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This works until it doesn’t. I have seen many startups raise a ton of cash from pre-payments, burn it on marketing and R&D, and then find that the cashflow isn’
by ttul 2y ago
This works until it doesn’t. I have seen many startups raise a ton of cash from pre-payments, burn it on marketing and R&D, and then find that the cashflow isn’t forthcoming as expected. I force my companies to clearly show prepaid revenue on their balance sheet and treat it as debt. Any discounts provided to win the pre-payment also have to be recorded as a financing cost - not a “sales discount” or buried in lower ARR. It might be borrowed from your customers, but it’s still debt and you have to “service” it by providing products and services that do have a marginal cost. Showing the financing cost achieves two things:
1. It allows you to run a higher EBITDA metrics because financing costs are backed out of EBITDA.
2. You record the non-discounted revenue for the customer, which is a truer representation of where the business could be one day when it’s no longer playing the pre-payment game to generate cashflow.
Generally speaking, it’s a good idea to generate cash from pre-payments, but don’t treat it as free no-risk money. You can get over your skis quickly, run out of cash, and then be in a world of hurt when you’re unable to service those customers.
- cess11 2y agoI've recently been in contact with a SaaS company that failed in part because they changed their revenue model from pre-pay for something somewhat easy to deliver to something quite hard to deliver. Along the lines of 'pay (by buying 'credits') for any response to your marketing' to 'pay (by buying 'credits') for only positive responses to your marketing'. A deal isn't closed until both parties have done their part, and, as you aptly describe, until one has done the delivery any payment is akin to a debt, and hence it's a liability or risk until the customer got what they signed up for.
- kevincox 2y ago> but it’s still debt and you have to “service” it by providing products and services that do have a marginal cost. This should be accounted for. Say you sign a customer for $100 for a year. You should be able to estimate up front that it will cost you $5 in service costs, $15 dollars in support, $5 in ... then you can book the $75 as expected profit. Some of that can be put back into marketing in a short loop. The main difference from monthly is that it takes N months for that revenue to be captured. However you are more certain about it. (Especially in pay-after where you can subtract actual support and infrastructure costs from the revenue.)
- scott_w 2y agoThat’s why you have a deferred revenue report. You divide the income across the length of the contract so you “earn” each month as it comes. This can help prevent you overspending on contract delivery because you can see your numbers go red more easily.
- cj 2y ago> I force my companies to clearly show prepaid revenue on their balance sheet and treat it as debt. Any discounts provided to win the pre-payment also have to be recorded as a financing cost - not a “sales discount” or buried in lower ARR “Unearned revenue” is a common account on any company’s balance sheet and is standard best practice. You sign a 12 month deal, and it immediately hits your books as a liability because the revenue isn’t “earned” until your company provides the service, so each month 1/12 of the contract moves from the “unearned” revenue account to an income account. But the 2nd idea of treating sales discounts as a financing charge sounds like some questionable financial engineering to me. If your sales guy offers a “10% end of quarter discount if you sign in the next week” you shouldn’t be booking that discounted 10% as financing income because, simply, that’s money you’ll never receive. I’ve never heard of “non-discounted revenue” as a serious SaaS metric. Sure it will inflate your revenue (as will booking discounts as revenue) but those practices won’t pass the sniff test when any outside VC or auditor looks at your books. But 100% agree with the first part of your comment: from an accounting perspective, prepaid contracts are typically booked as a liability or debt on your balance sheet, and gradually moved over into your Income/Earned Revenue account in 1/12 increments (or equivalent) over the upcoming year.
- ttul 2y agoI should clarify: The IFRS statements do not break out the discount in this manner. In accordance with IFRS/GAAP, revenue should be reduced by the amount of the discount, not treated as a financing item. However, for internal reporting, particularly to the board, I have found it useful to break out discounts for pre-payments in this manner and to force the CEO to think about pre-paid revenue as “debt” and the inherent discounts as “financing cost”.
- cj 2y agoAppreciate the clarification. That makes perfect sense. I work at a B2B SaaS company that sells $50k contracts, and we don’t offer monthly billing and we’ve done quarterly billing maybe once (for a premium). I could imagine the way you’re thinking being helpful if you offer monthly billing and you have lock in to the point where you know people won’t churn so there’s no major benefit to locking people in for a year.
- unixhero 2y agoThis guy accounts! Thanks for the insightful analysis.
- lmeyerov 2y agoTracking monthly/annual bookings (or whatever the MRR/ARR number is) for investors seperately from monthly/annual recognized recognized revenue for conservative operations seems simpler and achieves the same? And yeah, the blog's advocacy of spending unrecognized revenue is indeed risky, and how to do that safely is an interesting q...
- scott_w 2y agoYep, this is what deferred revenue reports are for. I’ve seen a business skirt close to the edge because they didn’t respect what it was showing until it was almost too late.