On Wednesday, we hosted a webinar about the critical accounting challenges SaaS companies face with inDinero. Investment Director Zach Hoene represented Lighter Capital, and inDinero brought Carter Hawke, Accounting Manager.
The webinar covered many bookkeeping woes, from the new revenue recognition rules (effective 2019 for private companies) to accounting stock-based compensation to capitalizing CAC for new customer contracts. It ended with a Q&A where listeners asked for advice solving their businesses’ accounting challenges. The whole video is available here, and here’s what our experts had to say about your questions.
On finding a good accountant
Q: If we’re doing our accounting in-house, should we find an accountant that specializes in SaaS or are these standards that all CPAs will know?
Hawke: Any CPA should be able to get you in compliance, but if your accountant isn’t well versed in how SaaS companies work and how to apply accounting standards to that model, you may run into some issues.
You may have problems with setting up your financial accounts and statements as well as booking entries on a day-to-day basis. SaaS is quite a bit different from a conventional business in that regard. If you’re processing thousands of transactions that are low dollar-value through an online payment processor, it can be tricky to wrangle that volume of transactions into the financial statements—even if you know how the financial statements should look and how to apply the accounting standards.
So I would definitely suggest going with someone who is well-versed in doing the bookkeeping and preparing for SaaS businesses, as well as someone who’s well-versed in applying current accounting standards to that business model.
Hoene: We see huge variation in the quality of books we receive, whether they’re true cash, true accrual, or some hybrid. Companies engaged with someone who knows how to put together SaaS books produce financials that allow us to move a lot faster on our end. They’re also better at answering any questions we have and providing clarity and analysis.
If you’re doing it internally or working with a CPA who isn’t familiar with SaaS, it can slow down the capital-raising process and create a lot of issues. The bread and butter of what a VC’s going to look at (or an angel or Lighter Capital) is the financial statements, so having a clear picture and knowing that the numbers are accurate helps us assess the company and determine its creditworthiness.
On the new revenue recognition standards
Q: What are the FASB numbers Carter’s referring to?
Hawke: The new revenue recognition standards are ASC 606, released in May of 2014. They go into effect for public companies in 2018 and private companies in 2019. I should note that in 2016, they released a number of amendments and clarifications because there was uncertainty around some elements.
Q: Can you give a brief comparison between GAAP and IFRS revenue recognition specifically for SaaS companies?
Hawke: It would take more time than we have to go through all the revenue recognition standards for both of those, but I should say that this new revenue recognition standard is a joint standard issued by both FASB and IASB in order to bring those two sets of standards more in line with each other. Once it’s implemented, revenue recognition for US GAAP and IFRS should be nearly identical—although there are a few details that will differ based on later addendums published by the two boards.
On capitalizing costs of acquiring new customer contracts
Q: What if you’re a new SaaS provider and don’t know how long the relationship with a customer will be? How do you capitalize the cost of customer acquisition then?
Hawke: Typically the length of the contract would be the default, unless you have reason to believe that you’ll maintain that customer’s business for longer than the contract stipulates. If that’s the case, you’ll have to apply your professional judgment.
Hoene: You should be gauging CAC and LTV by churn and retention. You may be able to forecast the length of the relationship and renewal pattern based on historical retention among the cohort.
Q: How does capitalizing the cost of customer acquisition work if we also pay sales commissions for renewals?
Hawke: The standards say that if the commissions on renewal aren’t commensurate with the initial ones, then the rule still applies. For example, if you’re paying $1000 commission for the initial contract and you expect that contract to last five years, you would still amortize that $1000 over five years even if there’s a $100 or $200 commission upon renewal.
Having said that, if the commission for signing a new contract is the same as the commission for renewal, that wouldn’t apply. You would amortize the asset, which is what you’ve capitalized those commission costs up front, over the length of that initial contract.
[There’s more information on capitalizing CAC—which can be confusing—in the video]
On accounting for stock-based compensation
Q: Do you need to record stock compensation related to RSAs/options when there’s no established par value for issued preferred stock?
Hawke: For accounting purposes, there’s not much to record there, but there are often tax implications, which I don’t know if I want to get into here, for two reasons. The tax implications are definitely worth exploring, but I’m not a tax specialist. Sorry that’s not more helpful!
Hoene: To get a 409A valuation you need audited statements, at which point you can assign a par value to your shares. Paying a CPA to do this early in the lifecycle of a startup isn’t always feasible from a cost perspective. But it’s the cart before the horse, so I can see why this would be a common question.
Q: Can you give me an example of recognizing stock-based compensation that would raise a red flag for Lighter Capital?
Zach: There could be a cash liability associated with a co-founder deciding to leave. If there’s an obligation to buy back their shares upon their exit and the company doesn’t have the cash reserves to do it, that would be a risk we’d want to address as we go through our diligence.
On breaking out payroll expenses
Q: Currently I’m not accounting for any payroll against COGS. We have R&D, G&A, and sales head costs, only fifteen people. What roles should be counted against COGS in a small company?
Hawke: That’s not too uncommon. If there are any employees or specific items running through payroll that are variable cost, that are directly tied to your revenue, you want to allocate them into COGS. That doesn’t necessarily have to be a specific employee. It can be a percentage of that employee’s salary, like a salesperson’s commission or managers’ bonuses for reaching revenue targets.
You want to do this because it impacts your margins. To keep your margins accurate, you’ll need to include all variable costs in COGS rather than operating expenses.
Hoene: Those are the kinds of one-time attributable operating activities that are tied to revenue and should be moved up to COGS. When we do our analysis, we want to understand those variable costs that fluctuate in-line with revenue-generating activities for the business and would be expected to scale up or down with revenue of the company. We need to know the true gross margin of the business.
It’s not uncommon for us to see nothing in COGS except for hosting fees, but when we do our internal analysis sometimes we’ll try to identify those line items—if we can pick them out of payroll—and move them up to COGS to get a better picture of the true margins.