Katelyn Horowitz is senior vice president in the accounting and reporting advisory practice at Stout. Views are the author's own.
In a typical transaction-based business model, a good or service is exchanged for an agreed-upon price. However, recent creative innovations in technology have led to the popularity of collaborative business models, where the customer assumes little or no upfront cost or risk but shares in the savings or revenue generated.
Redaptive, for example, installs smart sensors, LED lighting, HVAC and other renewable energy equipment at their customers’ sites with the goal of increasing energy efficiency, reducing carbon emissions and lowering utility bills. The customer pays nothing upfront; instead, it generally pays Redaptive out of the money it saves in energy costs. Another company, BusPatrol, installs camera kits on customers’ school buses to capture information on illegally passing vehicles. There’s no upfront cost to the school district; payment is taken from the citations generated.
In both examples, the revenue to be earned over the contract term is unknown at the onset of the agreement, but the company providing the goods or service is certain there will be adequate cash flows to cover their upfront costs. The customer is willing to accept this structure because they don’t share in the risk.
Put another way, if a company were to buy their own assets, they would be paying cash or incurring liabilities. Under this model, they effectively acquire their assets using off-balance-sheet financing. The customer has no financial risk because they don’t owe anything for the good or service if the promised return on investment isn’t delivered.
The negotiating of that revenue-split is different from typical transactional business models, since the pricing can be a creative blend of fixed and variable costs. How much revenue is given to the client? Who absorbs the costs of maintenance and service of assets?
These collaborative business models are becoming more popular, and their value is often attributed to an innovative use of technology.
Redaptive collects and analyzes data at a granular level using smart sensors for real-time information on power usage. The data helps identify ways for the customer to reduce energy consumption and measure actual energy savings gained through updated equipment, such as LED lighting upgrades. BusPatrol uses artificial intelligence to identify potential infractions, then routes the footage for internal review.
In these and other cases, technology allows for a rethinking of a business model. A company can now offer an asset to the customer, and the customer only pays out of generated revenue, or savings, made possible by the technology.
The model is generating enough interest that we’ve seen collaborative companies capitalize by going public in traditional IPOs and special purpose acquisition companies (SPACs) and enter into joint ventures. But the risk-and-reward structure is so new that the model is hard to value.
Valuation specialists need to account for the difference in overall risk profile (i.e., retaining risk vs. transferring it in a purchase and sale) and the comfort gap as investors get more familiar with a different kind of financial projection. Most valuations are based heavily on forecasted cash flow, and in these situations, cash flow is variable because it’s based on the use of the underlying assets. More effort might be necessary to justify the inputs and assumptions used in developing the financial models.
From an accounting standpoint, the model raises novel issues, for both the company and the customer, starting with whether a lease exists under Accounting Standards Codification (ASC) topics 840 or 842.
If an identified asset is being used in the delivery of a service, the transaction might be accounted for, either fully or partially, as a lease. If it is not a lease (perhaps due to lack of control over the asset), the appropriate framework would be ASC 606, “Revenue from Contracts with Customers.” Under this guidance, one must analyze the performance obligations in the contract to recognize revenue when or as the contract is fulfilled.
Many accounting standards are based on a transactional business model, so when companies with variable payment structures began to emerge, challenges arose. Initially, companies that leased assets with variable payment structures would get forced into recognizing a day-one loss, since they had no contractually guaranteed money. The Financial Accounting Standards Board (FASB) heard concerns from companies that were moving to a variable payment structure that financial statements did not make intuitive sense to investors. Just because a company was on a variable payment model did not mean that they were not anticipated to be profitable. Accounting Standards Update 2021-05 modified the accounting to treat such contracts, in many situations, as operating leases instead.
Other accounting challenges remain for companies with collaborative models:
- Is the company the principal or the agent?
- What’s the fair value of the good or service provided?
- Whether any risk-mitigation strategies around minimum payments constitute “in-substance” fixed amounts under the lease guidance?
- Is disclosure of the transaction structure sufficient to identify each party’s rights and responsibilities?
As collaboration-based models become more prevalent, they will likely snowball in popularity. They present a challenge for companies and investors to think about how the creative use of technology can solve problems in new ways, and the new models represent a development in the marketplace that one should surely pay attention to.