Show Me the Money! Revenue Recognition Best Practices (Part 2)
In my last blog entry (Show Me The Money, Part 1) we looked at a number of factors that play into software revenue recognition when a vendor (ISV) introduces electronic license enforcement into their product lines. Part 1 focused on the principles and mechanics behind giving customers access to the software upon order execution so that the ISV may recognize revenue. Part 1 concluded by bringing another key element into the revenue recognition equation: time. Time can affect revenue recognition in a number of ways:
- We have the time required by the customer to actually get their license keys after the ISVs claims to have given them “access” to the software.
- We have the software’s ability to run by default without a license key for a temporary amount of time. Does that count as “access”?
- We have some ISVs selling perpetual entitlements but wanting or needing to deliver license keys that expire annually. Does the customer really have access to what they bought?
Let’s examine the timing of events more closely…
We’ll start by breaking down the software delivery process into four key elements as shown in the image below. The process starts on the left in Box 1 with the ISV executing an order. Next we have the customer being notified of the order execution in Box 2. Box 3 represents the end customer installing and launching the software. The process completes in Box 4 when the end customer activates the software license. Between the boxes you will find Gaps A, B, C, labeled as such so that we can more easily discuss the sequence of timing between the boxes.
Part 1 focused on Boxes 1 and 2 and looked at the common mechanics behind customer notification of a new software order. Many backoffice ERP and licensing systems are automated and integrated so that notification occurs within seconds of the ERP processing the order, making Gap A virtually negligible. From a revenue recognition perspective, speed can be of the utmost importance so a tiny Gap A means the ISV has given their customer “access to the software” immediately upon order execution. Many ISV CFOs are perfectly comfortable recognizing software revenue at this point.
Other software vendors feel more comfortable building in an extra level of revenue recognition comfort by ensuring their customers can use the software immediately upon installation for a reasonable amount of time prior to activation. This comes into play particularly with businesses who process orders very late on the last day of the fiscal quarter. Many CFOs want to be 100 percent sure the customer gets notified and can run the software within the given quarter. To be more exact, they want to avoid the situation where the customer gets notified of the availability of the software on the last day of the quarter but cannot run the product until the software is activated (gap C) which could be days into the next quarter.
The accepted answer to this dilemma is to engineer the license enforcement within the products in a way that allows the user to run the product for a short amount of time prior to requiring activation for longer term use. In the revenue recognition world, the “short period” is typically somewhere in the 7-30 day range. ISV’s want to leverage the temporary mechanism to: a) allow the user to run the product immediately upon download and installation and b) give the user a reasonable amount of time to activate the product for longer term use. To many CFOs, the use of a model that gives the user immediate but temporary access to the software will satisfy revenue recognition concerns around end of quarter timing.
Mechanically, there are typically two methods for engineering the temporary use period. The cleanest method (best customer experience and easiest for the software vendor) is to use a product like Sentinel RMS or Sentinel HASP for license enforcement. Both RMS and HASP allow the vendor give their users a temporary use period by default without the user needing to take any action (i.e. no license keys or activation codes to handle). The user simply installs the product and runs it. The vendor has full control over the default usage period. The second method is to provide the customer with a temporary use license key or a temporary activation code at the time they notify the customer of the order. The drawback is that the vendor must deal with issuance of the temporary keys/codes and the end user needs to handle them.
- Many businesses who use software license enforcement recognize software after the customer has been notified by email as to where to download the software and how to activate (Box 2).
- Integrated and automated systems make Gap A very small so that notification happens within seconds of processing the order. ISVs who do not have integrated ERP and licensing systems may have a substantial Gap A, which adds time to the period at which the vendor can recognize the revenue.
- Many businesses want to ensure the customer can use the software immediately and choose to use license enforcement products like Sentinel RMS and HASP to provide access and control. Being able to run the software upon installation closes Gap B significantly.
- Temporary access to the software allows the end user to use the product during Gap C.
As I mentioned in Part 1, I am not suggesting how your company should manage revenue recognition nor do I claim the practices described above are acceptable or VSOE compliant. These techniques, however, are in use today by several global companies. Your company’s finance team should be the ultimate authority as to what is acceptable for your business. I encourage any business considering license enforcement to ensure your CFO is will deeply engaged in your license delivery processes.