In most emerging and growth SaaS businesses, the focus is on cash flow and growth. Bookkeeping and choice of accounting method is many times left to whomever is sending the invoices and paying the bills.
And the method tends to be whichever is easiest and least expensive.
Since you have to file taxes (and for most early stage companies, taxes are done on a cash basis), then the company books tend to remain that way. However, what you save in bookkeeping costs may really cost you in the end.
The Accounting Method for SaaS Businesses
When it comes to taxes, there are a number of IRS rules to determine if you have the option to use one method or the other, or if you are required to use one. However, for GAAP financial statements, the accrual method is the only approach. That means you accrue revenues for subscriptions and other services that are delivered over time, and you do the same for expenses such as rent, sales commissions and service expenses delivered over time.
Naturally, if you raise capital and your investors require an audit, you are going to be concerned with proper GAAP financial reporting. Most small and emerging businesses don’t, and therefore don't typically concern themselves with GAAP financials. It is sometimes difficult to justify the overhead and expense of keeping your books using the accrual method, especially if you keep tax books using a cash method.
But there really is a need. It's called liquidity! It might be a ways in the future, but it's out there. Whether it's through a merger, acquisition or if you're one of the lucky ones to go public, the need is great.
For most traditional businesses, liquidity comes through cash flow. For many others, including most SaaS/software businesses, liquidity comes through an acquisition. And, it is the acquisition that is the driving need for accrual accounting.
The company looking to acquire you produces GAAP financials.
The huge fish eat the big fish, and the big fish eat the small fish. You are the small fish. The huge fish is likely a public company and works exclusively with GAAP/accrual accounting. No surprise there. What might catch an entrepreneur off guard is that the big fish is almost certainly using accrual for taxes and producing GAAP financial statements.
A corporation with revenues in excess of $5 million is typically required to report taxes using the accrual method, and since the big fish has investors, a board and is looking to get taken out by a larger fish, he produces GAAP financials. Remember, the big fish almost always creates liquidity through the same method as small fish: acquisition. It runs down stream, so to speak.
3 things to prepare for before acquisition conversations.
When you enter into acquisition discussions, you will need audit-ready, GAAP-compliant financial statements. No big deal, right? Here is the catch. It's significantly harder to generate financial statements when your record keeping and culture are based on the "cash" accounting. The impact is significant.
- The cost of the audit and accounting efforts climbs dramatically.
- It takes significantly more time. Time almost always works against you during due diligence and closing.
- Most importantly, there is the buyer perception of significantly added risk — risk to the buyer that your financial statements may not be accurate (anything done after the fact is always going to be perceived as more risky).
The more history to recreate, the riskier the purchase. How do buyers manage risk? Through lower valuations, bigger hold-backs and more earn-out. These transaction adjustments are often thrown in during the final days and in minutes of the closing.
Start preparing now for an audit.
If an acquisition is a possibility for your business, save yourself some heartache and preserve your valuation. Start now by adopting proper revenue recognition and expense amortization practices that are essential to accrual accounting. And remember, that selecting the Cash or Accrual options in QuickBooks isn't the answer. That only changes the income reporting period from the payment date to actual invoice date.
You will need to manage revenue recognition and expense amortization in a spreadsheet or product like SaaSOptics, because QuickBooks has no inherent ability to do so.