The Non-GAAP Trap

From an accounting standpoint, there's a weakness in GAAP's (Generally Accepted Accounting Principles) ability to measure the profitability and success of SaaS businesses. Sales predicated on annual contracts and recurring business up to as many as 5 years recognize revenue slowly and in turn, companies that appear to be losing money on a net income basis annually are in fact producing large amounts of available cash flow that is being reinvested in the company's growth. Even large public companies like NetSuite still haven't "turned a profit" on a GAAP basis, however that's not to say the company isn't profitable (although there are some out there that disagree).

In light of GAAP's weakness - companies and investors look to SaaS metrics to ascertain whether or not businesses are scaling efficiently and effectively to ultimately determine long-term profitability. However, given that they're non-standard, each of these figures can be misleading if not viewed with the proper context. While a good VC can typically identify and process these metrics for what they mean - their LPs are often unfamiliar with this style of reporting and can lose context of what each of these figures can mean when presented next to the rest of the portfolio.

Here's just a few examples of how even the most seemingly run-of-the-mill figures can run an investor afoul.

Bookings: Meant to represent a customer commitment to future sales, most SaaS businesses present this number as an annual contract value (ACV) booked with cash collected upfront, however this convention is not always upheld. Multi-year contracts, deferred billings, or long implementation times all can distort how much bookings translates into revenues.

Revenue Run-Rate: Many SaaS businesses use MRR (Monthly Recurring Revenue) or ARR (Annual) to estimate how much revenue the company would do - assuming zero bookings or churn over that time period. However - high touch enterprise services that have professional services components often fail to distinguish these non-recurring and often low-margin services from the overall figures.

Gross Profit: This one isn't so much non-GAAP as much as it is often miscalculated. Highly-valued SaaS services typically can see margins as high as 85-90% on revenue, allowing for much of the cash collected from customers to be immediately reinvested into the business in the form of operating expenses (sales & marketing), however many companies just calculate this figure as revenues less hosting, without looking deeper at what costs of operations scale linearly with revenue and what are independent variables. Most commonly left out is a measure of client success - which unless automated, scales as SaaS businesses grow their customer base.

Entrepreneurs, VCs, and LPs alike need to understand the nuances of what goes into every metric on every chart presented related to company performance. Unlike raw GAAP figures, no two SaaS metrics are comparable across the board but with a clear understanding of what each metric is comprised of, you can get a much greater feel for a company's scalability and potential for success.