Important Changes in Revenue and Profitability Definitions for SaaS Companies

October 28, 2017

Starting in January, public software companies will report their financials using ASC 606. Normally, accounting changes are not that interesting, but ASC 606 will change several of the key attributes and benchmarks SaaS startups use. The two most important changes are changes to revenue and profitability.

Today, all software revenue is recognized ratably over the contract period. If a business finds a 12 month contract for $12,000, the company record $1000 of revenue for each month. Under ASC 606, hosted revenue recognition doesn’t change.

But if the software is run on the customer’s servers, sometimes called an on-premises deployment, the entire revenue value of the contract is recognized immediately, not over the life of the contract. The same is true for renewals. Before, new bookings translated smoothly into revenue, but with the new guidelines, revenue can become quite lumpy.

Imagine a $10M ARR company that books a $1M recurring on-premises account in Q1. That $1M bookings and revenue must be recognized entirely in Q1. If the company books $2M of hosted business in Q2, revenue would fall from $3.5M ($2.5M in hosted recurring revenue plus $1M in on-prem) in Q1 to $3.0 in Q2 ($2.5M in hosted recurring revenue plus $0.5M in new hosted recurring revenue).

MetricQ1Q2
On-Prem Bookings, $M1.00
Hosted Bookings, $M02.0
ARR, $M11.013.0
Revenue, $M3.53

For companies that sell significant amounts of on premises software, this accounting change has the potential to introduce a substantial fluctuation in revenue accounting. Revenue is now less clear a metric of execution predictability than it was previously. In order to understand what’s going on underneath the covers, an investor or analyst examining a business will need to understand bookings by type: hosted or on-premises.

The second major change for software companies from ASC 606 is profitability. Public companies will instantly become more profitable starting in 2018.

Today, incremental sales are accounted for in the quarter in which they are spent. So if sales commissions cost $1M this quarter, the P&L will show $1M in sales commissions. Starting in 2018, sales commissions will be amortized over the life of the contract.

That $1M spent in Q1 will appear as $0.25M in commission costs. This change immediately changes two figures. First, profitability. Net income will increase markedly each quarter and may push many SaaS companies from a median -10% net income to a figure much closer to zero. Management teams then face a question: continue to operate at higher profitability, or invest even more in sales, and remain at -10% net income margin?

Second, sales efficiency can no longer be calculated using the P&L, or the benchmark will change, since the quarterly S&M expense has changed.

ASC 606 is complicated and will change many other aspects of revenue recognition including utility based pricing, discounting contracts for volumes, and many other attributes. When these changes do take effect, sales and finance teams must work even closer together to ensure contracts are structured properly and don’t introduce undesirable variances in revenue recognition.

While public companies must move to this new standard starting in 2018, private companies must move in 2019. With this change, many key metrics and benchmarks will change, as will internal operational practices.

I am not an accountant. Consult your accountant for advice about ASC 606.

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