THE FOUR KINDS OF SAAS CHURN

“Churn” is too vague a word to be useful when talking about growing your SaaS business. You need more context to understand what someone means: revenue or customer churn? Billed monthly or annually? Gross churn, or net of upgrades? And which of the 43 ways is it being measured?

When it comes to improving churn, the same holds true. You want to unpack the type of churn that’s causing you grief, and then solve for that specific kind of churn. In my five years running SaaS businesses, I’ve learned that:

There are four types of churn

  • Onboarding
  • Product
  • Credit card
  • Champion

Your approach to reduce your churn will be different depending on the type. Below, I’ll describe the four kinds of churn, the metrics to pay attention to, and a few tactics to address each kind.

1. Onboarding Churn

This happens when your customer doesn’t have a first good experience and thus decides your product isn’t for them. Another way of describing this is that your customer doesn’t have the “a-ha” moment — the moment where they understand how your product will solve their problem.

Who Owns This

Your customer success and product teams play a major role here. They need to understand what value your customers expect from your app, and help them get it as soon possible (this measure is called “time-to-value” in the customer success world). Product can always make the onboarding experience tighter, but customer success may need to step in with training, webinars, phone check-ins, lifecycle emails, etc. for those that don’t see value after signing up.

Key Metrics

– At-risk users. You’ll want to determine how to measure your app’s “a-ha” moment (see how we did it at my last SaaS company here). You can figure this out by looking at what your current customers did in your app that your churned customers didn’t do.

Once you know these “a-ha” metrics, your product team should change your onboarding flow to increase the likelihood that customers will have an “a-ha” moment soon after signing up. And customer success will want to keep a close eye on who hasn’t gotten value after signup (at-risk users) and proactively reach out to help them get to the “a-ha” moment.

– Trial-to-paid conversion. This is the ultimate indicator that a customer values your service: what percentage of signups end up paying you?

– 30 or 60 day churn. Even after customers pay you, the risk that they churn in the first couple of months is higher. Measuring churn in the first 30 or 60 days after a customer starts paying you will help you understand and overcome the obstacles they face that prevent them from using the tool regularly. Is your service easy to integrate into their workflow? Can they drive adoption internally? Does it solve their problem? Do customers need more training, more material to socialize your app internally, or better product hooks to drive adoption?

Once you uncover which customers are leaving in the first couple of months after signing up and understand why, you’ll be in a better position to fix your onboarding churn.

2. Product Churn

This happens when the product doesn’t appear to solve the problem that the customer needs solved. This is fatal if not resolved: high product churn usually means you’re not in a good market with a product that can satisfy the needs of that market (e.g. you don’t have product-market fit).

This churn can happen for a variety of reasons, things like a bad product, or the wrong customer for the product, or a price that’s too high.

Who Owns This

Product, Marketing, and Customer Success typically play roles in reducing this churn. Marketing needs to bring the right customers to your site. Product, Marketing, and Sales need to make sure plans are segmented correctly and pricing is appropriate. Customer Success needs to understand who your at-risk customers are, and have a process in place to help them.

And most importantly, Product needs to understand the core customer problems and build a solution that elegantly solves them.

Key metrics

– Engagement. What are the key activities that a customer should do to get ongoing value from your product? And what are the activities they should do to engage deeper and make it more valuable to them? These are your key leading indicators of churn. It’s key that customer success is on top of these metrics to understand who’s at risk.

– 30+ or 60+ day churn. Once a customer gets over the post-sales, high-churn hump (usually 30 to 60 days; at the last SaaS company I founded it was 61 days), you want to keep an eye on this figure and make sure it stays low.

If it creeps higher than you like, try looking at 60+ day churn on a cohort basis by signup date, marketing channel, pricing plan, amount paid, feature usage, and cancellation reason. You’ll likely find some clues as to how to bring it down.

3. Credit card churn

If you take credit cards, this kind of churn occurs due to failed payments and expired cards. Roughly 3% of your customers’ cards will expire every month, which means 36% of payments may fail per year just due to expiring cards. This doesn’t include cards that fail due to other reasons (card over limit, card number changed, etc).

Who Owns This

This is usually a product or revenue team function. You can reduce this by sending emails out when payments fail (called dunning emails). You can build this in-house or through a 3rd party SaaS app. Another way to attack this is using a “card updater” service that’s offered by many credit card gateways. It ensures a customer’s card will continue to work even if the physical card gets replaced by the bank (due to expiration or theft, for example). A phone call to the customer is also incredibly helpful to save a customer with a failed credit card.

Key Metrics

Since credit card churn is immediate (in the case of a failed payment) or possible to see coming (in the case of an expiring card), most of these metrics help you understand and anticipate the impact on your cash flow.

– Expiring dollars. How many dollars are expiring in the next 30-60-90 days? How will this impact your ability to spend over the next 90 days?

– Failed dollars. How many dollars are currently in a failed state? These are dollars you’ll lose unless a customer updates their card.

– Time to recover. How long does it typically take to recover a failed payment? When can you be reasonably sure to get the money back, or kiss it goodbye?

– Dollar recovery percentage. Of all your dollars that go into a failed payment state, what percentage do you recover?

4. Champion churn

Your customer champion or economic buyer leaves, and the new one wants to use a different solution. The best way to handle this is to build other “mini champions” as your customers. This is especially important if switching costs are low.

Who Owns This

Customer Success or your Account Reps can help prevent this kind of churn. One of the best ways to do this is to ask your economic buyer which other people use your software (so you can thank them). Then, send those people a gift – fruit basket, bottle of whiskey, Starbucks gift card, etc. This can help inoculate you against the “cleaning house” that occurs when a new economic buyer comes in and wants to boot you — a (now very popular) vendor with useful software — in favour of someone else.

Key Metrics

There aren’t really; keeping on top of champions is a matter of regular contact from your Customer Success team or account managers. Keeping on top of LinkedIn is also helpful, though if you’re hearing about your champion leaving via LinkedIn you’re probably behind the curve already.

Understand, then attack

Since “churn” can mean different things to different people, I have found the above framework useful for putting churn into the right context. For example, these two examples both describe “churn”, but are very different in how to diagnose and solve the problem: we’re losing $20K MRR per month and we think it’s due to product churn vs. we’re losing 100 customers per month and we think it’s due to onboarding churn.

Once you understand which of the four types of churn is losing your business the most money, your team can focus on solving the right problem to make sure you get the best bang for your buck.

Blog post by Kareem Mayan, Principal at TheChurnGuys.

This article originally appeared as a guest post on the Predictable Revenue blog.

Writer’s note: Thanks to Arif Bandali and Ryan Stocker for reading drafts of this, and to Hiten Shah for helping me understand key components of this framework.

EXCITING NEWS ABOUT ESPRESSO CAPITAL

I’m pleased to share some exciting news about our expansion plans.

Since Espresso Capital was launched six years ago, we are proud to have provided fast, fairly priced and user-friendly risk capital to more than 200 early and expansion stage technology companies in Canada.

This is an exciting time for the Canadian technology sector. Coast to coast, we’re seeing a new generation of companies developing world-class technologies with the potential to be global market leaders. As one of the most active providers of venture debt in Canada, we’re privileged to support this community of entrepreneurs and investors.

It’s against this backdrop that I’m pleased to announce that my senior management team and I have acquired majority ownership in Espresso. We have also secured financing to support the next phase of the company’s growth, which includes an ambitious technology investment program and the launch of a new, evergreen fund.

At the same time, Enio Lazzer has joined our team as COO/CFO and Will Hutchins as Managing Director. Espresso co-founder Gary Yurkovich and outgoing CFO Chris Hill will continue to be actively involved in the business. Gary has become Executive Chairman, while Chris is Chairman of our Credit Committee.

This is a time of rapid innovation in financial services as ‘fintech’ firms leverage technology and sophisticated analytics to disrupt existing business models and provide novel solutions to previously underserved markets.

We believe that ‘fintech’ innovation will dramatically reshape small business lending, and we are fully committed to be at the forefront of technology driven change as it relates to our category. Earlier this year, we launched an online loan application portal to make it easier for our clients to share information with us. Over the next twelve months we will be rolling out additional innovations relating to loan underwriting, documentation, servicing and monitoring.

Of course, it’s not just about technology. Our goal is to further improve on our capacity to deliver fast, fairly priced, user-friendly risk capital to our clients, and to better manage risk for our investors.

Our proposed Espresso Capital Fund V will build upon the innovative financing solutions that Espresso has become known for. In 2009, our business was created to bridge finance SR&ED tax credits. Since then, we have expanded our tax credit financing to include a wide variety of accrued tax credits as well as other government incentive programs, and also launched recurring revenue financing. With the launch of Fund V we look forward to further bridging the gap between bank financing and equity with new working capital and growth financing products. Finally, Fund V will be our first RRSP eligible fund, and the first to be distributed by registered dealers. For details, see the definitive fund documents for Fund V which should be available shortly.

As we enter this new chapter, we believe Espresso is well positioned to be the leading provider of venture debt to the Canadian technology sector. If you would like to learn more about our plans or explore financing options, please get in touch.

STORYTELLING FOR STARTUPS

Book Cover Amazon

Storytelling has quickly emerged as one of the hottest marketing buzzwords.

As someone who spent 15 years spinning tales on broadcast television, I welcome the hype. Five years ago I set out to use storytelling techniques to help corporate clients craft their message. It felt novel back then. Stories offered a way to cut through all that marketing noise.

Mark Evans’ Storytelling for Startups is a “how to” guide for founders and other start-up executives on how to create stories that pave a path to success.

A former technology reporter for The Financial Post, Evans delivers the goods in a refreshingly straightforward manner, without any needless hype. The book evolved out of his experience in helping dozens of startups acquire the skills needed to engage investors and customers in today’s rich media environment.

According to Evans, “Storytelling is more important than ever. Companies that tell great stories, win. Company’s that don’t, lose.” In addition to drawing from his personal experience as a consultant, Evans highlights the best storytelling practices from Steve Jobs, Dropbox, MailChimp and numerous other case studies.

Evans doesn’t sugarcoat the process. He asks the tough questions right off the bat: “Why does your organization exist?“ Admittedly, this self-examination is often difficult, time consuming, and rarely unanimous. But agreeing on an internal story is necessary before one can share it with the world. Evans spends a considerable amount of time discussing ways in which startups can land on a message that resonates.

Honesty is also paramount when discussing potential outcomes. “For storytelling to work, there has to be a well defined plan with clear goals – be it brand awareness, media coverage, website traffic, partnership, leads or sales.”

Evans steers clear of prescribing one-size fits all solutions. He intelligently guides the reader through a maze of platforms – old media, social media, video, web, email, blogs, infographics – you name it, the book has a chapter on it.

Evans reminds the reader to never lose sight of their audience. “Effective storytelling happens by having insights into your audience. What stories do they like to hear?” Companies tell the story, but the story is always about their customers. Their needs. Their feelings. Why else would the customer care? The book also offers different methods to measure audience engagement and includes a useful list of online tools specializing in analytics.

Unlike some marketing gurus, Evans is very much a realist. He understands startups cannot possibly master all of the platforms available to them. It’s one thing to embrace storytelling. It’s another thing to find one’s voice and hit it out of the park. Success will definitely require practice. This book is a great way to get started.

Marco Bresba is a branding, storytelling and social media strategist. Espresso Capital is one of his clients. You can connect with him on LinkedIn.

SR&ED AUDITS: THE 10 STEP SURVIVAL GUIDE

If you file SR&ED claims, you know all too well that audits are now a common occurrence. In my early days as a SR&ED practitioner, defending claims chewed up a mere 15% of my billable time. In recent years that number has shot up to 40%.

Filing a claim that is defendable and will survive an audit has become a significant part of my job. Based on my experience, here are ten tips that will help you navigate a potential SR&ED audit.

Respond ASAP: Immediately acknowledge the Request for Information (RFI) letter by calling CRA. Estimate the timeline involved and the associated deliverables. Let CRA know if their standard 30-day response time interferes with a major release or busy period. They can usually extend the deadline for an additional 2 weeks.

Understand the Scope: Examine the RFI letter carefully to determine if the audit is a financial review, a technical review, or both? Does the letter hint at specific issues? If multiple SR&ED projects are filed, the review will usually be limited to just some of the projects. While most letters are “form letters” (particularly on the financial side) some letters from technical auditors are often specific to their domain. Note that most auditors do not know the reason you were selected — they were assigned your case by their manager via automated CRA screening.

Assign a Project Manager: Treat the SR&ED audit as you would any other company project. Map out the deliverables, scope, timeline, and budget. Assign the task to a Project Manager – that person will lead the project and manage any additional contributors. As with other projects, your internal bandwidth and resources will depend on the business case of the claim and the dollars at stake. You may consider hiring an external consultant. Either way, I’ve seen the best results come from clients who assigned someone to support the audit as a “project”.

Present Your Case Logically & Concisely: Your response should address each requested item directly. Since the review can be quite voluminous, it’s best to organize all responses accordingly, using indexed binders or an organized file/folder system referencing each question specifically. Considering that your auditor may be reviewing 20 different cases at any one time, it’s in your best interest to make the process easy for them – essentially helping them help you. Presenting the initial RFI package correctly also helps CRA hone in on potential issues for further (on-site) investigation.

Quantity and Quality: When presenting your technical materials do not expect that providing technical specs, a white paper or a design document will suffice. Nor should you expect that overloading CRA with technical documentation is going to win them over. SR&ED is about the HOW, not the WHAT. The key is to focus on specific pieces of evidence that highlight technological uncertainty and experimental work performed — NOT specs of the final product, marketing or sales collateral. You need to show this “smoking gun”, emphasizing your strongest pieces of evidence. It’s good practice to correlate all data directly to the specific technological uncertainties and work performed that were originally presented in your claim.

Prepare: The next step is usually an on-site review by CRA where you meet the reviewers and discuss the merits of the project. It’s important that any individual directly involved in the project is present. Do you know what SR&ED really is? Do you believe the work is SR&ED eligible? Everyone involved should understand what SR&ED work is or isn’t. Have all your documentation and evidence organized so you can demonstrate and communicate the SR&ED work efficiently.

Find Your Star Witnesses: The review is primarily about communication, so you need to decide which one of your team members can communicate your position most effectively. If your CTO is more of a high-level, business minded individual, you may want to rely on the project’s R&D lead instead. In my experience, the CEO is usually not the best person in reviews. Find the hands-on “doers” who can communicate your SR&ED position with the best technical fluency.

Know thy Customer: This classic commandment also holds true for CRA audits. Like all your important meetings, understanding your audience is key. Are they younger or older? What is their background? Do some research and tailor your presentation accordingly. For example, if I know a certain auditor is visually inclined, I will be prepared to whiteboard things out. If an auditor possesses a specific scientific background, I will use relevant analogies that help them understand the case in the most familiar terms. A quick pre-meeting call to CRA may reveal areas they want highlighted during the meeting. In general, treat CRA like you would your banker — keep it professional and productive.

Question Assumptions: If your auditor starts the meeting with certain assumptions such as “this is routine engineering”, ask them why they feel this is the case. Do they have examples to back up their beliefs? Make sure all your talking points and documentation are accessible. Never assume the positive audit experience you had a few years ago will be replicated. Do not even assume your auditor has read your claim. Each claim needs to stand on its own, with each auditor having their own way of interpreting and applying SR&ED policy.

Learn: Audits present the best opportunity to learn about eligible work, refine your SR&ED process and improve your documentation. Do not assume you are now “safe” in the near term, as CRA can audit you as many times as they want. If you were given formal written guidance to improve your documentation, you must comply in the future or risk denial of your claim.

For further reading, I would suggest CRA’s own Claim Review Manual. It outlines the process CRA should follow in taxpayer reviews. I hope these tips have provided you with helpful strategies on how to survive a SR&ED audit.

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Ryan Pernia is Partner at ENTAX Consulting and is based in Vancouver, BC. He is also the founder of SREDScore; which helps claimants to easily, securely and effectively write quality SR&ED reports. He can be found on twitter @getSRED.

FINANCIAL REPORTING DIAGNOSTIC

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The following are some diagnostic questions to gauge the quality of your financial reporting:

  1. On what basis are financial statements prepared?

Accrual basis accounting matches the revenues to the expenses incurred to generate the same revenues in order to provide a more accurate view of profitability, whereas cash basis accounting essentially mirrors the cash flows of the business as they occur, potentially distorting profitability and failing to account for future obligations. It’s better to use cash flow statements to understand cash flows than an income statement using the cash basis accounting method.

  1. How/when is revenue recognized?

When contracted? When paid? If revenues are subscription based, then they should be recognized over the life of the subscription period. Professional services are typically recognized using either percentage of completion or milestone completion method. In conjunction with the appropriate accrual accounting methodology, the revenue recognition policy should match the revenue earning cycle and take into account any contractual obligations for the “completion” of the sale and acceptance of the “purchase.”

  1. Are variable gross margins clearly (and accurately) segregated from fixed overheads?

Identifying and allocating all direct variable costs that are incurred in producing revenue is essential to understanding product or service profitability. Companies should be careful in delineating non-variable costs from gross margin metrics.

  1. Do you track the cost of customer acquisition, churn, and payback period?

Companies that are investing aggressively for growth need to have a good grasp of their unit economics to determine if growth is profitable, and if it is profitable, exactly how profitable it is. They should also be able to identify which revenue segments are more and less profitable, in order to optimize allocation of growth investments.

  1. Have all appropriate and likely expenses been accrued? How timely is the accounts payable recorded?

Not only do expenses need to be recorded accurately and in a timely fashion, businesses must also “accrue” for expenses that are known and likely, but not yet billed or realized. This can be through a general “catch-all” accrual, or a specific expense accrual. Knowing what expenses will be incurred in the future is critical to understanding the company’s financial position, and projected cash flow requirements.

  1. Have expenses been categorized and allocated well enough to understand total cost of customer acquisition, R&D vs. service delivery COGS, etc.?

Allocating salaries departmentally should be easy enough when one individual has a dedicated role, however in smaller companies certain individuals may wear multiple hats, and therefore allocation of time by function is important to get at a more accurate sense of functional costs. Another area where time tracking is critical is in situations where the company is claiming tax credits, as time sheet review often forms a key part of the tax credit claim review process. Equally important is ensuring appropriate expense classification around General & Administrative expenses – knowing which expenses are discretionary vs. not is helpful in managing business finances, particularly when cuts need to be made.

  1. Do you produce cash flow analysis and 12 month projection?

If a business is strong but has little or no cash in the bank, it is almost ALWAYS due to poor planning and financial management. Cash flow statements and projections are an essential part of the survival of a growth business.

  1. Do you dynamically adjust cash flow (and other) forecasts based on actual results and how often?

Projections get stale eventually and need to be revised regularly to reflect actual experience. This in turn leads to better planning in future cycles.

  1. Are you tracking performance by segment, be it by customer size, product version, pricing model, vertical market, geography, etc.?

Segmentation analysis can yield valuable insights, identifying opportunities for operational improvement and investment prioritization.

10.  Do you present reporting with comparison to prior periods?

In order to fully understand your financial position at the end of any given period, it is important to review it in the context of the change (or trends) in key metrics as compared to relevant prior periods.

11.  How long does it take to produce month end statements?

Timeliness is essential in the production of financial information as most monthly statements can have a “half-life” of two weeks or less. The longer it takes to produce, the less valuable this essential information becomes.

12.  Are non-cash items such as depreciation and amortization clearly delineated or understood?

Understanding what items are non-cash and corresponding balance sheet implications is critical in analyzing the cash that is generated (or consumed) by the business.

Blog Post by Enio Lazzer, BrightIron.

HOW TO GET GREATER INSIGHT ON YOUR REVENUE PERFORMANCE

In the never-ending quest to obtain greater insight into business performance, companies routinely spend considerable time and resources in identifying the key performance indicators (“KPIs”) for organizational health and performance. Best in class companies religiously track their KPIs, often creating dashboards and leveraging real-time reporting tools, in order to provide management with a real time view on how the business is performing and highlighting areas that need attention.

One such KPI is revenue performance. As a business owner, entrepreneur, or finance leader, being able to break down your revenue by product or service type, market segment, sales channel, geography, and whether revenue is coming from new or existing customers is invaluable information in helping understand business performance. Even entry level accounting packages can provide these insights, provided you do some upfront planning as to what type of revenue information you would like to report.

Typical Revenue Reporting

As an illustration, below is what many companies typically report as their revenue detail:

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The reporting shows that revenue doubled, with subscription revenue growing 125% and other revenue flat. This level of information while appropriate for external and summarized reporting, provides very little information for internal management analysis. Additional revenue information must be obtained by other means and analysis.

Customized Revenue Reporting

In order to drive greater insight into revenue performance, you will need to customize your chart of accounts. The chart of accounts provides the structure for how information will be stored and reported from your accounting system and will impact the quality of information that you can obtain as your company grows over the years. Do it right, and you will capture meaningful data within your accounting system for monthly reporting. Do it wrong, and you will spend more time trying to compensate for the limited reporting data available in your accounting system by gathering data from other sources.

In the example below, the chart of accounts has been customized to report revenue by sales channel, product type, new vs. renewing customers and geography:

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Some additional insights from this level of revenue visibility based on this illustration:

  • Subscription revenue from new business grew from $800,000 to $1.35 million.
  • However, subscription revenue from renewing customers was only $450,000, which compared to prior sales, represents a renewal rate of 56%. Drilling deeper, the data indicates that renewal rates for online sales was only 25% vs. a renewal rate of 75% for inside sales, highlighting a serious issue that needs further investigation and resolution.
  • The fastest growing revenue segment was the inside sales team targeting the Canadian market, which grew by 400%. This performance disparity compared to the rest of the sales segments is worth investigating for potential insights and learning that can be applied across the rest of the inside sales organization.

Summary

Improved insight on revenue performance or most other financial KPIs can be achieved by customizing the chart of accounts in your accounting system. Setting up the right chart of accounts early in a company’s lifecycle allows KPI data to be captured and measured on a consistent basis month after month, providing a rich set of trended financial data to monitor the progress of the business.

About the Author

Wilson Lee has over 20 years of experience operating and scaling technology companies and is the founding partner of BrightIron www.brightiron.com. BrightIron was created to fill a void for founders and CEOs of growth technology companies by providing access to a team of seasoned C-level finance and sales executives, on a fractional, on-demand basis to help drive growth in enterprise value.

Wilson can be reached by email at wilson.lee@brightiron.com.

MONTHLY FINANCIAL REPORTING – DO YOUR STATEMENTS MAKE THE GRADE?

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As a very active lender to early stage and growing technology companies, we receive hundreds of loan applications every year. The quality of the financial reporting provided to us varies greatly, and unsurprisingly, correlates highly to the seniority and experience of the company’s lead finance executive. When we review loan applications, we are not only assessing the borrower’s financial and operational health, but also whether the company’s financial and operational reporting provides management with the insights necessary to make informed operational and investment decisions. Take the following illustrative example:

A company sells its software as an annual subscription priced at $100 and experiences 4% monthly churn, which equates to customer lifetime value of two years. Unless the company has good data on the total cost to serve, net revenue churn, total cost of customer acquisition and weighted average cost of capital, it is nearly impossible to tell if each incremental dollar invested in acquiring new customers is profitable or not. If the company is selling multiple products or selling into multiple customer segments with different revenue, margin, churn and customer acquisition cost dynamics, determining investment payback becomes even more challenging.

Based on the loan applications we review, the financial reporting of many post-revenue companies fails to make the grade. Far too often, companies supplement their monthly reporting with manually maintained Excel spreadsheets, which is not only error prone, but also an unnecessary duplication of effort that can usually be fixed for a relatively modest cost.

Fixing poor reporting is not rocket science, but it does require a reasonable level of finance and operational sophistication. If your budget does not allow for an experienced full-time CFO, consider engaging one on a fractional basis. Depending on your company’s needs, the cost can be nominal — as little as $60,000 per annum.

Poor quality financial and operational reporting (and the underlying business processes) can be real impediments to securing growth. We routinely refer clients and prospective clients to CFO resources, and I recently reviewed a dozen such referrals made during the past year. Of the dozen companies, nine companies adopted our recommendation with impressive payback – three quarters are already reporting material improvement in business performance (improved margins, reduced churn and improved cash flow), and half have secured incremental financing.

While there is no “one-size-fits-all” approach to preparing financial statements, there are some common elements that are universal, and understanding users’ needs and requirements is critical. Secondly, “cash is king” when it comes to early stage companies. The ability to fund growth, pay employees, creditors, and generally “keep the lights on” is paramount. We’ve prepared this list of diagnostic questions to help you assess the quality of your financial reporting, and if you’d like a professional opinion, one of the many fractional CFOs working with our portfolio companies would be pleased to provide a complementary, no-obligations review of your financial reporting package.

Blog post by Alkarim Jivraj, Managing Partner at Espresso Capital.

SR&ED AUDIT NIGHTMARE – A TRUE STORY

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A company with a ten-year track record of successful SR&ED tax credit claims and government audits suddenly finds its status as a Canadian Controlled Private Corporation (“CCPC”) revoked by the CRA, rendering the company ineligible to receive  SR&ED tax credit refunds.

The company was shocked: its corporate structure had not changed since inception and had been clearly disclosed to CRA in each of its tax returns.

So what happened? This time around, the CRA determined that the Canadian operating company was not a CCPC because it is indirectly, “simultaneously” controlled by a US parent company.  This was a surprising blow since the US parent is itself controlled by Canadians and the company did a tremendous amount of due diligence work from day one to ensure its structure complied with the CCPC status requirements.

At inception, the original Canadian investors wanted the operating company to have a US parent, presumably in order to better attract US investment and/or make it more attractive to future buyers. The company and its lead investors entrusted two large, reputable Canadian law firms to formulate a corporate structure that would meet the CRA’s definition of a CCPC. The lawyers agreed on a corporate structure with a US parent at its head controlled by Canadian shareholders and with a majority of Canadian directors. The US parent would have a wholly owned subsidiary in Canada that would hold a third wholly owned Canadian operating entity that would file the SR&ED claims.  This structure was reviewed by numerous CMAs, CAs and CPAs. All parties agreed the structure met the definition of a CCPC as specified by the Income Tax Act.

Unfortunately, after ten years of CRA reviews and audits, CRA suddenly viewed things differently and gave the company 30 days to comment. The company responded promptly with a letter of objection and is now waiting for a reply a month and a half later.  Management expects the appeal process to take anywhere from 9-12 months. The long back and forth process will no doubt weigh heavily on the company, even if it is ultimately vindicated.

The issue will hopefully be resolved in the company’s favour, but this story is a stark reminder that tax law is riddled with ambiguous “grey” areas, and that the CRA always reserves the right to change its mind each time a company undergoes an audit. More importantly, complicated corporate structures can increase the risk of a negative audit outcome, even if the structure has been conceived and vetted by the nation’s top legal and financial minds. Has your company’s CCPC status been called into question because of its corporate structure? If you have a cautionary tale to share, please contact us.

Blog post by Stephanie Andrew, Associate Partner at Espresso Capital.

SUCCEEDING UNDER THE NEW SR&ED REGIME

Do changes to the SR&ED program make it more difficult to obtain funding for industrial research and development? We take a look at the revised criteria and its potential impact on your tax credits.

In many of my conversations involving SR&ED tax credits, I get questions regarding the eligibility rules that have evolved over recent years. In my view, there has been no fundamental change to the eligibility criteria. The original criteria of technological uncertainty, experimental development and technological advancement remain central to eligibility.

However, part of the criteria underwent refinement in the December 2012 release of CRA’s consolidated policy document. This document introduced two distinct sets of tests for experimental development, and also reiterated CRA’s expectation for contemporaneous evidence in support of experimental work performed. This led to a “new” five-point evaluation criteria, enumerated below, and taken verbatim from the CRA document:

1. Was there a scientific or a technological uncertainty—an uncertainty that could not be removed by standard practice?

2. Did the effort involve formulating hypotheses specifically aimed at reducing or eliminating that uncertainty?

3. Was the adopted procedure consistent with the total discipline of the scientific method, including formulating, testing, and modifying the hypotheses?

4. Did the process result in a scientific or a technological advancement? 5. Was a record of the hypotheses tested and the results kept as the work progressed?

The tests implied by questions 2 and 3 are probably the most intimidating since most industrial R&D departments do not formally structure their experimental development with the formulation of a hypothesis. Such formalism exists primarily in research laboratories and academic research environments.

However, in our interviews with industrial R&D personnel we often discern fragments of information that can form the basis of a hypothesis. After all, a hypothesis is defined as: “A statement that explains or makes generalizations about a set of facts or principles, usually forming a basis for possible experiments to confirm its viability”. Many who engage in R&D work, intuitively begin with a set of assumptions that may pave the way towards resolving or understanding a problem. Thus, it is both possible and worthwhile to construct a formal hypothesis by intelligently dissecting the larger thought process.

Technical reports accompanying a claim should demonstrate the hypothesis guiding the experimental work. A good report will narrate the process in line with the sequence of activities imposed by the scientific method of; formulation, development, observation & testing. Each cycle should provide the feedback loop that informs the next formulation stage.With tests 2 and 3, the CRA is effectively attempting to exclude activities that lie outside of experimentation by scientific method. The intent is to exclude trial and error or successive iterations of a solution that are not guided by the scientific method. As an aside, it should be noted that for every formal hypothesis that is eliminated through the scientific method, the elimination of a hypothesis can be claimed as a technological advancement.

Test 5 is also relevant as it involves collecting evidence related to your hypothesis. Companies should treat the CRA as they would a client. Just as a client will not sign a check until all of a deliverable’s requirements are met, the CRA requires contemporaneous evidence before they “pay” the R&D expenditure.

Collecting all this relevant evidence without weighing down your development team with excessive record keeping can be a challenge. Here are some practices that require minimal time.

• Keep track of technological uncertainties and obstacles with emails to internal staff or documentation in project management tools. This is a simple way to establish a basic timeline;

• Since a timeline is insufficient for CRA purposes, support the above with other information records such as activity logs and time keeping;

• Leverage software development tools, from issue tracking to source version control; • In non-IT environments, chronicle prototype development with photo, video or data capture. This evidence tends to be well received by the CRA.

In conclusion, companies involved in eligible SR&ED activities should heed the evidentiary demands of the CRA. They should also formulate their R&D narratives to align with the structure expected by CRA. The SR&ED program remains a thriving and valuable source of funding, and no company should forgo their rightful claim due to an inadequate presentation of the facts.

Author: Kegham Redjebian, Eng.

Kegham is an engineer with over twenty years in software development industry experience and over seven years as a consultant in SR&ED and related technology development tax incentives

Copyright – MNP.

IRAP VS SR&ED?

irap-sred

If your company conducts research and development, you most likely have or will consider a number of government funding and tax credit programs. How do you assess which program is right for you? How do you determine which program offers the greater expected return for your time and effort?

This article will compare two of the oldest and most popular federal programs: the Industrial Research Assistance Program (IRAP) and the Scientific Research & Experimental Development program (SR&ED).

IRAP is a federal program administered by the National Research Council that providesR&D grants to qualified innovative small and medium sized enterprises in Canada. The program has a limited budget (about $270 million in 2014/15) and receives hundreds of submissions annually, making it a very competitive funding option.

To apply you will need to submit a comprehensive business plan outlining your go to market plan as well as revenue and profit projections. IRAP evaluates these projections as part of their approval process. Subsequent to funding, IRAP will periodically measure your company’s progress relative to your projections, and will make recommendations as needed, occasionally mandating changes that you may not agree to.

For some companies, IRAP’s ‘hands on’ approach and influence in project management may be a welcome source of value add. In our experience, however, government officials do not make the best entrepreneurial coaches and mentors. We believe better strategic, commercial and operational advice can be found elsewhere.

The SR&ED program is administered by the Canada Revenue Agency (CRA) and offers tax credit for eligible R&D expenditures. The SR&ED program has no fixed budget, so every eligible claim is approved. In 2012, the program processed 25,000 claims worth approximately $3.6 billion in tax credits.

It’s worth noting that any IRAP funding will reduce your eligible expenditures for SR&ED claims. Additional differences between IRAP and SR&ED include:

  •  IRAP only considers applications for future R&D projects. SR&ED approves eligible expenses already incurred;
  • IRAP benefits are usually paid in instalments as you report on your project’s progress. SR&ED tax credits are approved in a lump sum after your year-end tax filing has been accepted by the CRA;
  • IRAP funding is restricted to companies with fewer than 500 employees. SR&ED has no limits on company size; and
  • SR&ED includes a broader category of expenses than IRAP.

Final Verdict:

We believe SR&ED is the better option for the majority of companies, delivering greater results both in financial return and time invested. Our advice, based on over a decade of experience, revolves around three key reasons:

  • SR&ED is not based on a prior selection process;
  • SR&ED is available to any company that qualifies; and
  • IRAP funding will be deducted from SR&ED claims.

Guest post by Mike Evans, Emergex SR&ED Subsidies Inc.

Emergex has become one of Canada’s most successful tax credit consulting practices over the past decade. Our professionals have degrees and experience in computer science, engineering and tax law. They specialize in software and information technology, along with other technology sectors. Because of our experience, professional credentials and reputation with the CRA, we enjoy an overall 98% claim approval rate. Mike Evans can be reached at +1 (416) 697-4110.