The Elephants and the Rabbits (Accounting at SaaS Companies)

August 19, 2009

Brian Sommer just posted a very funny piece on how SaaS CEOs can prepare for an earnings call. If anything, he understates the problem.

We have learned over the years how to respond to software company earnings calls. We look at license revenues; we look at revenues; we look at margin; and we decide whether the company is doing what it “should” do at its level of maturity.

What few people realize is that the rules governing SaaS vendors are different, so comparing SaaS vendors and perpetual license vendors is like comparing–oh, let’s try to avoid a cliche–elephants and rabbits.

This gives these guys so much opportunity to obfuscate that frankly, they don’t even need to practice.

To understand how this works, you need to understand the differences between the rules. I’ll stick with the basics. The key difference is that when a perpetual license vendor sells something on the last day of the month, they report the total amount of the contract as revenue; when a SaaS vendor sells the same software, they don’t.

With the perpetual license vendor, the idea of the accounting powers that be is that selling a software license is like selling a piece of packaged software over the counter. You sign the contract; they invoice; ka-ching. With the SaaS vendor, the idea is that they’re not selling an over-the-counter product, they’re selling a promise to deliver a service. And, since there’s always a risk that they won’t deliver, they can’t recognize revenue until they actually do that delivery.

Let’s see how this works in an example. What we’re trying to do is evaluate how sales are going. With a perpetual license vendor, at the end of the quarter, we can look at their reports and be able to tell, basically, what they sold, and how sales are going. If SAP sells a $1 million contract on June 30 (and ship and invoice), they report $1 million in license revenue, and we know that’s what the sales force did.

Now imagine that a SaaS vendor is working equally effectively. At the end of a quarter, they sign a $1 million contract that is effectively equivalent in the customer’s eyes. (Who knows, maybe SAP and Salesforce were competing and Salesforce won.) If we look at their revenues, we’ll have no idea that this is the case. Almost none of that $1 million will appear as revenue, because they are only allowed to report revenue for the days of SaaS that were actually delivered. For that $1 million contract signed on the last day of the quarter, SAP will report $1 million in license revenue, but Salesforce will only report $1,000, assuming they turned the product on that day and so delivered one day of a 1,000-day (3-year) contract.

This makes Salesforce look bad. But later on, things reverse. Imagine there’s a quarter when both SAP and Salesforce reps sell bupkes in a quarter. That quarter SAP reports $0 license revenue, but Salesforce reports the $90,000 that it earned from the 90 days of delivery on that old contract.

Two companies. Identical performance. Completely different-looking results. Now, we’re not completely trapped. We can get some idea of what’s going on, by looking at what are called the “bookings” numbers. (The booking is the amount of money invoiced during the quarter for the contracts that are signed.) Most financial analysts just use a quick and dirty rule of thumb for comparison purposes; bookings for SaaS companies are roughly equivalent to sales revenues for perpetual license companies.

if SaaS companies booked revenues the same way that perpetual license companies bill for revenues, this would be fine. But in fact, SaaS companies don’t necessarily book all the revenue from contracts like that $1 million contract that I’m using as an example. Very often, they don’t invoice for the product until it actually starts being used. So on that last day of the month, it’s reasonably likely that the bookings will be, say, $299,000 and the revenues $1,000 for that contract. But the rest of that $1 million won’t appear anywhere. It will be booked in the fullness of time, but by that time, we won’t really care.

So how do you compare the elephants and the rabbits? You don’t. To compare the two, you would have to know the value of the contracts that the SaaS companies signed And they have no responsibility whatsoever to tell you what that value is. In fact, they can say anything they want to about that imaginary $1 million contract; they can announce it, hide it, whatever. If this quarter, they want you to believe that they’re selling as much as SAP is, well, they can release figures that make it seem that way. And if this quarter, they want you to believe something else, well, OK. All perfectly legal. In our example, Salesforce and SAP are “actually” doing equally well. But there is no way of knowing this.

Oh, it gets worse. It turns out that the accounting standards that govern SaaS companies make margins worse than they “actually” are. So even if you did get data that let you compare sales accurately, the accounting standards would automatically make the SaaS company look less profitable than the on-premise company.

Awful, right? Not even close. You see, very soon, it’s going to get even worse. The accounting standards are changing. But hey, that’s material for another blog.

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