Income is something that we all want to some extent. Income as defined by Investopedia, “Income is money that an individual or business receives in exchange for providing a good or service or through investing capital.” Businesses, no matter what kind, want income in order to pay off debts, in order to grow, and in order to pay employees. All businesses want more money coming in than going out. SaaS businesses are no different.
It’s hard to talk about income or revenue in regard to business without talking about accounts receivable.
You are probably familiar with that term, accounts receivable, or AR. Accounts receivable basically refers to when a company is owed money for a service or product that has already been delivered. Essentially, accounts receivable is like an IOU from a customer. When looking at a business ledger, accounts receivable are noted as assets, versus accounts payable—which are considered to be liabilities.
With accounts receivable, one thing to be aware of is the DSO or Days Sales Outstanding. The DSO measures the average number of days it takes a company to be paid. Usually when an invoice or bill is sent to a customer it specifies how many days the customer has to make a payment or pay the bill in full. As a business, you don’t want the DSO to be too high, because you that means your cash flow may drop, which can present problems. However, not allowing some leniency with your customers in regard to when they pay you could cause you to lose their business.
Overall, income, revenue, and accounts receivable seems pretty basic, right? With SaaS companies, things are a little bit different. When it comes to making money, here are three ways that SaaS companies differ:
Bookings and AR aren’t the same
A booking, simply put, is a customer signing up for your service. They are agreeing to spend money with you, but no service or product has been provided for them yet. It’s like making a reservation at a restaurant. The person has agreed to come, but they haven’t actually been given any food or drink yet.
Imagine that a hypothetical SaaS company charges $200/month for use of its software. A customer signs up for a year of service, which means that the booking for that customer is $2,400. However, since the customer has not yet been provided with the software yet, that $2,400 is not an asset nor is it revenue.
As a SaaS business, booking metrics are still important to look at even though they aren’t considered to be revenue just yet. They allow you to look ahead at revenue to come and also to examine how well you are getting customers as well as how well you are delivering your service.
Not all revenue is equal: recognized revenue versus deferred revenue
Revenue is income, right? It’s the money your business makes. While this is true, it is not that simple. Subscription businesses, such as SaaS companies, have to consider recognized revenue versus deferred revenue. Recognized revenue is the money that you can actually count as revenue. Revenue is recognized when the customer pays for the service AND the service is delivered. Money that is paid before a service is delivered is considered to be deferred revenue.
Remember that hypothetical company that charges $200/month we talked about above? When a customer books a 1-year contract with it, they may pay all $2,400 upfront. While this means the business now has $2,400, they cannot actually consider it as recognized revenue until the service is delivered to them. So, if the customer begins a contract in January and pays $2,400 for a year of service, you start off with $0 of recognized revenue and $2,400 of deferred revenue. As the software is delivered to the customer each month, the scale tips slowly as $200 is added to recognized revenue each month and taken away from deferred revenue.
Glenn Wisegarver warns SaaS companies of potential problems with deferred revenue in this article for Forbes. He advises that, “Management should continually revise its forward-looking forecast and model what-if scenarios to understand the range of outcomes.”
Things will dip before they get better
As with all businesses, customer acquisition is important. Without acquiring customers, there can be no revenue or any accounts receivable. Unlike traditional businesses, in SaaS companies, customer retention is just as, if not more important. Good SaaS companies will invest quite a bit in customer acquisition and retention. However, it is crucial to determine whether or not that initial investment is worth it. Lean-Case is a business that specializes in metrics to help you answer that question.
The nature of the subscription business means that your customers are only paying you small amounts of the total booking monthly, quarterly, etc…. Or, if they did pay you the full amount upfront, it can’t be considered as recognized revenue until the service is delivered. So, while you should eventually make up for all of that initial investment, it will happen gradually, which means will take a dip before they get better. David Skok mentions, “The faster the business decides to grow, the worse the losses become.”
Making money isn’t as straightforward as it seems, especially for SaaS businesses with multiple customers subscribing to a variety of different plans. It is easy for things to get muddled and to not have a clear picture of where the business is actually at—particularly when the business is just starting. Lucid Advisory and Finance can help you keep everything lined up. Contact us to learn more!