Why SaaS Revenue is Different
Every company’s CEO thinks they know what their sales revenue figure is. It’s what’s on the sales invoices, right? Wrong. And if you are running a SaaS (Software as a Service), company, that’s really wrong actually. SaaS revenue is simple to work out, but is different to what you might expect. This article outlines the basics of revenue recognition in a SaaS company, and why, as founder of a SaaS, you should even care.
Vanishing Sales Syndrome
When a SaaS company is in start-up phase, every sale is gratefully accepted. The founders self-fund, bootstrap and get investment from friends and family. It’s tough going, and they lurch from quarter to quarter until, hey presto, they’ve made it through a whole year. They’ve been keeping track of sales revenue on a spreadsheet and the bank balance too.
One day, they hire an accountant to do the numbers and file taxes. The founders get a surprise to discover that the sales revenue figure in the Profit and Loss Account is much less than what is on their spreadsheet. Assuming that both the founder and accountant have included all the invoices, how can this be?
Revenue: It’s About Time
Sales revenue, indeed all components in your accounts, is about time. If you say “Sales are $1 million”, in respect of a start-up, that sounds impressive. However, if you say “Sales are $1 million for the first 10 years” that’s not so impressive, running at an average of $100,000 per annum. Financial accounts are all about time. Accounts are prepared for specific time periods; monthly, quarterly and annually. A unit of time is what is used to compare and evaluate every company. Companies the world over produce accounts at least annually; it’s a basic reporting convention.
It follows that the accounts only contain income and expenses for the period of time to which the accounts relate. You wouldn’t put next year’s sales into this year’s accounts, would you? Yet it is a mistake easily made in a SaaS subscription model, if you are not clear about what you are selling and when.
SaaS – It’s About Subscriptions
SaaS companies commonly offer multiple pricing options. They might offer a monthly subscription fee, as well as options for an annual subscription and perhaps a two year price as well. These offers are based on a “the more you buy, the less you pay” premise. So, for example, if a SaaS company offers a monthly subscription of $25, they might offer an annual subscription at $250. This means that you get a year for the price of 10 months, or to look at it another way, you get two free months if you subscribe for a year.
When it comes to your accounts, it’s simple:
- All monthly subscriptions are for one month and can go straight into that month’s accounts.
- Annual subscriptions are for 12 months. Remember, it’s about time. So if a customer signs up for an annual subscription at $250, then that’s $20.83 per month for 12 months, (i.e. $250 divided by 12). So for each month, over the next year, you include one twelfth of that annual subscription in each month’s accounts.
Sales Revenue that is related to a future accounting period is “stored” in the balance sheet as “Deferred Revenue”. It is shown as a liability, because you have invoiced for a service you have not yet delivered. In effect, you “owe” that service to your customers. In future periods, this “Deferred Revenue” will be released to the Profit and Loss Account as you deliver the service. In other words, it’s “drip fed” in. It is only recognised as income over the lifetime of the subscription, not up front.
What About the Cash?
Some founders get confused about the SaaS subscription model. As they see it, they have raised a sales invoice and have been paid by the customer, (i.e. they have received the cash). They see this as an immediate sale. They think the invoice should be fully recognised immediately in the Profit and Loss Account. But this isn’t the case. Here’s why:-
- Invoices need to be allocated to specific time periods. If an invoice covers subscription services for more than one month, split the income between those months. This is the principle of revenue recognition for a SaaS – i.e. how you calculate when revenue, (sales), is recognised or allocated in your accounts. In the case above, that’s $20.83 per month for 12 months.
- The receipt of the cash is a separate transaction. It reduces the amount that your company is owed by your customers and increases your bank balance. It does not affect profit.
Why Should You Care?
SaaS founders care about increasing shareholder value. A higher company valuation will result in more money for shareholders on an exit sale. SaaS companies are valued as a multiple of Sales Revenue. If you record Revenues correctly from the outset, you will have a credible history to show investors, and have data upon which to build forecasts. Investors are interested in the future, not the past. But you need the past to present and forecast the future.
If you understand the basics of revenue recognition, you will find it easy to understand the other concepts that you need to master to effectively manage the value of your company.
Remember that for SaaS subscription revenue – it’s all about time.