In the arcane world of tax law, there is an ogre of a rule that has choked a few deals to death. The American Institute of Certified Public Accountants Statement of Position 97-2 (“SOP 97-2”) provides that a company cannot report revenue as realized (earned) until it delivers the product or service. In the SaaS world this rule requires that vendors, when charging a blended fee for access to a software systems, show vendor-specific objective evidence (“VSOE”) of value. VSOE is a method for determining the individual value of each invoiced item within a contract to accurately recognize partial revenue before the entire contract is fulfilled. Ugh!
So, when a SaaS company sells licensed software on an annual contract, the fee must be separated into its various parts (license, set-up, service, hosting, etc.) and recognized ratably over the entire year. The revenue collected must match the timing of the service provided for the vendor to accurately recognize the revenue according to GAAP and SOP 97-2. Hence, the first month’s revenue for the license fee can be recorded as current revenue, but the later month’s revenue must be reported at deferred revenue.
So why does that matter?
Take the case of an unnamed publicly traded SaaS company seeking to sell licensed access to its enterprise-level product at hefty price point. The sale to a very interested and willing prospect was likely to occur near the end of the sales quarter. Hobbled by the laws of revenue recognition, the SaaS vendor could not “recognize” the fat tranche of newly booked revenue in the near term without providing VSOE. Assuming the SaaS product was well designed and easy to set up and use, VSOE for revenue occurred as the new customer accessed the system over time – consequently delaying revenue recognition until later quarters. Not good news if you are publically traded company when end-of-quarter sales numbers directly affect your market value.
Seeking to front load that revenue and, thereby, make itself look more profitable, the SaaS vendor chose to “locate” more of the overall revenue in the near-term by front-loading the professional services fee and discounting the ongoing license fee under the argument that the services required were very important to a successful launch. To warrant a high fee, the vendor jacked up its per hour pricing. The prospect balked. It’s understanding of the product, realized through many demonstrations, was that easy to deploy and easy to use. The salesman had used that premise all during the sales cycle. When queried by the prospect about the large professional services fee, the vendor contradicted the core value upon which it had originally interested the prospect – ease of deployment and use – explaining that the start-up might be more complicated than first realized. No matter how hard the prospect pushed for a clear explanation or a reduced professional services fee, the vendor could not explain their reasoning and would not reduce the professional services fee to a palatable number.
The vendor would not reduce the fee because management was more interested in pumping up the recognized revenue number within the quarter than in delivering a valuable product. The result was a lost deal; an unhappy willing-and-ready prospect; a ticked off salesman; a lower overall sales number for the SaaS vendor, a lower quarterly earnings report; a lower stock price, and all the attendant bad news and sorry consequences that go along with a sale lost for all the wrong reasons. Bad tax rules spawn bad business practices. Who can blame management for wanting to report a full sales number? Who can blame the customer for wanting a reasonable explanation, even if the overall cost would be identical?
Even with ogres like SOP 97-2 lurking in the shadows, the moral of this story is simple: Provide value to your client by producing the best product at the best price. Worry about your revenue later.