Entrepreneurs: Even If You Hate Accounting, Keep An Eye On This Ball
Accounting is a nuisance for many entrepreneurs: a lot of time spent on things that don’t feel like top priorities. However, entrepreneurs should never take their eyes off one financial ball: “Rev Rec” (revenue recognition). It tells you a very important thing: how much money you have to work with, now and in the near future.
The base principals of Rev Rec are simple. 1) You recognize revenue when you have earned the right to receive payment and you have a strong expectation of receiving that payment. 2) You earn the right to receive payment by delivering your value proposition as agreed. 3) You match revenue earned to the costs associated with producing that revenue: i.e., if delivery occurs over several quarters, you recognize revenue each quarter in proportion to delivery of value. This tells you what your profit margin is: how much you have to spend on variable and period costs over the time it takes you to deliver the product that brings in the revenue. That tells you how much free cash you will gain when the job is done. 4) You judge whether the customer will pay: if payment is in doubt, you don’t have revenue.
These principles apply a bit differently in different business models, but the intent is always the same: to determine and report how much money is coming in.
Booking and payment are not the same as revenue. A booking happens when a customer enters an agreement to purchase. At that point your company has not yet earned the right to be paid, and (typically) the customer has not paid. Bookings are a useful leading indicator and you should track them closely, but substantial risk separates bookings from revenue.
Payment can occur before or after Rev Rec. Early payment is great for cash flow, but keep in mind that your company has not delivered yet, and the customer has not yet put your product to use and received value. The contract may say that you get to keep the money if the customer never utilizes your product, but that is low-value revenue: customers who don’t use your product probably won’t buy again and new customers will learn to refuse up-front payment. Late payment is less good, but if the customer is satisfied and a good credit, you can count on the cashflow over time and borrow against it if necessary.
Investors track revenue closely: it’s often the #1 success indicator for a company. When a business takes off, revenue growth happens first, then margin expansion, then positive cash flow. When revenue growth stalls, something is wrong: product/market fit, go-to-market strategy, people not up to the job, etc.
As a general rule, it’s not wise to be aggressive with Rev Rec, even if GAAP (generally accepted accounting principles) permits it. Stuffing your distribution channel with product is an example of aggressive Rev Rec: the channel may buy on terms that technically allow Rev Rec, but an overstuffed channel does not re-order until sell-through occurs, and if financially fragile it may not pay until it collects from end-customers, regardless of what the contract says. Sometimes your distribution channel is inside of your customer: you might be selling seats for a SaaS product to a corporate function in a big company that needs to deploy your seats to operating groups. I’ve seen situations where the corporate function over-buys and then stops buying until it can use what it’s bought. If the channel is stuffed, a recent revenue up-tick does not indicate real momentum. Many companies look through channels and base their Rev Rec on end-user purchase and adoption. That is a gold standard.
Understated Rev Rec is a mistake too: a customer or investor may be lost due to under-selling. Few entrepreneurs have this problem, however, and it’s self-correcting. The company quickly acquires a reputation for beating expectations, and that brings customers and investors in.
Think of Rev Rec (and really all financial reporting) as communication: helping your stakeholders understand what is happening and strengthening your partnership with them by building trust. It’s tempting to push revenue up to build perceived momentum, perhaps ahead of a financing or a big customer proposal. But, if your Rev Rec later falls apart, there is a big price to be paid. Stakeholders will automatically discount future revenue reporting until you re-build credibility, which takes a long time. This taints everything you say, not just revenue. Sometimes this situation creates pressure to exaggerate revenue further to overcome the discount factor, leading to bigger roll-backs and greater stakeholder alienation. In bad cases a death spiral results: investors, employees, and customers lose confidence completely and walk away, or senior management is forced out.
Take two ideas away from this post: you can delegate a lot of accounting tasks, but keep a close eye on Rev Rec. Use it as a tool to keep stakeholders informed as to the health and momentum of the business, building trust and loyalty. With your feet firm on this foundation, you can tackle other challenges with confidence.
First posted @ blogs.forbes.com/toddhixon on March 26, 2018.