Today, every professional, in every industry, uses multiple SaaS platforms on a daily basis. It’s practically impossible to imagine your work life without them: they power everything from virtual meetings to product development.
The result of this? SaaS is big business––all told, the industry has revenues of hundreds of billions of dollars every year. Hundreds of new SaaS companies are founded every year, all led by ambitious founders aiming to build the next Salesforce or Intuit.
The software industry has grown dramatically in recent years. Today, it’s no stretch to say that SaaS represents one of the most important sectors of our economy, and it’s only going to become more important as the world continues to become more digitized.
Many SaaS businesses operate in a fundamentally different way from traditional legacy businesses. SaaS platforms tend to be run by innovative entrepreneurs with ambitious visions and an unwavering focus on growth.
Such fast-paced growth demands rigorous accounting that’s tailored to the financial climate of a scaling SaaS business. Without this, it’s impossible for leaders to get a read on key metrics that define the survival of their firm; KPIs like cash runway, growth rate, and Annual Recurring Revenue (ARR).
As the economy begins to slow and investors guard their purse strings more tightly, it’s more important than ever for founders to closely manage the finances of their businesses. Doing so effectively demands an understanding of the intricacies of SaaS accounting.
Read on to learn all about:
- What Makes SaaS Business Accounting Different from Traditional Accounting?
- Transitioning from Cash Accounting to Accrual Accounting
- GAAP for SaaS Businesses
- Profit & Loss Statement
- Balance Sheet
- Cash Flow Statement
- Revenue Recognition Principles for SaaS Businesses
- ASC 606: Revenue Recognition for SaaS Business Accounting
- The Key Elements of Successful SaaS Accounting
- Adopting Non-GAAP KPIs
- Building a Scalable Financial Infrastructure
- Achieving a True Understanding of Financial Metrics
- Full-Service Outsourced SaaS Accounting with G-Squared Partners
At G-Squared Partners, we’ve provided SaaS accounting services to over 100 SaaS businesses. Our team has years of experience leading publicly traded SaaS companies and have the skills required to upgrade your financial systems, help you raise investment rounds, and more. Contact an advisor today to learn more.
What Makes SaaS Business Accounting Different from Traditional Accounting?
By and large, SaaS businesses are subscription businesses. Their revenue models are entirely different from companies in traditional industries. Provided customer retention rates are high, a SaaS company typically has reliable monthly revenue streams that either grow (through new customer acquisition) or shrink (through churn) over time.
At first, you might think this income is relatively predictable. And for some SaaS companies, it can be. However, SaaS revenue often fluctuates based on a number of factors.
Depending on your business model, customers may add or subtract seats from their subscriptions. They may choose to renegotiate their contract with you or leave your business for a competitor. On a more positive note, your customers could also upgrade to a more expensive tier to unlock access to new features. Or you could get a shout-out from a tech influencer on Twitter, causing new sign-ups to spike overnight.
The point is this: all kinds of events could happen that could cause your previously predictable revenues to change. Without a financial system that’s built to handle that type of environment, these sudden changes could cause your plans for your business to materially change.
More Than Revenue: Other Ways SaaS Accounting is Different
The way that a SaaS business receives revenue is far from the only difference between SaaS business accounting and accounting in more traditional businesses. Understanding these differences is key to building an accounting and financial infrastructure that’s equipped to handle the fast-paced growth many SaaS businesses strive towards.
In their early stages, many SaaS companies operate at a significant loss, sacrificing profitability to invest in product development and sales and marketing to achieve rapid growth. To support this, entrepreneurs seek investment: at first through small seed rounds and later from more sophisticated institutional investors.
As these institutional investors gain seats on the SaaS company’s board, they often require the company’s management team to improve their accounting and reporting processes. It’s at this stage that many startups pivot away from a rudimentary accounting system and adopt Generally Accepted Accounting Principles (GAAP).
In addition to this, SaaS business leaders have to understand their cost structures. Unlike traditional product-led businesses, which have much more variable costs, many of a SaaS business’s costs tend to be fixed operating expenses known as Selling General & Administrative (SG&A) expenses. Examples of SG&A expenses include rent, payroll, marketing, and more.
Having an accounting system that’s configured to handle the needs of a SaaS business model is crucial. Without this kind of system, it’s difficult for leaders to track vital KPIs like burn rate and cash runway––metrics that can make or break any SaaS business.
Transitioning from Cash Accounting to Accrual Accounting
In their early days, many SaaS startups begin with cash accounting. Under cash accounting principles, revenue is recognized as you receive cash, and costs are recognized as they are paid.
In practice, accounting at an early-stage startup tends to look like this: the founder purchases Quickbooks, sets up a few integrations, and then leaves this basic accounting system to run in the background.
That can be fine at first, but once your business starts to scale and attract investors, it’s time to make the switch to accrual basis accounting.
Under accrual accounting, a business doesn’t recognize cash until revenue is earned. This is a great fit for SaaS businesses with significant subscription revenue, enabling them to record recurring revenue and other complex transactions more accurately. Accrual accounting also affords leaders a more accurate position of their future cash flow position: vital in calculating cash runways and planning for future investment rounds.
GAAP for SaaS Businesses
Since almost all early-stage SaaS businesses are private companies, they’re not required to be GAAP compliant––but that doesn’t mean they shouldn’t be.
If your goal is to raise a Series A and keep investing in growth, you might find some investors require your financial reports to be GAAP compliant. The same goes for bank debt or venture debt: often underutilized funding mechanisms that can significantly extend a business’s cash runway.
So, what is GAAP?
GAAP stands for Generally Accepted Accounting Principles. These principles are a set of accounting rules and standards issued by the Financial Accounting Standards Board (FASB). Essentially, they create a level playing field: a way for investors to judge companies on the same standards and metrics.
There are a lot of intricacies inherent to GAAP and if you’re not an accountant, it can be difficult to navigate them. That’s particularly true for SaaS businesses: accounting for setup and implementation fees is challenging, as is accounting for stock options that often make up a large portion of your employees’ compensation packages.
Despite these challenges, if you intend to grow your business past a certain point, you should consider becoming GAAP compliant to be non-negotiable. This isn’t to say you can’t include non-GAAP metrics in your reporting: many non-GAAP metrics can be invaluable indicators of how a SaaS business is performing.
These complexities underscore the importance of working with experienced financial consultants who have the skills and experience to support your business in becoming GAAP compliant.
One key requirement of GAAP is to produce three key financial statements every month. These are the Profit & Loss Statement (AKA an Income Statement), Balance Sheet, and Cash Flow Statement. Let’s take a closer look at what’s involved in each of these financial reports.
Profit & Loss Statement
A Profit & Loss Statement, also known as a P&L or an Income Statement, records the revenue, expenses, and net income (or loss) of the business during the reporting period.
Expenses are typically broken down into several categories. These fall under Cost of Goods Sold (COGS), operating expenses such as SG&A and R&D, and non-operating expenses including interest expenses or taxes.
A Balance Sheet is a snapshot of a business’s assets, liabilities, and shareholder equity at a specific point in time.
This allows leaders and investors to understand the value of what the company owns (such as cash and accounts receivable) and what it owes to others (such as outstanding debts or accounts payable). Shareholder equity, also known as net assets, is what the company would be worth to shareholders if it were liquidated after all liabilities were paid off.
A Balance Sheet is so called because it must follow the fundamental accounting equation: Assets = Liabilities + Shareholder’s Equity.
Cash Flow Statement
A Cash Flow statement shows the money that both flows into and out of a business during a specific period. They track three key flows of cash:
- Operating Activities: cash the business receives or spends in the course of normal business activities, such as selling products to customers and paying employee salaries. For SaaS companies in the process of scaling, it’s likely the bulk of cash flows will be in this section.
- Investing Activities: gains or losses stemming from investments, including capital expenditures.
- Financing Activities: cash used for financing the business, including interest expense or dividends paid to shareholders.
Many SaaS businesses have negative operating cash flows, especially in their growth stage. Provided you have a clear plan and sufficient support from investors, a negative cash flow can be a powerful growth lever that enables your business to scale fast.
Revenue Recognition Principles for SaaS Businesses
One of the many ways in which SaaS businesses are unique is in their recurring revenue models. For SaaS businesses, it’s preferable for customers to make an up-front payment for an entire year’s worth of service. From an accounting perspective, this creates a liability that should be recorded as deferred revenue and recognized on a pro-rata basis as the contract is fulfilled. Operationally, this aids cashflow and gives the SaaS business additional capital to invest in growth.
Alternatively, it’s also common for customers to sign a contract for a year and agree to pay a fixed monthly fee for the duration of the contract.
Understanding when to recognize these revenues in a business’s books is a key focus of SaaS accounting. If the business follows GAAP, it cannot typically recognize the full value of the contract upfront. Instead, they must prorate it over the period of the contract and recognize the revenue as they provide the customer with the agreed-upon services.
These principles stem from ASC 606: a framework laid out by both FASB and IASB in 2014. To abide by GAAP, SaaS companies should follow the five-step approach laid out in ASC 606.
ASC 606: Revenue Recognition for SaaS Business Accounting
When it was instituted, the goal behind ASC 606 was to create a more consistent financial reporting framework for companies with ongoing contracts with customers. This principle doesn’t just apply to SaaS businesses: it’s relevant to all businesses with long-term contractual relationships with customers.
There are five key principles to revenue recognition under ASC 606. Let’s take a look at each of them, using the hypothetical example of a SaaS business that has signed a $100,000 year-long contract with a major new enterprise customer.
1. Identifying the Contract
For a contract to be identified, several criteria must be met.
Both the business and the customer should be aware of and in agreement on the terms of the contract, especially those related to payment terms and schedules. Each party should have clearly defined responsibilities and an agreement, signed by both parties, should be in place.
2. Identifying Performance Obligations
For most SaaS businesses, meeting performance obligations typically just means providing your software to the customer as agreed upon. In some situations, there may also be additional performance obligations around implementation, user training, or other deliverables.
These performance obligations must be fulfilled in a way that enables the customer to benefit from the service provided to them by your business. It’s common to identify monthly performance obligations that allow SaaS businesses to recognize revenues in their monthly financial statements.
3. Determining Transaction Price
In return for fulfilling these performance obligations, the business can expect to receive consideration from its customers.
The transaction price is the total value of the contract. In this example, the sales team has sold a contract worth $100,000 to provide your SaaS product to a new customer for a period of one year. $100,000 is the transaction price.
4. Allocating the Transaction Price
The transaction price that was determined in Step 3 must then be allocated against various performance obligations.
If, as in this example, performance obligations are fulfilled monthly against a year-long contract, the business would allocate 8.33% of the transaction price against each monthly performance obligation.
5. Recognizing Revenue as Performance Obligations Are Met
As performance obligations are met, the business is free to recognize the portion of the transaction price allocated to that particular performance obligation.
In our example, that means the business would allocate $8,333.33 in revenue in each month’s financial statements, provided they continue to meet their performance obligations as outlined in the contract.
The Key Elements of Successful SaaS Accounting
Becoming GAAP compliant is one of the keys to successful SaaS accounting for fast-growing technology companies. The majority of the time we onboard a new client at G-Squared Partners, our initial focus is typically on helping the business become GAAP compliant.
GAAP compliance is only the first step in your journey toward accounting maturity: it’s not the end goal. While becoming GAAP compliant helps to demonstrate to investors that your company has good internal governance, embracing a more sophisticated accounting infrastructure enables SaaS businesses to unlock all kinds of additional benefits.
Let’s explore some of the other key steps in SaaS business accounting. By following this framework, companies can create a more sustainable growth trajectory that’s equipped to meet the challenges of today’s macro environment.
Adopting Non-GAAP KPIs
The financial statements that a business is required to produce under GAAP are useful in enabling business leaders and investors to understand how a business is performing. But to truly tell the financial story of a business, it’s often necessary to design and monitor a bespoke set of metrics.
In addition to GAAP metrics, it’s also crucial for SaaS businesses to align on and adopt non-GAAP KPIs that give them a more accurate understanding of how the business is performing. This practice is very common: in 2017, 97% of the S&P 500 supplemented their GAAP reporting with non-GAAP metrics.
That gives way to the question: which non-GAAP KPIs should SaaS businesses be tracking?
The answer: it depends. A business’s choice of non-GAAP metrics can be driven by its business model, growth strategy, and more. It’s likely you’ve already heard of some common non-GAAP KPIs used by SaaS businesses. They include:
- Recurring Revenue: Monthly Recurring Revenue (MRR) and Annual Recurring Revenue (ARR) are important metrics that allow SaaS businesses to understand their projected income. Some investors use ARR multiples to help them value companies.
- Customer Acquisition Cost (CAC): CAC refers to the dollar amount your company pays to acquire a new customer. To calculate CAC, sum all your sales and marketing costs and divide this by the number of new customers you gained in a period.
- Revenue Churn Rate: It’s impossible to keep every customer forever. Your business’s revenue churn rate measures the percentage of revenue that is lost when customers leave your business. Aim to keep this number as low as possible.
- Logo Churn Rate: This additional churn rate metric tracks the number of customers who leave your business during a certain period.
- Burn Rate: Many SaaS companies have negative cash flows as they scale and supplement their revenue with investment that helps fuel growth. Your business’s burn rate is the amount of negative operating cash flow each month.
- Cash Runway: No business can continue burning cash forever. A cash runway is the amount of time a business has until its cash runs out. It’s calculated using the business’s burn rate and is typically expressed in months.
This isn’t a complete list. We encourage you to work with a financial consultant to determine which KPIs paint the most accurate picture of your business’s performance and sustainability.
Building Scalable Financial Architecture
A key component of any scaling business is a robust, forward-looking financial model. Many founders create a basic version of this, but working with experienced financial consultants to build out a much more comprehensive forecast is a vital step in your growth trajectory.
Exactly what this looks like will vary from business to business, but it begins with a solid understanding of your financial performance and KPIs. Over time, you should constantly revise, tweak, and amend your forecasted budget to account for changes in your business, new funding, or other events. Doing so allows you to better plan for future growth, staffing needs, and other resource allocation decisions.
Achieving a True Understanding of Financial Metrics
Understanding the data behind your business’s financial metrics isn’t the only goal of developing financial metrics: you also need to understand the stories that these metrics tell. The audience for your financial statements - your board members and investors - will pay close attention to these documents.
Understanding how these stakeholders will interpret reports enables you to proactively address any issues and prepare for questions. As the leader of the business, it’s your job to weave a compelling narrative around these facts. You must be able to justify your choice of metrics, clearly demonstrate how they are interlinked to business growth, and get everyone aligned on the plan moving forward.
Success in this domain gives your investors confidence in your business and your leadership, helping propel your business forward to continued growth.
Full-Service Outsourced SaaS Accounting with G-Squared Partners
Building a sophisticated accounting and finance infrastructure that’s equipped to handle the rapid growth of your SaaS business is no easy task. It is, however, a necessary and entirely worthwhile step in your journey to becoming an established company.
In the early days of your business, it’s possible to get by with a basic cash accounting system. But once you start to gain traction, you’ll quickly find you need a more sophisticated approach. That holds true whether you’re raising your first round of institutional funding or are positioning your business for an exit.
High-quality accounting provides unparalleled insights into financial data that defines the future of your business. Access to this data enables leaders to make decisions faster and with greater levels of confidence, paving the way for continued growth.
At G-Squared Partners, we're uniquely well-positioned to serve the accounting and finance needs of fast-growing SaaS businesses. We provide strategic financial, accounting, and operational advisory services to SaaS businesses looking to upgrade their financial infrastructure. Our outsourced CFO and accounting services cover the full spectrum of a SaaS business’s financial needs, from basic bookkeeping to executive-level financial leadership.
Several of our team have served in leadership positions at publicly traded SaaS companies. Together, we’ve helped technology companies close hundreds of millions of dollars in equity and debt financing and have led over 50 M&A transactions.
Interested in learning more about how outsourcing your SaaS accounting needs to G-Squared Partners can help accelerate your growth? Contact us today – we’re excited to get started.