What makes Tech so important
Since the availability of the internet in the 1990s, the tech industry has centered on the transformation of the data revolution from the industrial manufacturing led revolution. Today, it stands in the trillions of dollars and is the single largest addition to wealth in the last 20 years (over 45% of Total Market Cap in NASDAQ are tech companies in 2017). This information in the internet age has been touted as the fourth industrial revolution (The Global Information Technology Report 2016, World Economic Forum). Tech is here to stay.
What makes Tech so different
Now, while the finance in the tech industry seems simple, Revenue – (Employee Cost + Facility Costs), the complexity comes from the absence of physically tangible commodity which can be consumed over time and a fundamental shift in the dynamics of the relationship.
Let’s break this down into 3 fundamental aspects which set ‘tech finance’ aside:
Value in use as compared with value on sale: The emergence of consumption tied directly to the provider’s revenue (SaaS, pay-per-use, freemium, pay-as-you-go, pay-per-instance…) opens up a number of questions of when value is being delivered and when commensurate consumption of effort occurs.
For example, a company (let’s call it, ‘Healthinity’) which I had worked with, had built a unique device in the field of healthcare where the revenue model was linked to a franchise and pay-per-use structure. Healthinity would receive revenue from the product over the lifetime of the product as the value of the product would keep getting enjoyed rather than on the sale of the device.
Longevity: Compared with a tangible product, the technology industry requires consumption of service over a period of time with an implied promise of support which may not be commensurate with revenue generated.
For example, a company (let’s call it, ‘GilFrend’) which I had worked with, had perfected a SaaS based solution to ERPs. While the service was priced on the basis of number of licenses used on a monthly basis, there was an implicit understanding that the company needed to support the data and integrity of the system as a whole in perpetuity and an express understanding for technical support for the next 3 years.
Investment on intangibles first: The fundamental of technology services implies a significant investment of time, effort, resources and capital initially. Whether it is learning/ building a domain expertise or developing a product, the value is being generated much before the consumer fetches a service/ product.
For example, a company (let’s call this one ‘Ensecore’) which I worked with, had built a product after 4 years of research and development of over $5M. This product had received adoption with its first few clients jumping on to the beta product which was refined over time which would do significantly different functionality from the final product. However, aonly the final product would make revenue when the circle would be completed.
The intricacies of Finance in Tech
Revenue is very different from invoicing.
GilFrend’s was initially contemplating booking revenue as invoiced. Applying the simple principle of ‘Substance over Form’, the revenue recognition is to be deferred till the time that the company has an obligation to perform services though the collection of moneys may have happened much earlier.
The role of estimations is quite prevalent.
Let’s take an example of the popular collaboration software, Slack. Slack is free upto 20 users and upto a volume of conversation threads. Slack begins collecting revenue when an organization has been crossed the 20-user limit. Does this mean that the revenue was not earned the time that the product was being used by under 20 employees? No. It was. The value was being delivered and the customer engaged from the time that a company started using it and began engaging with the product.
Longer horizons and the duality of cost and investment.
Ensecore, which had built the product over the years had booked ‘losses’ against all the development effort expended, which was not right. An assessment of the time expended showed that the endearing value of the product would be over the next few years and there was a definite association of the effort to the product being developed. Isn’t the development effort’s value going to reap benefit over the next 5 years or more? Yes. Then the cost of the development effort was really an asset that human effort was used to build.
This being said, there is no ‘one’ way. While GAAPs have guidelines for measurement and recognition, the business can choose to differ on certain aspects simply because of the uniqueness of their business model. The real decision of what is right needs to come from experience on the technical side as well as the business side. This is what is making CFOs great CEO candidates off late.
If you think your organization is facing a similar set of dilemmas, situations commanding an understanding of Strategic Finance or you know you need to go forward while you’re still ahead, I can be reached on nag[at].