Operational, Control and Investor Reporting Considerations for Software Vendors Migrating to the Cloud
Revenue and cost accounting considerations are important for every traditional software vendor seeking to make the transition to a cloud service provider model of selling software-as-a-service (SaaS). However, making a successful software-to-SaaS transition also hinges on numerous other factors.
Although advancements in cloud technologies has lowered the cost of and technical barriers to making the software-to-SaaS transition, the transition will likely have a significant impact on the business. Understanding new risks arising from, and how to adapt performance and operating metrics to, the change to a SaaS business model will both be key to a successful transition.
Transitioning companies may face new risks, with direct implications on day-to-day operations, that did not exist as an on-premise software provider. Some of those new risks may not have previously been in the purview of the internal audit department or others that historically oversaw internal control over financial reporting; consequently important questions can arise about who is responsible for addressing these risks and who “owns” the associated controls. Consider the following as some examples of new potential risks:
1) Changes in or enhancements to product offerings. For both pure-play SaaS companies and those that sell a hybrid product – i.e. an offering with on-premise and SaaS elements, adding new features and functionalities will typically require the company to revisit its accounting conclusions about its offering(s). Changes to service and product offerings can create new performance obligations (e.g. change the distinct or non-distinct nature of a promised good or service) or change the nature of existing ones (e.g. its nature as a license versus a service). Thus, it is important that the company have proper processes and controls in place to identify and evaluate product offering changes.
2) Customer transition requests. While the company wants to transition its customers to a SaaS model, the customers may be content with their current on-premise solution or fear disruption from the transition. As a result, they may request certain accommodations or concessions to make the transition. Examples include requests to keep the on-premise license for an extended transition period that overlaps with the SaaS term, provide discounted implementation or other ancillary services, or provide price concessions on their existing agreement or other agreements. These types of requests create additional risks for the company in that they may go undetected by the accounting team, particularly if they are negotiated and agreed outside of a formal contract amendment process, and generally create additional accounting complexity.
3) Changes in customer provisioning/fulfillment. How the company provisions or fulfills its contracts with customers will likely change as it transitions to a SaaS model. For example, rather than sending customers license keys as a traditional on-premise software vendor, the mechanism the company will use as a SaaS provider to provision access will likely differ from the key system that was previously used. Therefore, new and different business and financial reporting controls may be necessary – e.g. to ensure only authorized customers have access to the company’s hosted software and that revenue recognition commences at the appropriate time. Frequent revisiting and adjustment of these controls may be necessary if the company continues to make changes to its offering(s) over time.
4) Compensation arrangements. Compensation arrangements, including commission, bonus and share-based compensation plans, may have been designed around the company’s legacy licensing model. In addition, operating as a SaaS provider may change what the company values in terms of employee performance – e.g. nurturing long-term customer delight and relationships versus short-term sales. Consequently, companies making the software-to-SaaS transition may need to modify their compensation arrangements to reflect their new business model and employee performance objectives. Making changes to employee compensation arrangements may take time and give rise to accounting consequences. Therefore, companies should identify affected arrangements and make necessary changes early in the transition process so as to avoid employee angst and later accounting surprises.
5) Cybersecurity risks. Evolving global regulations around data hosting and security means that cybersecurity may become a more vital imperative if the company, or a third-party provider on its behalf, will host client data.
INVESTOR REPORTING - NEW METRICS
Transitioning to a SaaS business model will frequently require the company to re-evaluate its operating and performance metrics. The subscription-based SaaS business model elevates the importance of accurately evaluating customer experience, as customers' decisions to renew or cancel their services have a lasting impact on revenues. Meanwhile, the growing importance of, and obligation to disclose SaaS-centric performance metrics also necessitate a fresh look by transitioning companies at their enterprise performance management frameworks.
Adopting updated metrics
Many companies would benefit from replacing or deprioritizing metrics they used to communicate business performance under a licensing business model with a new set of metrics designed and intended to communicate their sales performance and operational efficiency as a SaaS provider. In addition, as these companies mature in their new space, they may want to migrate from customer base metrics, such as number of customers and subscriptions per customer, to measures more often and specifically used by SaaS companies. These more insightful metrics may include customer lifetime value, customer acquisition cost, and annual recurring revenue.
It is important to recognize upfront that there will be some growing pains associated with the transition, as there is going to be a period of time where the company will have a portion of its business still operating under an on-premise licensing model and a portion that is now operating as a SaaS provider. During this transition period, it will be particularly important to be transparent with investors about how much of the business is still operating under the legacy model and how much of the business is operating under the new SaaS model, and how that impacts the metrics being presented.
Processes and controls
When a company adopts new non-GAAP and/or operating metrics, it will need to put processes in place to determine what data requirements are needed to compile the new or changed metrics, as well as processes and controls to monitor the consistency and accuracy of the reporting of those metrics. Because those metrics are often presented in SEC filings, earnings releases and other investor materials, companies need appropriate processes and controls to ensure transparency, consistency and accuracy of the information provided.
The bottom line
Of course, gaining a high-level understanding of the changes in business and operating metrics, risks, processes and controls is just one step towards a successful SaaS transition. However, it is a critical step. Companies that recognize their new responsibilities early on and are proactive about business process and control changes will experience a smoother, more organized transition. Companies should consider offering additional training to equip employees with the appropriate tools and knowledge to proactively identify and meet these new challenges.
Read Part I of this series, Accounting and Financial Reporting Implications for Software Vendors Migrating to the Cloud, here. For more detailed information about the revenue and related cost accounting and reporting of SaaS and traditional software companies, read our in-depth Handbook: Revenue for Software and SaaS.