Dear SaasCo
At its most basic level measuring financial performance is the review of revenue, gross profit and income/loss before tax. For many start-ups busy with growing teams, building product, dealing with customers and planning for the future the analysis of financial performance remains this simple – probably for too long. As long revenue keeps going up and SaasCo is making sales each month and we know what profit or loss is, we know we’re making progress and everything is fine – right?
Well maybe, but maybe not. Most start-ups lose money – which is fine – they are in “investment mode.” But how do we know the business makes enough on each sale to allow the company to scale into profitability? How do we know that the income we are reporting in the P&L is actually turning into cash? How do we know whether we are retaining customers as well as selling to new ones? How do we know that the company and management is improving and become more effective?
When we perform financial diligence on a business it’s often the first time that founders have seen financial analysis beyond the basic P&L and maybe current recurring revenue (monthly: MRR or annually: ARR). This analysis can often uncover underlying issues which need remediation and point strategic problems with the business – a nasty surprise for a founder when they need it the least.
So, the next series of emails to SaasCo will consider some of the issues with financial performance and look at some of the financial performance measurements for software companies that we use and you should be considering incorporating into board packs now. We’ll start by looking at some of the standard P&L presentation considerations and then progress to more complex measures over the series.
“Cash” revenue is a better proxy for cash generation than “earned” revenue
Most software businesses have unearned revenues raised on the sale of software service to be provided over the next month or year depending on how the sales cycle works. This unearned revenue is usually taken out of the P&L revenue and appears as a liability on the balance sheet. This treatment has the advantage of being a “prudent” approach – it removes revenue out of the P&L and leaves the cost. Consider the following company with lumpy B2B software sales, £40k of costs per month and no working capital (i.e. payments and costs are made immediately):
Some months it makes good sales and covers its costs, others it doesn’t – the net profit line will closely resemble cash movement in the month. The next diagram is the same company with exactly the same costs but with unearned revenue (or deferred revenue) removed and recognised over the period of the contracts.
This is “correct” from a general accounting principles (“GAAP”) point of view but has created a mismatch between the Net Profit of SaasCo and cashflow. This overlay of the cash “profits” of the business in red shows the extent of this difference:
So, in the GAAP instance, it’s been a tough and quite lossy year with £171k negative equity. In cash terms, it’s been okay and we’ve got a net increase of £100k of cash.
If your accountant does defer revenue get them to produce a cash flow statement as well – otherwise it’s hard to understand the whole picture. Our preference for management, particularly in the days before an FD is on board, is to report and forecast the P&L and save GAAP revenue for the statutory accounts.
We would also present this type of analysis in any investment/financing/sale process – it looks better and gives a much clearer picture of the business’s ability to generate cash.
Next time we will take a look at gross profits and the importance of gross margin.
Keith Benson
Partner, DSW Ventures