David Cummings on Startups

Pre-Paid SaaS Contracts are Free Working Capital for Startups

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David Cummings

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Software-as-a-Service (SaaS) as a business model has a number of advantages including alignment of value between customer and vendor, strong cash flows, high gross margins, and great economies of scale. As with any growing startup, one of the most limiting factors is cash — the faster the business grows, the more cash it eats. Another benefit of SaaS that should be mentioned more often is that of pre-paid contracts.

With pre-paid contracts, like Salesforce.com requires, payments are made in advance of service being rendered. These contracts are often pre-paid quarterly or pre-paid annually with a discount (e.g. pay for the full year and get 10% off). For the startup this results in free working capital to grow the business. Yes, there’s an unearned income liability and an obligation to fulfill the service, but with the money in the bank, many startups use it to grow the business even faster than if they didn’t have pre-payments.

There’s another secondary benefit of pre-paid SaaS contracts: potential profits in the bank aren’t taxed until revenue is recognized and profit earned. Say it is December 31st and the startup’s bank account has $100,000 more than it started the year. Normally, if that’s profit it would be taxed around 30% leaving only $70,000 left to invest and grow the business. Well, with accrual accounting and $100,000 of unearned income due to pre-paid contracts, that money isn’t taxed until the revenue is recognized resulting in more capital to grow the business on January 1st.

Pre-paid SaaS contracts provide free working capital for startups and should be considered when thinking through business ideas (e.g. can we get customers to pre-pay us to help fund the business?).

What else? What are your thoughts on pre-paid SaaS contracts as free working capital for startups?

Comments

4 responses to “Pre-Paid SaaS Contracts are Free Working Capital for Startups”

  1. Mike Schinkel (@mikeschinkel) Avatar
    Mike Schinkel (@mikeschinkel)

    Yes!

    I always amazes me when would-be startup entrepreneurs focus all their energy on courting investors whom they would have to “marry” and give up significant equity and control when they could instead focus on selling in creative waysto prospective customers in order to build their working capital.

    To me the mark of a great entrepreneur is one who can bootstrap doing the latter. And you are clearly, from your results, are one who has learned that art of creative financing. 🙂

    -Mike

    Reply
  2. Paul Freet Avatar
    Paul Freet

    Hmmmm, are you really recommending accrual based accounting for startups? Oh my.

    Reply
    1. David Cummings Avatar
      David Cummings

      Cash basis makes sense most of the time:

      Accrual vs Cash Basis Accounting for Startups

      Reply
  3. Sanford Levings Avatar
    Sanford Levings

    It’s called “deferred revenue” on the balance sheet and is moved to revenue when the service is performed.

    I had two great business partners in the 90’s and we started, arguably, the first pre-paid calling company in the country.

    Two more great advantages of prepaid contracts are:
    1) no collection problems, i.e., the money is already collected.
    2) “escheat”, the legal term for “abandoned property”. it became known as “breakage” in our industry. A consumer purchases a prepaid calling card and they don’t use all of the time on the card. Eventually we would “turn the card off” and at that time, we would record the unused service as additional revenue. Our breakage averaged about 15% of the sales price and remember all of this fell to the bottom line.

    In 1993, we just about went out of business. We had less than $10,000 in the bank. Long story short, we somehow got in front of Lufthansa airlines. They already understood the concept of prepaid calling cards because phone booths in Europe offered them. Remember, it’s 1993..nobody knew the concept of prepaid telecom in the United States. Lufthansa decided to do three $250,000 prepaid calling card campaigns with our company. We put vintage airplanes on the front of the card. Lufthansa gave out these cards, for free, to their first class customers. I don’t think one card was ever used…no kidding. The only cost we had was to design the card and offer special Lufthansa thank you prompts. So our margins were 95% and presto..we were back in business!

    Reply

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