When a new customer signs up for your SaaS subscription, cash comes in, and you’re ready to do your revenue happy dance - A new customer! More cash! Revenue is up and to the right!
Hold on to your dancing shoes for a moment. Cash is not the same thing as revenue. Let me say that again - cash is not the same thing as revenue. You receive cash when the customer signs the contract, but you don’t recognize revenue until you’ve earned it - which is typically over the life cycle of the contract. This is the concept of SaaS revenue recognition.
We meet a lot of Founders who unknowingly mistake these two concepts, especially when they’re moving from tracking SaaS metrics to full GAAP accounting. Ultimately, mistaking these two can lead to mismanagement of cash in your business and opens you up to potential risk.
What is SaaS revenue recognition?
Recognizing revenue in a SaaS business is different from recognizing it in a traditional business. Generally, revenue should be recorded when you have delivered a product or service. If you sell a physical good, you can recognize the revenue of that sale the moment you deliver the product. Your customer bought something, you delivered it, and you aren’t held liable to keep delivering the product or service once they walk out the door.
But in a SaaS business, you receive the payment up front - i.e. a quarterly subscription paid on the first day of the quarter - but the service is provided over the course of the entire quarter, not up front all at once. Your customer bought something, and you have to keep delivering the service over the course of that contract. That money in your bank account is cash, but it’s not yet converted to revenue until the service is provided.
And here’s the sticking point: the customer can request that money back any time until you’ve finished providing service for the time period in question (more on that later). So, getting it right is important in managing the cash flow of your business.
When should you recognize revenue for your SaaS business?
If you can’t do your revenue happy dance up front, then when can you recognize the revenue?
The answer is: over time. More specifically, over the service period of the contract.
Despite getting all the cash upfront for your SaaS subscription, you should recognize the money gradually over the life cycle of the contract. The process of recognizing revenue in even intervals over time is called straight-line accounting. This is as simple as it sounds - if you’re recognizing revenue evenly over the life cycle of the contract, your graph will be a straight diagonal line that rises the same amount each day.
Let’s take a look at an example.
If your customer pays you a quarterly fee of $1,500 on the first day of the quarter, you should recognize 1/3 of that total — $500 — each month that goes by. Only on the last day of the quarter will the total $1,500 be recognized as revenue on your books.
Why is revenue recognition important?
The answer to this question has to do with managing working capital in your business. If you aren’t recognizing revenue correctly, you might think you have fewer liabilities than you do which could lead you to spend money when it’s not technically yours yet. And if those customers ask for their money back, but you’ve already spent it, you’re in trouble.
Let’s take a look at the previous example to see how this plays out.
If your customer gives you their $1,500 subscription fee on October 1st and you go out on October 2nd and buy a new printer with that money, you’ll be in deep water when the customer comes to you in November demanding $750 back for the second half of the quarter because the service is glitchy and they can’t get their work done.
And while it would be a minor tight spot if you did that with one customer’s $1,500, imagine if you did it with all of the payments you received? If 100 customers each pay you $1,500 on October 1st and you spend all that money on payroll the 2nd, what will happen when your server catastrophically crashes in November and you have to somehow compensate your customers for the three days’ loss of service they experience?
Of course, you don’t intend to let your customers down, but let’s be honest, you’re running a rapidly growing SaaS business. Growing pains and some customer churn is to be expected, but if you’re managing your revenue properly, it shouldn’t sink your business.
Final takeaway - revenue recognition is key to tracking SaaS metrics
Embracing the concept of SaaS revenue recognition helps manage your cash flow and safeguard your business against future liabilities. But protecting your business isn’t the only reason to get this right.
Revenue is the basis of nearly every SaaS metric that matters for your business. If you’re accurately recognizing and tracking your revenue, you can begin to understand the unit economics of your business, where to invest more time and resources and how to move the needle on growth, which translates into a higher valuation of your business. Most importantly - you can finally do your revenue happy dance.