SaaS revenue recognition is critical to understanding, managing and valuing the business. Rev rec must be timely, accurate, consistent and auditable in order to be reliable as a management tool. Strategically, deferred revenue has sizable implications on how cash in the business is managed and invested. This is a CEO’s look at revenue recognition, not a CPA’s look at GAAP.
When SaaS people talk revenue recognition, they mean counting the revenue in the period that it was actually earned. It’s important to emphasize that this is a revenue—not cash or billings metric. Whether or not revenue has been collected is of consequence primarily when assessing deferred revenue on the balance sheet. I will however look quite a bit at the cash implications, since so many SaaS contracts are annual, billed and paid in advance.
Winning a Contract and a Liability
The moment you close-win a recurring revenue contract, it’s a liability—100% deferred revenue. Why? Because you haven’t done any of the work yet. It’s unearned. You begin to earn that revenue following the deployment of your software. So the moment you close-win a deal, you technically book the entire thing as a deferred revenue liability on your balance sheet. Then, periodically following deployment of your software, you move a portion of that deferred revenue liability into earned revenue. The granularity and accuracy of the transition from deferred revenue to earned revenue comes down to the method or revenue management tools you have at your disposal.
Revenue Recognition Tools
I’ve implemented several methods of revenue recognition over the years. Before there were savvy tools developed to deal with the complexities of subscription rev rec, the method was spreadsheets. Holy sheet that was painful (sorry). Billing bookkeepers would book contracts and manually divvy them out across earned revenue period columns (by month) and then book those totals back to the accounting system each period. That’s fine when you have ten customers, but when you have a thousand, you need a better way (or a steady stream of plumbers to clean your hair out of your drains).
Spreadsheets are cheap to get rolling and fine at very small scale. But, they’re labor intensive, unscalable, subject to inaccuracies and untimely in surfacing management data.
The next wave of revenue management came from dedicated billing tools that sat outside of the financial accounting package, but billed, tracked and applied earned revenue. These tools are good in that they’re purpose-built for the task of billing and applying rev rec templates. They’re challenging because they live outside of financial management and are likely to introduce latency into the management-critical accounts receivable, earned revenue and deferred revenue balances (often monthly updates). On top of that, the relationship between systems is a complex one that requires an integration that can be fragile or even volatile.
Billing systems are nice in that they bolt on top of existing financial accounting systems. They are less laborious than spreadsheets, much more scalable and less likely to have inaccuracies as they are single entry. But, the relationships to the rest of the organization can be fragile and the timeliness of management data is often delayed.
Integrated Financial Accounting Systems
The most mature and accurate method of revenue recognition is fully integrated modern financial accounting packages. These end-to-end tools get granular with daily recognition, accurately pulled back into financial statements and timely management dashboards. These enterprise-level tools also accommodate common rev rec complexities like: first month free, discounts and services attached. Again, this is a CEO’s look at rev rec, not an accountant’s look, but I will say to have your CPAs involved in your rev rec template design if you want to be GAAP compliant and/or auditable for valuation. Your quality of revenue will take a hit if these ducks aren’t lined up.
Integrated financial accounting systems including complex billing and rev rec are by far the most accurate, scalable and timely solutions. But, they are costly, take time to implement and most significantly, they introduce the extreme switching cost of financial accounting migration.
Capital, Management and Valuation Implications
Using whatever method you choose—with granularity and reporting as accurately as possible—you have capital and cash flow considerations. Aside from the way deferred revenue is booked, it’s often invested and consumed as working capital in growing SaaS businesses—often spent in advance of being earned. This is fine, as long as the flow of contracts being pre-paid continues at a predictable pace. If that pace slows, the cash flow slows.
If cash reserves (in the form of deferred revenue) have been spent, you can find yourself in a negative cash flow situation chasing deals. The moral there is not to fall into a trance where you assume that your borrowed cash flow (deferred revenue) will continue to flow—or at least give yourself a buffer to allow for volatility. What you don’t want is to trap yourself strategically because of cash mismanagement around deferred revenue. You need to keep yourself in a position to make decisions that have short-term negative impact on contracts without crippling cash.
Deferred Revenue will be Deducted from Your Valuation
There are valuation considerations here on top of cash management/balance sheet ones. Deferred revenue is a real liability that will be deducted from your valuation. If you’ve consumed all of that pre-paid cash to grow the business, then you have something to show for it and it should all balance out in the end—despite being missing from your bank balance. But, if somehow you’ve squandered that cash and have little in the business to show for it, you will likely take a big hit, so invest that borrowed capital wisely.
One thing to consider on the valuation side is how deferred revenue actually gets counted against the business. While your liability is technically whatever is in that deferred revenue account, that’s not actually what it’s going to cost the business to deliver that revenue. Cost to deliver is your above-the-line percentage. If you have $1M in deferred revenue and your gross profit is 80%, your cost to deliver $1M in deferred revenue is 20% of that or $200k. Again, how that will come into play depends on a lot of variables, but it’s still something I keep in mind.
Scalable, Consistent and Predictable Processes
Avoiding the pitfalls of revenue recognition starts with establishing scalable, documented processes and systems. Each time a new precedent is set for how a specific type of booking is recognized, it should be documented with both the ‘how’ and the ‘why’. This running list of institutional knowledge helps ensure that situations are handled consistently and predictably—two words that will be welcomed when you review or audit your rev rec in a diligence process. Considering how critical revenue recognition is in determining value for a SaaS, you can bet that your next round, or your buyer, will dig deep, get specific and penalize for missteps. Avoid rev wreck and all will be well.
For a dash of perspective and context, please watch my related video.