Important Implications For Software Businesses
Revenue recognition can quickly become complex, especially with ASC 606 in full force. Your accounting method, revenue types, and contract lengths all impact when and how revenue is recognized in your software business. Accurate revenue recognition is not just important to file compliant financial statements and tax returns; it is one of the fundamental components that can impact your valuation calculation.
In this article, we will explore the different components of revenue recognition for software businesses, touching on churn, why you need to break out different revenue types, and how to set reasonable valuation expectations.
Recurring vs Non-Recurring Revenue
There are two primary types of revenue: recurring and non-recurring. Recurring revenue is income that is reasonably expected, such as a software license that bills the customer each month. On the contrary, all other services or project-based revenue will fall into the non-recurring revenue category. These are generally one-time expenses for your customers.
Recurring revenue is easy to predict, as your customers will be billed the same amount each month, while non-recurring revenue can be sporadic. Most software businesses will aim to maximize recurring revenue rather than seeking one-time, non-recurring revenue projects.
The Importance of Breaking Out Different Revenue Types
Differentiating between recurring and non-recurring revenue is not only mandated by regulatory agencies, but it is also helpful for internal reporting purposes. For one, cost of goods sold is different for services than it is for software. One-time installation services will have direct labor, materials, and shipping expenses in cost of goods sold, while recurring software revenue might only have engineer wages and server fees.
In addition, revenue valuation multiples vary based on the type of revenue you are generating. Recurring revenue has a higher multiple due the predictability of the revenue source. The multiple for non-recurring revenue is significantly less given that project base revenue is less predictable. Having clean reporting will help you differentiate between your revenue types to apply the correct multiple when piecing together valuations and preparing for a business sale.
Revenue Recognition Differences Based on Contract Timelines
ASC 606 requires revenue to be recognized based on contractual obligations. A contractual obligation is each separate contract requirement, such as software installation, staff training, or the physical use of the program. There are five main steps associated with recognizing revenue:
Identify the contract with a customer
Identify the performance obligations
Determine the contract price
Allocate the contract price to each performance obligation
Recognize revenue once the performance obligation is satisfied
Let’s say that you are a calendar year-end software business and solidify a $12,000 annual contract that runs June through May. If the customer prepays the full $12,000, your team will most likely remove the receivable and report the $12,000 as revenue. However, by December 31, you would have only fulfilled your contractual obligation for June through December, or $7,000. The remaining $5,000 should be removed from revenue and put into a deferred revenue account on your balance sheet.
This recognition principle follows both accrual accounting and GAAP reporting. Month-to-month contracts will also mimic the same concepts but can be easier to keep track of. One complexity of month-to-month contracts is payments received after year-end for software used during the calendar year. One example would be your customer paying their December software invoice in January of the next year. Under revenue recognition principles, the payment received in January should be recorded as revenue in the prior year.
What is Churn, and How Do You Measure It?
Churn is an important metric to track, especially if you plan on selling your business in the near future. This formula tracks the percentage of customers lost over the course of a period, which can vary from one month to a full year. The official churn rate formula divides lost customers by the total number of customers at the start of the time period, which is then multiplied by 100.
A healthy churn rate for SaaS businesses varies depending on the customer type, but tends to fall between 10% and 15% per year. If you notice your churn rate is outside of these parameters, it might be time to revisit your product strategy and explore where the value creation is missing the mark for customers. Beyond product, how is your customer support and account management? What other reasons may compel customers to churn? Ask yourself these questions to get to the root cause of your high churn.
Closely managing churn can help increase expansion revenue. Expansion revenue are revenue increases derived from existing customers. For example, if you offer tiered software packages, maybe you incentivize moving up to the next tier, generating more revenue. With low churn rates, your company is able to leverage expansion revenue and business growth.
Setting Reasonable Revenue Valuation Expectations
Understanding your revenue makeup is imperative when setting valuation expectations. If revenue that’s not recurring is labeled as recurring or inaccurately booked as recurring, then you might arrive at a valuation expectation that’s inconsistent with market rates. The opposite effect is true as well. If you label all revenue as non-recurring, you could significantly underprice your company.
Let’s take a look at an example. Your company generated $10 million in revenue last year, which comprises 80% recurring and 20% non-recurring revenue. Using an average value multiple of 3x for recurring and 1x for non-recurring, we could calculate an overall valuation of $26 million. Now, let’s say that you applied the recurring revenue multiple of 3x to 100% of your revenue. This would create a valuation of $30 million. Breaking out your revenue types and applying different multiples will give you the most accurate revenue valuation.
More Resources For Software Businesses
Revenue is important to granularly track, especially if you are planning on selling your software business. However, revenue isn’t the only factor that impacts your company’s valuation. Operating cash flow, growth, asset quality, liabilities and your industry are a few factors, of many, that play a role.
For more information, check out our eBook on preparing for and navigating a lower middle market business sale, our article on preparing for an exit, or contact us to discuss valuation or other sale related topics.
