If you're running an early stage company (particularly software companies) and you're in the process of closing your first, hard-earned customers and starting to ramp up revenues then you must pay attention to a couple of key areas.
One is revenue recognition - how you manage, record and account for these results. The second is to start the process of establishing key success metrics. The latter you have time to do as your client base develops and I'll talk more about that in future posts. The former you need to get right from day one.
Now, most CEO's of startups find their eyes rolling into the back of their heads when you talk revenue recognition. Its a desperately arcane and difficult area, yet if you screw it up you can materially misstate the results of your business to your investors, Board and others. And fixing it can be expensive and time consuming. More than that, getting it right from day one establishes a discipline of pricing, process and operating that can be hugely beneficial to the ongoing business.
On the face of it revenue recognition has just four key components. A transaction is revenue if:
- You have persuasive evidence of a business arrangement (typically a signed contract defining all the terms and conditions)
- You've shipped the product or delivered the service (earned the revenue)
- You believe you have a high probability of getting paid (and if not why are you doing business with these wasters?)
- The price being paid is "fixed and determinable" (which is not always clear if there are ways the price scales with transactions, users etc)
in the old days this was simple enough. You got the contract, you agreed the price and got a purchase order, the customer passed a credit check and you shipped the box (often on a truck at 11.59 pm on the last day of the quarter) and - bingo! - its revenue. Yes, it all had to be clean. No contingencies (contract still waiting for Board approval, future deliverables), no side agreements ....
Then along came software. Software sold via a perpetual license, then on a subscription term, and now via SAAS (software-as-a-service). Then there is where the software resides - on the customer site, hosted on your site, or via a shared, single instance (the SAAS model). Then there's implementation and professional services. And training. And software maintenance and upgrades. And customer service and support. The combination of many of these elements in one business relationship can create huge challenges for proper revenue recognition. My friends at PriceWaterhouse have published a manual on software revenue recognition - rather tongue in cheek subtitled "a user-friendly guide" at over 300 pages!
Even the hardware guys got in on the game as software has become a bigger and bigger component of their sales. In many cases now the hardware is simply the physical container - a server with a specially programmed chip. The software programmed into the chip is the real value add and, in rev rec terms, is more than incidental to the operation of the product. So for quite some time now the software component - along with services - has become a key factor in revenue recognition for these products. So now companies like Aruba, Riverbed and others have had to follow these rules. You may not know this but until some rules changes just last month Apple has had to recognize iPhone revenues not upon delivery of the phone to you but over the useful life of the phone and the underlying AT&T service contract - in other words, two years (in this case its complicated by the subsidization of the phone price by AT&T).
So its ugly, complex and hard to manage and track properly. In my next post I'll offer some suggestions as to how to make it simpler and more manageable within the startup environment.
(By the way, with Apple I mentioned the rules have recently changed. From now on Apple will be recognizing revenue upon shipment, not over two years. So on a reported basis heir revenue will appear to grow even faster. And, for the next two years there will be all that deferred revenue for prior periods to be added back in as well. Yes, I own Apple stock!)
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