The Compliance Chasm

Innovation is still the key to growth in the high tech business, but it has broader implications than in the past. Today some of the most important innovations are about the business model—how technology is being sold and delivered. Software as a service (Saas), on demand, hosted, and subscription models are all reshaping key customer relationships for high tech companies.

Customers are looking for an easier way to acquire technology. Instead of large payments up front and on delivery, customers increasingly want to mortgage the cost of the technology over a series of monthly payments. This takes a huge burden off capital budgets. It also provides a much more flexible and, in most cases, more appropriate financial arrangement for customers.

Fees can be determined not only by the technology itself but by how it is used, which is what really matters to the customer. The base monthly payment can be adjusted by usage levels so the relationship is much easier to scale up and down according to business requirements. Budgeting, paying bills, and controlling the technology are all substantially easier for the customer. In addition, because of the more attractive financing, ROI can often be achieved more quickly.

Even though we’re primarily talking about B to B relationships, the economic gap between Saas and traditional models makes it a very powerful market force. For a good lesson on what is happening in software industry today, look no further than the telecom industry. Innovation and market share are a matter of how services are sold. Rollover minutes, off peak pricing, free weekends, family and friends plans, these offerings are all simple for customers to understand because they are based on how the service is used. Companies that make the transitions first get the biggest market share advantages.

The Path to Market Goes Through Finance

In the long run these new models also smooth out the revenue curve for vendors, but the transition can be tough. There are a lot of things that must be in place in order to be successful. Sales, marketing, development and support must all work together to define offerings, but some of the key operational issues occur in the finance department. Billing, renewals, cash flow, and revenue management practices must change dramatically from the traditional product licensing days.

When you sell software as a service you are essentially bundling a whole set of products and services with support and other customer entitlements into a single financial arrangement. Contracts become more intricate with tiered pricing strategies that differ by customer, product and consumption levels. This triggers a number of technical accounting rules that make revenue accounting very complex.

Billing capabilities must also become more sophisticated. Services have to be added to the bill upon completion, support has to be tracked against the commitment level. Usage items must be billed in arrears while subscriptions are billed in advance—on the same invoice. Making sure revenue is being optimized while all this is going on requires the ability to monitor vast amounts of transaction activity and quickly find meaningful insights.

The crux of the issue is integrating contract terms into all the downstream financial workflows from order entry to billing, metering, renewals, revenue and expense accounting, and financial forecasting. Many existing financial systems are not equipped to support these demands and there is a risk of having spreadsheets crop up like weeds around the core system. This is one of the key things CEOs are concerned about today—how many spreadsheets did it take to produce the financial data they are being asked to sign off on? Ideally the answer is none. While regulations like Sarbanes-Oxley have forced the issue, software as a service models also demand more timely and detailed financial data.

The New Performance Metric - Revenue

The financial infrastructure has to be adapted to accurately capture, track, and forecast totally new revenue streams. Once the initial infrastructure readiness is accomplished, the demands for performance monitoring are also very different. In order to really understand how well the business model is working, we see CEOs asking for more detailed and timely answers to performance metrics by product, region, and customer segment, even down to the account level. Revenue and profit contributions are key issues. In order to better forecast future performance CEOs are asking for more details on the whole revenue chain from bookings to backlogs, billing, and revenue recognition. Some financial reporting capabilities that will be essential to success include:

  • Reporting and comparing bookings and revenue growth
  • Tracking renewal rates
  • Matching expenses (especially commissions) against revenue
  • Understanding how add-on sales to existing customers contribute to bookings and revenue goals
  • Having instant insight into revenue growth by new and existing customers
  • Improving visibility into how deferred revenue will be recognized over time

Reporting in all of these areas is required to measure the success of your Saas initiative and to support the ongoing strategic decisions that will need to be made. In particular, analyzing how efficiently revenue goes from deferred accounts onto financial statements is emerging as an effective tool for finding operational problems as well as keeping revenue recognition practices in compliance with complicated accounting rules. Not only will these reporting capabilities help you manage for success, these are the metrics your board and financial analysts will be looking for to evaluate your Saas business.

The Complexity Tradeoff

The complexity involved in all of this is a zero sum game. Making it all look simple and easy at the front end for the customer requires some very sophisticated capabilities at the back end. This is particularly true when hardware and software components are involved, or when you are required to track consumption or usage – as in some ecommerce businesses – and bill based on a sliding scale. The relationship between billing and revenue becomes completely separated. In order to provide meaningful performance information to executives, the system must be as automated as possible. Contract data, metering feeds, and pricing tables must independently drive both billing and revenue recognition. Otherwise revenue will fall through the cracks and the risk of reporting irregularities greatly increases.

This is no small undertaking for most companies, especially if separate systems for contracts, orders, billing, and accounting are entrenched, or if spreadsheets have proliferated. The key thing for CEOs to keep in mind is not to underestimate the operational issues that the addition of a Saas model is going to demand, particularly in the finance department.