A reader suggested this topic for MBA Mondays. It is a good one.
When a customer commits to spend money with your company, that is a “booking”. A booking is often tied to some form of contract between your company and the customer. The contract can be simple or very complicated. And some bookings do happen without a contract. Examples of these contracts with customers include an insertion order in advertising, a license agreement in enterprise software, and a subscription agreement in “software as a service” businesses.
Revenue happens when the service is actually provided. In the case of advertising, the revenue is recognized as the ads are run. In the case of licensed software, the revenue is recognized when the software is delivered and accepted by the customer. In the case of a subscription agreement, the revenue is most often recognized ratably over the life of the subscription.
The customer’s cash shows up in your company’s bank account when it is collected. That can happen at the time of booking the business (as is typical in subscription businesses), or it can happen at the time of revenue recognition (as it typical in ecommerce), or it can happen a long time after revenue recognition (as it typical in advertising).
It is important to track all three of these metrics very closely. You want to know how much revenue your company has booked, you want to know what your monthly revenues are, and you want to know how much revenue you have collected, and most importantly, how much you have not yet collected (that is called Accounts Receivable).
It is also possible to collect cash at the time of booking in advance of when the revenues will be realized. That is called deferred revenue and it is a liability because delivery of the revenue is an obligation of the company. Many companies have four revenue oriented items they track; bookings, deferred revenues, revenues, and collections.
An interesting metric that many analysts and financial managers track is the book to bill ratio. You get that by dividing monthly (or weekly or quarterly) bookings by the revenues in the same period. If bookings are lower than revenues, that can be a negative sign. If bookings are a lot higher than revenues, that can be a positive sign. But it can also mean that your company is having a hard time getting revenue realized.
In some industries, not all bookings turn into revenues. In the advertising business, for example, it is often the case that not all the booked business can be delivered (and thus recognized as revenue). This is a big issue in highly targeted advertising businesses. If you have such a business, it is important to track your yield which is the percentage of booked revenue that you actually deliver in a given period.
I like to think of the bookings to billings to collections as the way revenues “flow” through the business. And since revenues are the life blood of any business, it is important to understand your company’s specific flow and measure it along the way.
Very important topic. As an acquirer of start-ups (I run M&A for a public tech company) this is one of the things I look at most closely during due diligence. Does the company understand and track the difference between their bookings and revenues, or are they playing “fast and loose” with the numbers to show me an artificially smooth growth curve? Eventually we will reconstruct it all, so it’s important to us that we have a team that is (a) honest and (b) sophisticated in how they present this.
Collections and deferred revenue are more important for more mature businesses, to determine (as you point out) the quality of revenue. For small, high-growth start-ups, though, it’s really important to set strong policies about revenue recognition and stick by them.
Here’s a topic idea for you, Fred: compensating salesteams for bookings vs. revenue vs. collections. (Though I know your ideal investment doesn’t need a traditional sales team!)
At my previous job we built a sales team from the ground up as part of a (relatively) mature business. The sales comp question was a tough one to crack. As you said, it’s important to see cash for a big win, but you don’t want to pay out too much on a $50k booking from an F500 company only to wait 90 days for the cash to come in.
Eventually, we settled on a hybrid where you got paid commission up front (within the month) for ALL bookings, and if your collections ended up past due in future months that was docked against your commission for the current month. Yes you run the risk of people booking a huge deal and walking out the door with no eventual collection, but our un-collected/cancellation rate was <1% so it wasn’t a huge problem. But we went through a bunch of iterations before we settled on this model.
The key takeaway was that is was really really important to have the salesperson have some skin in the collections game. Wouldn’t necessarily work at a bigger company, but at the beginning stages you want salespeople focused on closing AND collecting (which is often a proxy of the quality of the deal they are bringing in in the first place).
This article was originally written by Fred Wilson on August 16, 2010 here.