in many other jurisdictions," Zoom wrote in its filing. "If we had to relocate our product development team from China to another jurisdiction, we could experience, among other things, higher operating expenses, which would adversely impact our operating margins and harm our business."

In the fiscal year that ended Jan. 31, Zoom spent $33 million on R&D, or just 10 percent of total revenue. That's a much smaller share than other business software makers, and less than half the median R&D percentage of its peer group, according to Redpoint Ventures' Tomasz Tunguz. For example, Atlassian's development cost accounted for over 40 percent of its revenue, while smaller companies like Zendesk and Hubspot both spent over 20 percent of their revenues on R&D.

That helped Zoom record a net income of $7.6 million last year, even after spending more than half of its revenue on sales and marketing, like many young business software companies. Its revenue more than doubled to $330.5 million in the same period.

"One key driver of profitability is labor-market arbitrage," Tunguz wrote in a blog post about Zoom's financials.

Zoom's representative didn't immediately respond to a request for comment.

'Labor-market arbitrage'

Tunguz told CNBC in an email that labor arbitrage, or moving jobs to inexpensive regions, is a growing trend among tech companies. Many of his portfolio companies are now looking for talent everywhere and are more willing to hire remote engineers outside of Silicon Valley because of the cost advantage.

According to Glassdoor, entry level software engineers in China make roughly $34,350 per year on average, a third of what their U.S. counterpart would be making ($110,000 per year in San Jose).

Zuora CEO Tien Tzuo said the salary difference between Chinese and American developers has narrowed in recent years, as competition for technical talent in China has significantly grown with the rise of local tech giants, like Alibaba and Tencent. Still, he said hiring remote engineers is an important part of his company's strategy, and he now runs five international development sites for Zuora.

"Any company that's not looking at distributed engineering organizations is missing out," Tzuo said.

In Zoom's case, having a CEO of Chinese descent seems to help recruiting in the country. Zoom wrote in its prospectus that Yuan's role is "critical" to the management of its engineering and general operations in China, as he spent most of his early life in China, and earned his bachelor's and master's degrees there.

Despite its cost benefits, Zoom's presence in China could also pose a security risk going forward. Zoom mostly deals with business customers, who are much more sensitive about data privacy, and having most of its development team based in China could expose the company to increased scrutiny, the filing said.

"We have a high concentration of research and development personnel in China, which could expose us to market scrutiny regarding the integrity of our solution or data security features," Zoom wrote in its filing.