Let’s start with some ASC 606 background. Public and private companies are now required to be ASC 606 compliant. ASC 606, and its sub-topic 340-40, have completely altered how companies recognize commission expense which is one of the largest components of customer acquisition cost (“CAC”) for SaaS companies.
If you haven’t read our blog post on ASC 606, check it out here. Under prior accounting guidance, the majority of SaaS companies expensed commissions as incurred. Under ASC 606 all companies must now capitalize qualifying commissions (this is not an option) and expense it over a period of time that is typically around 3 to 5 years for SaaS companies.
What’s the Impact to SaaS Metrics?
A core part of a SaaS company’s unit economics is CAC. Your CEO, CFO, investors, and hopefully one day Wall Street will obsess over your unit economics to determine if you have a viable and investable business. See the formula below for the basic calculation of CAC.
The problem with the above calculation is the determination of what goes into the numerator. The goal of CAC is to determine all the money a company spends during the sales cycle to acquire a single customer. Most companies calculate CAC by looking at their GAAP P&L for a given period and taking that period’s Sales & Marketing expense and dividing it by the number of customers added within that period. There are two potentially significant problems with calculating CAC this way:
- Expenses incurred in prior periods to acquire customers in the current period.
This is especially relevant for companies with longer sales cycles where the initial outreach or demand gen dollars are spent several months earlier. A potential adjustment for this would be to take current period sales expense and a prior periods marketing expense (depending on the length of your sales cycle). Not perfect, but better.
- Expenses recognized for GAAP purposes after a customer is acquired.
This primarily relates to capitalized commissions under ASC 606. For GAAP purposes, capitalizing commissions and expensing over a longer period of time makes sense (kind of…), but for management analysis of the actual dollars it takes to acquire a new customer it doesn’t really work.
For a slow growth company the above two issues won’t significantly impact your metrics or management decision making, but when you are a fast growing SaaS company (hopefully you are in this bucket) then these two issues will provide an inaccurate portrayal of your business because of the timing effects these issues cause on expense attribution to CAC.
ASC 606 SaaS Metric Example:
Below is a simple example of a fast-growing SaaS Company that shows what the Sales & Marketing (S&M) expense and related metrics is before and after the adoption of ASC 606.
When a Company is growing, less commission expense is attributed to current period CAC because the commissions are expensed on a GAAP basis overtime. This means that if you keep growing at a rapid clip then your CAC calculated based on GAAP expenses will be a lot lower than what it should be when evaluating “true” CAC. If that growth ever slows or flattens then GAAP calculated CAC is going to increase dramatically for a period during that slower growth even though nothing has fundamentally changed. This means your management team may make incorrect or untimely assumptions about your business based on inaccurate metrics.
As you can see in the example below, during high stages of growth, CAC and its related metrics (payback period and LTV:CAC) are substantially better when calculating CAC on an ASC 606 GAAP basis versus calculating “true” CAC.
What to do with ASC 606 capitalized commissions.
Start by getting a commissions tool with good reporting so you can calculate timely, accurate unit economics. In the above example we are just looking at blended CAC, but you will likely also want to analyze new customer CAC, expansion CAC, renewal CAC, etc. This will get complicated quickly unless you are on a system that can report on these different dimensions for the commissions component.
When you are a public company with outside investors, then they will be using your GAAP financials to determine your metrics so understanding and forecasting commission expense under ASC 606 is critical. Also, its helpful to be able to forecast ASC 606 commissions expense for private companies so you can explain the actual difference in GAAP CAC and your calculation of “actual” CAC. This will likely require both a flexible commission tool that can generate reports, but also an ASC 606 commission expensing tool so you can easily forecast and track commission expense by different categories.