SaaS and subscription business models are increasingly more pervasive each day. Benefits and conveniences are high for customers: they subscribe to a cloud-based service that is updated and maintained for them. Netflix or Office 365 are SaaS, as are subscription-based physical services such as BirchBox or Dollar Shave Club.
But the accounting and analysis can get a little hairy, making a SaaS plane a little trickier to fly. When your billing, customer payments and product delivery don’t hit at the same time, you have complexity that can have complex impacts on revenue, cash flow and profitability.
As CEO, you need to look at multiple metrics to understand what is really going on. You need to know what numbers reflect healthy company growth versus vanity metrics or problems or unimportant differences. Here are four.
1. Bookings: Contracting the Deal
A booking is recorded when a customer contracts to buy your services. Let’s say your new customer XYZ signs up for a subscription. You enticed them in the door with a reduced-rate $75 monthly subscription for the first 12 months if they agreed to commit to the full year.
So XYZ signs a one-year contract, but only is charged for the first month. When XYZ signed the agreement, you sold, or contracted, $75 a month times 12, or $900 of overall value, a booking for $900.
A booking is the total contract value of a sale. As a metric, bookings tells you about your sales activity or productivity, the results of your salespeople closing new deals. But bookings are not the complete economic activity of your organization, since you haven’t delivered anything or earned that money yet. Thus, it’s an important metric that contributes to the overall growth picture of the company.
That said, bookings is not an accounting term per se. The accounting system usually only tracks the revenue component, the $75 in this case. Many companies capture the $900 booking in a CRM or other transaction system. You may need to gather metrics from multiple data sources with strong control processes to ensure accuracy.
2. Billings: The Link to Cash
The timing of billings can add more layers of complexity. Billings to a customer can be timed completely independently of either bookings or when the revenue is earned. Or billings can hit month-to-month and be perfectly aligned with revenue, for instance in simple B2C subscription businesses like Dollar Shave Club.
As a B2B SaaS example, we have a client that just booked a 3-year, $3 million contract. The contract states that the client will be billed on a quarterly basis (in advance). At the contract signing, then, a $250,000 invoice is sent out for the first quarter’s SaaS right after contract closing. From a revenue perspective, this is earned (typically ratably) on a monthly basis. In this case, bookings, billings and revenue figures are all unique.
The critical component to understanding billings versus revenue clearly is that, in modeling out the business’s financial forecast, it’s utterly important to make sure you’re modeling cash from billings and not revenue because you can run/grow the business only with cash! Prepaid pricing models can vastly alter the working capital needs of a company!
3. Revenue: Funds are Earned
The third major leg in this stool is revenue. With bookings telling you when value is created, and billings being the link to cash for the business, then revenue is the marker of the economic “earnings” of the business. The product or service has been delivered or work has been performed.
There are plenty of additional revenue recognition details beyond the scope of this post. We could delve for days into the complexities of the subject matter. It’s important to note that requiring revenue to be earned is an accrual accounting definition. We almost always recommend accrual accounting for our early-stage SaaS and subscription clients, because accrual-based revenue provides a much stronger ability to analyze the true profitability of the business as it grows and scales.
To Fly Your Plane Well, Watch All these Dials
Anyone in SaaS needs to analyze all three of these numbers at the same time. As CEO, you are like a pilot. You’re looking at air speed and altitude. What’s the axis of a plane and is it rising or dipping? Is it to the side? What’s your vertical speed? If you’re going up, how fast? If the runway is 5 miles away and you’re going 100 miles an hour, what do you need to do to hit it? Because it would really suck if you get to the start of the runway and you’re still 2,000 feet in the air.
Much as speed, vertical speed and altitude all work in concert, so do bookings, revenue and billing. The runway you need to hit is the financial targets like cash flow that keep you operating. You need a plan, and you need to watch your numbers.
You could easily juice bookings by saying, “Hey sales team, let’s reduce our prices by 25%.” Bookings would jump, but that doesn’t mean the business is doing better. It just means the sales team was more productive or active, closing more contracts. But that jump in bookings will impact billings and revenue down the line.
You may have really strong bookings, but your billings and your revenue may show you that you’re actually in trouble. As you’re flying this corporate startup or early-stage growth company plane, keeping them all in front of you is a very good idea.
Side Note: On Which Number Do You Base Your Sales Commission Plan?
Sales commission plans can be developed based on a variety of numbers: bookings, billings, cash collection or revenue. There’s no overall right answer, just what’s right for your company.
In developing your sales plan, you need to understand how your sales force is paid out and how that will affect your financial model. If it’s based on bookings rather than revenue, more cash will go out the door sooner. Your cash flow timing will be much more negative because you have not been paid yet.
All these factors are important to understand in your modeling, in terms of cash flow forecasting and planning.
4. Deferred Revenue = Future Revenue
One more point. Let’s say your customer pays for a year’s service in advance. They write you a check for $1.2 million for one year, and you’ve earned $100,000 this month. The remaining $1.1 million that you haven’t earned yet is called deferred revenue. That’s actually a liability. The money is in the bank but you haven’t earned it and can’t book it as revenue.
As a solid accounting practice, you also account for deferred revenue. If it’s a substantial amount, deferred revenue should be one of those balance sheet accounts that you continually roll forward and know exactly why it has the balance it has (aka—reconcile it monthly).
Taking this step avoids serious trouble. We took on a client once with about $10 million in revenue, but they were not tracking their deferred revenue. It wasn’t being reconciled, and, as it turned out, it wasn’t accurate. As a result, the company had erred in their cash flow projections. This was a growth company that was not cash flow positive yet. We had to be the bearers of bad news to that CEO and board, saying: “You’re going to run out of cash six months sooner than you thought, because your accountant was not accurately tracking the deferred revenue balance.”
Tracking these four factors accurately is important.