For 25 years the software industry has changed in almost every way imaginable. But in one way, it hasn’t changed at all. Because for 25 long years enterprise software companies have chosen to record license fee revenue entirely up-front rather than “ratably” over time. It’s now time for software companies to go “ratable.”
Analysts and accountants have long questioned whether software contracts-which often take 18 to 24 months to implement, integrate, maintain and upgrade-deserve to pump up a current quarter’s balance sheet as up-front sales. Why record all of a company’s revenue and subsequent earnings at one time, creating lumpy financials and virtually no backlog of licensing revenue when there’s clearly a better way?
In a March 2001 U.S. Bancorp Piper Jaffray report, Senior Research Analyst Jon Ekoniak writes: “Most major software companies recognize revenue up-front, upon the deal’s closing. There are advantages to this approach, as it results in a higher level of reported revenue and accelerated profitability. However, it does not facilitate the building of significant license revenue backlog. Instead, companies enter each quarter with a relatively fresh start and must forecast revenues based on the pipeline and projected closure rates. This model offers limited visibility, results in uncertainty throughout the quarter, and more often than not creates a few sleepless nights.”
The same holds true today. Recording revenue up front does not help determine the true health of a company. The push to “make the quarter” becomes a driving business strategy simply because traditional revenue recognition has created this dynamic. And because the biggest players in the industry-IBM, Oracle, Siebel Systems-do it, so does every other software company hoping to go public.
In fact, though logic would dictate that recording revenue ratably would make far more sense from a simple sales, accounting and shareholder perspective, there’s little to no incentive for any company to be the first to pull the trigger. By switching to recording revenue over 18 to 24 months, companies would be making a conscious decision to significantly slice near-term revenue and profitability in favor of spreading revenue and earnings over time. In tough economic times, when companies are far more interested in sprucing up this quarter’s results, few would choose long-term logic over short-term window dressing.
From Wall Street’s shortsighted perspective, going ratable doesn’t make business sense. And for venture capitalists who are shining up software investments in hopes of shopping them to the highest bidder, reducing near-term financials makes perhaps even less sense. The higher the numbers, the higher the valuation.
Yet, if we can resist the temptation to think short term, the argument for ratable revenue recognition grows stronger, allowing companies to plan for and weather tough economic conditions while accommodating shifts in the software industry.
Time Is Money
The beauty of software as a product is that it has value over time. Yet, how we record revenue on that product doesn’t truly mirror its value. Analysts have difficulty covering software companies because the companies themselves have no visibility into the future. And customers, knowing full well this is how the game is played, will wait until the last possible moment to sign purchase agreements. Software executives wind up using pipeline estimates and past closure rates as their only revenue forecasting tools-tools that are suspect at best.
If revenue is recorded ratably, software customers will have less leverage over vendors; investors will have profit and loss statements more accurately reflecting the true economics of a business; and management, the company’s board of directors and Wall Street will have far more visibility into a firm’s current and future financials. As Ekoniak writes in his report: “With corporations scrutinizing their technology investments much more closely, software companies have much more limited visibility into future financial performance. Consequently, those with ratable revenue recognition models are winning the favor of institutional investors.”
Randy Bolten, former CFO of Broadvision, has given this issue careful thought and realizes the challenges ahead. “Revenue recognition within software companies is possibly one of the most controversial and important accounting issues anywhere in technology,” Bolten says. “Technically, it’s not that easy to just change accounting policy. First, you must change the way you do deals, for example, to subscription sales. Then, you must restate revenue for prior periods to conform to a new policy, even though using the word restatement’ is like using the word “bomb” in an airport.”
Yet, the benefits outweigh the disadvantages. “In this day and age, how you do a deal has more to do with what a customer wants than with what a vendor wants,” says Bolten. “Customers might prefer subscriptions rather than up-front license fees as a means of better managing their cash-in which case you have to record revenue ratably. And by doing so, vendors will be far less sensitive to whether deals get done by the end of the quarter, given that they know they will have other revenue back-ended into the future.”
From a CFO’s perspective, going ratable also radically reduces the tense and often-contentious discussions clients now have with their auditors. “Auditors are now tougher on big-ticket deals,” says Bolten. “But if revenue is spread over 24 months, there’s less pushback from auditors in signing off on financials.”
The Guessing Game