SAAS ACCOUNTING: A CPAs Guide

SaaS has been one of the hottest business models for the past decade, if not more. But accounting for SaaS is anything but simple.

From revenue recognition to understanding R&D vs customer service costs, SaaS business founders rely on tons of metrics to run their business. And VCs look for specialized SaaS ratios and calculations, like LTV to CAC, magic numbers and more.

Here are some of the reasons an high-growth SaaS business needs great accounting:

• Small changes in churn, ARPU or other user metrics can drive massive swings in cash flow
• Executives make better decisions when they use credible data
• Understanding and projecting working capital, especially as it relates to deferred revenue, can help a company reduce its need on outside venture capital - if managed well
• Sales taxes and state and federal taxes require good accounting
• Revenue recognition is always a pain, but is also critically important - especially when selling the business to a large player or when raising millions of venture capital financing.
• VCs love the financial metrics produced by subscription businesses. ARR, ACV, revenue churn, etc. all matter - so getting these numbers right matters at a fundraise!

Which does your SaaS business need, cash or accrual based accounting? If you are funded, you need accrual! Some bootstrapped founders may be totally fine only doing cash based accounting - but they do need to realize that all of the SaaS metrics that are commonly used to measure a subscription business’ efficiency and trajectory are NOT going to work. You need accrual accounting to use the most common SaaS metrics!

And VCs are GOING to need accrual accounting - as close to GAAP (generally accepted accounting principals) as possible. VC’s expect accrual. 

SaaS companies should create their financial statements in compliance with GAAP to ensure they maintain financial transparency, use trustworthy metrics to manage the business, and communicate clearly with venture capital investors. GAAP (Generally Accepted Accounting Principles) are created by FASB (Financial Accounting Standards Board), and GAAP uses accrual accounting. 

The biggest GAAP issue for most SaaS companies is revenue recognition, which we discuss above. Other items that require focus for accurate accounting include getting the cost of goods sold right, knowing when to capitalize software expenses, equity based compensation (tbh, not always worth the cost and effort for early-stage companies to do the equity based comp), and using accrual accounting for major expense items. 

How GAAP helps subscription company founders

GAAP helps founders better understand and manage their business in several ways:

• Produces Consistent and Accurate Financial Reporting: GAAP provides a standardized set of accounting principles and guidelines that subscription companies should use to ensure that their financial statements are consistent and accurate. This consistency and accuracy lets founders compare results across different time periods, and helps them make metrics-driven decisions about their business based on consistent/reliable financial data.
• Provides Visibility into Business Performance: GAAP-compliant financial statements provide a clear picture of a SaaS company’s financial performance, including revenue, expenses, and profitability. This visibility can help founders identify areas of the business that need improvement or investment and make strategic decisions based on financial data.
• Helps Secure Venture Funding: Subscription companies are favorite investment target for VCs - because of their metrics (and sticky revenue streams). GAAP-compliant financial statements can provide potential investors with a clear and reliable picture of the company’s financial health, increasing the likelihood of securing funding. And your BOD is going to want to regularly see financials presented in accordance with GAAP. 
• Facilitates Compliance with Regulatory Requirements: SaaS companies are subject to various regulatory requirements, such as sales tax laws (and once they get ready to go public, SEC reporting requirements). Consistent financials also help secure startup-specific tax credits like the R&D tax credit, which requires a founder to know which efforts were spend on innovation. 
• Enhances Transparency and Trust: GAAP compliance can enhance transparency and trust with stakeholders, including customers, investors, and employees. By providing accurate and reliable financial statements, SaaS companies can build trust with stakeholders and demonstrate their commitment to ethical and responsible business practices.

By adhering to GAAP US guidelines, SaaS companies can present accurate financial reports, build investor trust, and ultimately grow their businesses.

SaaS companies can serve enterprises, consumers or anything in between. The size and type of contractual relationship with a client makes enterprise focused Software as a Service companies completely different from consumer apps sold on a recurring revenue stream through an app store. While the LTV to CAC relationship and other metrics matter for both, enterprise-focused companies have to deal with other metrics like book to bill. And consumer focused businesses should be monitoring churn cohorts and other user data very closely. 

One of the biggest differences in how B2B vs B2C businesses run and manage their SaaS accounting is billing and invoicing. B2B startups with only a handful of large, enterprise clients often get away with using simple invoicing solutions like the billing offerings offered by Intuit (embedded in QuickBooks). Consumer facing companies have more robust billing requirements, and often have a SaaS accounting system setup that includes Shopify, app store billing and other complicated systems.

The good news is that Kruze’s team is familiar with all flavors of Software as Service business models, and we can support your financials and metrics whether you sell to Fortune 500’s or to consumers.

Software as Service companies need to regularly produce three major financial statements. These are the Income Statement, Cash Flow Statement and Balance Sheet. Additionally, SaaS companies have other metrics that may or may not be on the actual financial statements - like bookings, ARR and more. It makes sense to work with an expert bookkeeper or controller who understands how these numbers relate to your business’ GAAP financials.

The Income Statement

The income statement is often the first financial statement that a VC will evaluate when looking at a subscription business, so get the accounting right! This statement shows:

• Revenue
• Cost of Goods Sold (COGS or COS)
• Gross Profit (Revenue - COGS)
• Operating Expenses
• Net Profit

We go into the accounting for revenue and cost of goods sold in greater detail below, and we have an entire article on the income statement here.

Cash Flow Statement

This accounting statement shows the company’s:

• Changes in Inventory
• Other working capital changes (like changes in payables)
• Operating income
• Investments in equipment
• Capital raises and loan paydowns
• Net cash flow / change in cash position

The Balance Sheet

The balance sheet shows:

• Assets
  • Cash
  • Inventory
  • Accounts Receivable
  • Other assets like equipment, buildings, etc.
• Liabilities
  • Accounts Payable
  • Deferred Revenue
  • Credit Card liabilities
  • Loans (like Convertible Notes)
• Equity
  • Invested equity (includes SAFEs)
  • Retained earnings

Our Software as a Service companies tend to carefully track their MRR and ARR. However, along with deferred revenue, MRR and ARR calculation and revenue recognition is the most difficult part of providing SaaS accounting services.

ARR, MRR and recognized revenue are difficult for many SaaS companies. While accounting systems can produce automated revenue numbers, someone needs to review them. And if there isn’t a real accounting doing that, the work falls to the SaaS company’s CEO.

In SaaS, the customer never “obtains control” of the software/service, so the general rules of revenue recognition don’t cleanly apply. Instead, accounting rules generally require SaaS businesses to recognize revenue over the contract term. This recognition is the case regardless of when the client pays the SaaS company, so even if the client pays upfront or quarterly, the revenue is recognized the same. We can’t tell you how often we see this mistake when a SaaS company uses an “automated” accounting provider.

Deferred revenue is even more complicated since it’s not as easy of a financial figure to understand. At its most basic level, if your clients are paying ahead of time for services, your company will put a deferred revenue liability onto the balance sheet. And as you deliver this service and recognized revenue, the deferred revenue liability decreases.

The price of incorrectly accounting for revenue and deferred revenue can be high. During due diligence, experienced SaaS VCs will request your financial statements, and they expect the numbers to match (although, reporting a bookings ARR number is 100% legitimate and won’t be reflected in your GAAP financial statements). Public technology companies spend even more time doing due diligence of SaaS revenue recognition, so if you are going to be acquired these numbers matter.

Invest in a good partner to help your business get these right!

Investors love SaaS companies because they the predictability of the recurring revenue. But they also love all of the metrics that are generated by subscription businesses as they grow. Of course, the best founders also embrace these metrics to help them build a best-in-class company. On this page we’ll focus on the accounting driven metrics, but visit our SaaS metrics article to see an expanded list of important KPIs (or read about these metrics from one of the leading SaaS VCs), not all of which are driven by accounting numbers. The KPIs below are some that our accounting team has been asked to produce during VC due diligence.

LTV to CAC

LTV to CAC is the OG SaaS multiple. It combines a prediction of a customer’s ‘life time value’ (some VCs call it ‘long term value’; you say potato I say potatoe) with the cost to acquire the client. The theory behind the metric is that it shows how much possible cash flow each customer produces vs. the up front expense of acquiring them. 

It is calculated by dividing the lifetime value (LTV) of a customer by the customer acquisition cost (CAC). The formula is:

LTV to CAC Multiple = LTV / CAC

A higher LTV to CAC multiple is generally considered to be better, as it indicates that the company is generating more revenue from each customer over their lifetime, relative to the cost of acquiring that customer. Typically a metric over 3x is good; under 3x and there is a danger that the company will never generate enough cashflow to over come operating expenses, and thus will never become cashflow positive.

ACV - Annual Contract Value

Annual Contract Value (ACV) is a financial metric used by SaaS companies to measure the annual value of a customer contract. It is calculated by taking the total contract value and dividing it by the number of years in the contract. It’s not a GAAP or accounting defined metric, but it’s a way of looking at contracts that has been informally agreed upon by well-known SaaS investors and startup founders. It’s important to let investors know how you’re calculating it, so there are no surprises. It doesn’t include non-recurring revenue streams such as installation or one-off consulting revenue. It’s important for SaaS companies because it helps them understand the average value of a customer contract and predict future revenue. It’s also used to measure the performance of sales teams and the overall health of the business. Larger ACVs usually unlock more expensive and elaborate sales and marketing activities. We write more about ACV here.

Net Dollar Retention

Net Dollar Retention (NDR), also referred to as Net Revenue Retention,  is a crucial SaaS metric that gauges revenue evolution within an existing customer base over a specific period, taking into account expansions, churn, and contractions. It serves as an indicator of customer satisfaction, their perceived product value, and the efficacy of retaining and upgrading customers. For founders and venture capitalists, NDR provides insights into a startup’s health, growth potential, product-market fit, and profitability prospects.

Rule of 40

The Rule of 40 is a “back of the envelope” metric used by venture capitalists to evaluate the performance and potential of SaaS startups. It is calculated by adding the company’s annual growth rate to its net profit margin (typically this is a negative margin as the vast, vast majority of early-stage SaaS startups are losing money both on a GAAP accounting basis and on a cash basis!). The goal is to have a number above 40 as it indicates that the company’s growth is overcoming its loss.

Most VCs think of this metric as a quick and simple way to measure the health of a startup and is used by VCs to assess a SaaS company’s potential for scaling and profitability.

It’s important to note that most VCs only use recurring revenue growth in the calculation, ignoring non-recurring revenue or one-time earnings. The Rule of 40 should not be taken as a definitive metric and should be used in conjunction with other financial and operational metrics to evaluate the performance and potential of a SaaS startup. 

SaaS Burn Multiple

Not to be confused with a cash burn rate, a SaaS burn multiple is a measure of a company’s capital efficiency vs its growth. It’s a good metric for evaluating the financial health and growth potential because the metric takes into account both gross margins/profit and sales and marketing expenses.

To calculate it, divide the net cash burn (excluding any financing activities) by the net new ARR for the same period. 

Gross Profit

As accountants, it pain us to say this, but gross profit is an under appreciated SaaS metric. A SaaS company’s Gross Margin is a financial metric that measures the profitability of a company’s products or services. It is calculated by subtracting the cost of goods sold (COGS) from the revenue (generating the gross profit) and then dividing that number by the revenue. The resulting percentage represents the percentage of revenue that a company retains after deducting the direct costs of producing its products or services.

For SaaS startups, gross margin is a crucial accounting metric to track because it indicates the efficiency and scalability of their business model. A high gross margin means that the startup is able to generate revenue from its products or services at a low cost, which makes it more profitable and sustainable in the long run. Additionally, a high gross margin also indicates that the company has room to invest in growth, such as sales and marketing efforts, R&D, and hiring new employees.

ARR is generally the most important metric tracked by subscription companies. It shows the scale of a SaaS business, and can be used to track growth over time. Plus, comparing it to burn, spend and other metrics produces powerful efficiency KPIs.

Confusingly, it’s not a metric defined by accountants and it doesn’t show up on the income statement! 

Recognized revenue is the metric that should be used to calculate Annual Recurring Revenue for most SaaS companies. It is the revenue that has been earned and is recognized on the company’s financial statements, meaning the company has delivered the product or service and is entitled to receive payment. This is a major reason why it makes sense to work with an experienced SaaS accountant!

However, for some enterprise B2B SaaS companies, tracking booking ARR may be more appropriate. Booking ARR is the value of new annual contracts that are booked in a given period, regardless of when the revenue is recognized. This metric is useful for enterprise B2B SaaS companies because the sales cycle is often longer and the revenue may not be recognized until later. It can provide a more real-time view of the company’s revenue growth and sales performance.

Learn more about ARR here.

Working capital is one of the more challenging aspects of bookkeeping (and building projections) for subscription companies. 

At a high level, working capital is the difference between a company recognizes and expense or revenue and when it pays/collects the cash. 

Subscription companies often get paid ahead of time for a service that will be delivered over the course of a year. This is great for cash flow! However, it complicates the accounting. We see many inexperienced bookkeepers recognize the full cash payment upfront as revenue instead of recognizing it over time. This can cause significant misstatement of ARR, and can not only make a founder incorrectly run their business, but can damage a VC fundraise.