Deferred Revenue Management for SaaS Startups

If you’re leading a SaaS or subscription-based startup, you should get familiar with the concept of deferred revenue. While deferred revenue is beneficial for bringing cash into your startup more quickly, it presents unique challenges in accurately tracking and recognizing it, as well as ensuring compliance with industry accounting standards.

In the concept of accrual accounting, deferred revenue is defined as payments received for services that your startup has not yet delivered and is often called unearned revenue. It’s recorded as a liability on the balance sheet because a service has not yet been provided to a customer. However, a portion of the money is recognized each month as the service is provided to the customer until the contract is fulfilled.

This post is designed to serve as a practical guide for founders and financial leaders navigating deferred revenue from the early seed stage through Series A fundraising and beyond. Read on to learn more or contact Graphite Financial today.

How Deferred Revenue Works in a SaaS Business Model

In a SaaS business model, SaaS deferred revenue enhances cash flow by generating revenue before goods or services are fully delivered. Though it appears as a positive inflow on the cash flow statement, it creates a future liability. This means that deferred revenue requires careful financial management over the term of the customer relationship, as cash has already been received and there’s no new cash flow event, only a shift from liability to earned revenue.

For example, take a $12,000 annual contract that has been paid upfront by a customer. The $12,000 becomes deferred revenue on day one, with $1,000 recognized monthly as the service is delivered. Moreover, at the halfway point of the annual contract, $6,000 will have been recognized, while the remaining $6,000 is still listed as deferred revenue because your startup still owes the customer for the service they’ve already paid for.

Don’t confuse deferred revenue with cash-basis accounting. In a cash-basis accounting situation, revenue is recorded when the cash is received. Deferred revenue delays the recognition of revenue until your startup fulfills its obligation.

The Deferred Revenue Formula and Recognition Schedule

Follow the deferred revenue formula and a recognition schedule to ensure your startup accurately tracks recognition over time for consistent financial reporting. Here’s the deferred revenue formula to follow:

• Deferred revenue = Total contract value – Recognized revenue

It’s best practice to follow a recognition schedule to stay on track. A revenue recognition schedule is a plan that specifies how and when revenue from a customer contract is recorded in your startup’s financial statements across different accounting periods. The schedule is designed to align directly with the contract term by mirroring the actual delivery of a good or service per ASC 606 standards. Contract terms may be monthly, quarterly, milestone-based or annual.

While most contracts are annual, you may encounter situations where contracts are longer-term and span multiple years. You’ll follow a similar process by recording the upfront payment as a liability and then recognizing portions over the entire contract term.

However, you’ll want to separate current versus long-term liability on your balance sheet. For example, for a three-year contract valued at $30,000, you’ll portion out the deferred revenue expected to be earned within the next 12 months ($10,000) as a current liability and list the remainder ($20,000) as a long-term liability, since it extends beyond one year. A good accounting program can help keep you on track and can automate deferred revenue tracking.

Recording Deferred Revenue in Your Financial Statements

So, where does deferred revenue appear in your financial statements? Of the three core financial statements, it should appear as a liability on your balance sheet. However, as services are provided to fulfill the customer contract, it should be recognized as revenue on the Income Statement, thereby moving from a liability on the Balance Sheet to earned income on the Income Statement. This reduces the deferred revenue balance.

Deferred revenue initially boosts your startup’s cash flow even though it’s listed as a liability on the Balance Sheet. Yet, as services are delivered, the liability will decrease and revenue on the Income Statement will increase, thereby also increasing net income. However, as deferred revenue is recognized, it will reduce operating activities on the Cash Flow Statement because the cash was already received with the upfront payment.

Why Deferred Revenue Matters for Investor Due Diligence

Deferred revenue isn’t just something that matters when it comes to your startup’s financial management, it’s also a factor that’s carefully weighed by investors during the due diligence process as part of a fundraising round.

Investors are typically concerned with the quality of your deferred revenue accounts. What does this mean, exactly? It means they tend to assess the alignment of your deferred revenue with GAAP standards and attempt to determine the true liability value, as well as its potential impact on future earnings and your startup’s valuation. Assessing the quality of your startup’s deferred revenue helps ensure that they aren’t overpaying for future revenue that may not materialize, or for earnings or purchase prices that could be inflated. Growing deferred revenue tends to signal strong sales momentum and vice versa.

Investors will also look at Remaining Performance Obligation, or RPO, during due diligence as a forward-looking indicator. RPO displays future contracted revenue that has not yet been delivered, which encompasses both deferred revenue and unbilled amounts. This can reveal predictability and growth momentum, and is often presented along with ARR and NRR. RPO helps assess your startup’s financial health beyond just the recognized earnings and complements cash flow management plans when customers pay upfront.

Deferred Revenue and the Rule of 40

It’s important to note that deferred revenue does not directly contribute to revenue growth calculation in the Rule of 40. Keep in mind that deferred revenue is an indicator of future revenue potential. The Rule of 40 is a key benchmark that represents the sum of the recognized revenue growth rate and the profit margin.

While deferred revenue does not represent earned revenue, it’s still largely a positive for SaaS startups. Healthy deferred revenue trends and strong gross margins together provide compelling evidence of solid unit economics, indicating the quality of your customer relationships and the profitability of delivering on the service.

Enterprise SaaS firms, such as Salesforce and Snowflake, actually report deferred revenue and RPO in their quarterly earnings to signal future revenue visibility.

Common Deferred Revenue Challenges for SaaS Startups

There are various challenges associated with understanding deferred revenue that all startups should be aware of. These include:

• Recognizing revenue too early. This can lead to compliance issues and revenue restatements.
• Confusing deferred revenue with available cash. This can lead to spending cash that is already accounted for and result in overspending.
• Issues with upgrades, downgrades and cancellations. This requires frequent adjustments to deferred revenue schedules during the contract.

Managing Contract Modifications and Churn

Upgrades, downgrades and cancellations that modify contracts are one of the biggest challenges startups must overcome pertaining to deferred revenue. Adjustments require a systematic approach based on the new contract and various accounting principles. Ideally, the old contract’s terms are cancelled, and the new contract’s terms are assumed, with deferred revenue following suit.

Cancellations are a different story and largely depend on how the customer contract is written. Based on the situation, you may need to recognize the deferred revenue as revenue immediately, refund a portion of the payment, which reduces both liability and cash, or perform a combination of both.

Tools and Systems for Deferred Revenue Management

Various tools and systems can help your startup properly manage its deferred revenue while keeping your financials’ audit-ready. Platforms such as QuickBooks and NetSuite handle basic deferred revenue tracking, while more SaaS-specific and high-level solutions such as Chargebee, Maxio and Stripe Billing work to automate schedules based on subscription terms. The right programs can serve as a key asset for managing deferred revenue.

Another best practice is to integrate billing and accounting systems. This can help create a single source to derive key information from.

ASC 606 Compliance and Deferred Revenue

Startups should adhere to industry standards, such as the ASC 606, for revenue recognition. The ASC 606 follows a five-step process, which consists of:

1. Identify the contract with the customer.
2. Identify distinct performance obligations.
3. Determine the transaction price.
4. Allocate the price to the performance obligations.
5. Recognize revenue when each obligation is satisfied.

ASC 606 standards provide a consistent method for companies and customers to recognize revenue and match revenue with performance. It’s also important to note that audit readiness requires documented policies and consistent application of the recognition standards.

Build Financial Confidence with Proper Deferred Revenue Management

Are you struggling to manage your startup’s deferred revenue? Consider working with an expert financial partner, such as Graphite. As a full-service financial support firm, we specialize in working with startups to help them manage their financials and our services include deferred revenue management. When you work with Graphite, we’ll pair you with one of our fractional CFOs to help your startup with its financial forecasting, investor relations and financial compliance, and all at a fraction of the cost of what it would be to hire a full-time professional in-house.

Contact Graphite today for more information and to schedule a consultation.

FAQs

What is deferred revenue in SaaS accounting?

Think of deferred revenue as unearned money. That is, deferred revenue is money that your startup receives upfront for services that have not yet been delivered. Common in SaaS business models, deferred revenue is recorded as a liability on the balance sheet because a service has not yet been provided to a customer. However, a portion of the money is recognized each month as the service is provided to the customer.

How do you calculate deferred revenue for a subscription business?

Use this formula to calculate deferred revenue for a subscription-based startup:

• Deferred revenue = Total invoiced amount – Total recognized revenue

For instance, if a customer pays $1,200 for an annual subscription, the full $1,200 will be recorded as deferred revenue. However, each month of the year, you’ll recognize a portion of the payment as earned revenue. In this case, you would recognize $100 per month as earned revenue until the full amount is recognized as earned.

Is deferred revenue an asset or a liability?

Deferred revenue is a liability because it represents money your startup receives upfront for goods or services that have not yet been delivered. This creates an obligation to the customer until the service is performed or the product is fully provided. Deferred revenue is essentially a promise to deliver goods or services.

How does deferred revenue affect cash flow?

Deferred revenue boosts cash flow by bringing in money before goods or services are fully delivered. However, while deferred revenue appears as a positive inflow on the cash flow statement, it creates a future liability. Deferred revenue requires careful financial management over the term of the customer relationship. That’s because cash has already been received and there’s no new cash flow event, just a shift from liability to earned revenue.

What happens to deferred revenue when a customer cancels?

If a customer cancels, it’s typical for a startup to issue a pro-rated refund to the customer for the unused portion of the good or service, or retain the money in exchange for the customer continuing to access the service until the end of the contract term. Based on the situation, you may need to recognize the deferred revenue as revenue immediately, refund a portion of the payment, which reduces both liability and cash, or perform a combination of both. The answer largely depends on your startup’s cancellation policy.

How do investors evaluate deferred revenue during due diligence?

Investors are mostly concerned with the quality of your deferred revenue. For instance, they’ll typically assess its alignment with GAAP standards and attempt to determine the true liability value, as well as its potential impact on future earnings and your startup’s valuation. Essentially, evaluating the quality of your startup’s deferred revenue helps ensure that they aren’t overpaying for future revenue that may not materialize, or for earnings or purchase prices that could be inflated.