Revenue recognition: two words that can make or tank your start-up
“What is revenue recognition? I’ve never heard those two words together,” Bob said to me. Bob* is the founder and CEO of a four-year-old SaaS start-up backed by a preeminent San Francisco Bay Area VC. Bob also holds a PhD from a top-tier U.S. school.
For a moment I thought he was joking. The silence that followed assured me he was serious. I took a breath and began to explain the concept of revenue recognition and its importance. Soon Bob asked why this subject was on the agenda today. I’d discovered a several hundred thousand dollar problem.
Revenue recognition can be a tricky element of start-up operations. I’ll share a short sales operations lesson. Then show an example in action.
Sales Operations 101. Revenue recognition is how you account for income over time. Bob’s company had been accounting for revenue on a cash basis. That means the company had been recognizing and reporting revenue when the cash was received. This is a valid accounting method for some businesses.
SaaS businesses with monthly or annual contracts use the accrual basis for accounting. That means the company recognizes and reports revenue evenly over the period services are rendered.
An example may help with my not-so-riveting tales of accounting standards. Let’s consider an example where Bob’s company sells a $3,600,000 three-year annual contract. The subscription start date is 6/1/18 and the full contract is prepaid on that date.
In this example, as a SaaS firm Bob would recognize revenue on an accrual basis. That means the firm would recognize and report income across the contract period. To determine the value take the total contract value of $3,600,000 and divide by the total period of 36 months. Recognized revenue for this contract would be $100,000 per month.
In the example, imagine using a different company that would recognize revenue on a cash basis. Assume the the same contract with the same terms. This new company could recognize all $3,600,000 on the date of receipt of payment.
The difference between $100,000 and $3,600,000 is a big one. It is the kind of mistake to tank your company if you don’t catch it in time. I’m glad I was able to find this error, revise historical reporting, and work with the CEO to manage the message to the board. Just another day at the office!
Start-ups, what revenue recognition challenges are you facing and what has helped? Share your feedback below, and follow me for more on start-up operations.
Always happy to help, contact me directly for more information on how I can help your start-up today.
*Note: name has been changed.
