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MuleSoft Subscriptions: Cap-ex or Op-ex?

Lou Dora, VP, Sales & Revenue Operations November 2018

Disclaimer The following document does not constitute accounting or legal advice. You should consult with your own accounting experts, auditors and attorneys. Salesforce.com, inc. makes no representation, warranty, or guarantee as to the accuracy, reliability or completeness of this information, and shall not be liable or responsible in any way relating to your use of or reliance upon any information contained in this presentation. This document may not be copied, reproduced, or posted on a public or private website.

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Introduction Software purchases represent a significant investment for our customers. Yet, often times it can be difficult for them to determine how to treat their software investment from an accounting standpoint. These accounting decisions are also important because in certain cases funding may be more readily available for software expenditures when the expense is classified a certain way. For example, certain verticals such as transportation, telecommunications, or banking typically prefer to capitalize their IT investment as opposed to treating them as operating expenses (“OpEx”).

Determining the appropriate accounting treatment for SaaS subscriptions can be difficult due to multiple reasons. First, subscriptions as a licensing model as it pertains to core infrastructure software, is still a relatively new concept. While buying subscriptions to purely hosted service products such as SFDC CRM has been the de facto business model for many years, subscriptions to infrastructure software, middleware products and PaaS are relatively new. Infrastructure and middleware customers are more accustomed to signing perpetual or term license agreements with a separate maintenance and support arrangements.

Second, the accounting profession has gone through multiple iterations over the past years on how to record software expenses, and for that matter, how to recognize software revenue for software vendors themselves. This has caused some confusion in the marketplace.

Finally, the exact nature of the SaaS / PaaS offering in question matters a great deal in determining the appropriate accounting treatment. SaaS / PaaS offerings vary greatly in terms of their content. Often times, there are multiple elements involved in the offerings such as software licenses, hosted services, phone support, software updates and upgrades - commonly referred to as Post Contract Support (“PCS”) - and professional services. Delivery models for the licensed software also vary between cloud, on-premises or a combination thereof. As such, specific contents of each software vendor’s offerings have to be evaluated in order to determine the correct accounting treatment.

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Subscription as a Software Licensing Model Subscription to software represents rights and obligations surrounding the use of software over a period of time. Broken down, a subscription arrangement consists of the following elements: 1. Right to Use (“RTU”): RTU entitles a customer to use software for a period of time, after which a customer loses any residual rights to the software with the exception of any software assets they may have built during the term of their subscription. Nonetheless, usefulness of any such assets may be limited without the right to use the software that was used to build them or the platform they were meant to run on. RTU could be viewed as software licenses.

2. Post contract support (“PCS”): PCS entitles a customer to any updates and upgrades of the software that the vendor may release during the term of the subscription as well as technical support subject to agreed upon service level agreements (“SLA”). PCS should be viewed as services delivered over a period of time.

3. Recurring Payment Obligations: Subscriptions typically require recurring payments, most commonly annually but more frequent payment intervals (e.g. quarterly, bi-annually, etc.) and upfront lump sum payments for a multi-year subscription agreement are not uncommon.

When looked at in light of the components listed above, a subscription is simply a payment structure for a term license with the only distinction that PCS is inherently embedded in a subscription arrangement and is inseparable from the underlying term licenses. In other words, while it may be possible (albeit not advisable) to purchase software licenses for a period of time under the traditional term licensing model without the PCS element, a subscription model will combine licenses and PCS as part of the subscription fees. Accordingly, these two distinct elements will likely require different types of accounting.

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FASB Guidance on Accounting for Software Subscriptions in Cloud Computing Environments Financial Accounting Standards Board (FASB) is the independent, private-sector, not-for-profit organization based in Norwalk, Connecticut, that establishes financial accounting and reporting standards for public and private companies and not-for-profit organizations that follow Generally Accepted Accounting Principles (GAAP). The FASB is recognized by the Securities and Exchange Commission as the designated accounting standard setter for public companies. FASB standards are recognized as authoritative by many other organizations, including state Boards of Accountancy and the American Institute of CPAs (AICPA). The FASB develops and issues financial accounting standards through a transparent and inclusive process intended to promote financial reporting that provides useful information to investors and others who use financial reports.

In April 2015, FASB issued a new guidance titled “​Intangibles—Goodwill and Other—Internal-Use Software (Subtopic 350-40)​”. This document updated prior guidance on “Customer’s Accounting for Fees Paid in a Cloud Computing Arrangement” and clarified that the ​purchase of a license​ is an ​intangible asset​ and therefore should be capitalized. Under the old rules, companies could use the leasing guidance which allowed for greater flexibility for classifying software licenses as either a capital lease or an operating lease.

According to FASB, software licenses should be accounted for as an intangible asset so long as they meet the following two conditions: 1. Software is licensed for internal use purposes 2. Customer can take possession of software, whether they elect to or not, without incurring significant cost or modifying the agreement, and it is feasible for customer to run software on its own hardware or through another third party

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It follows per FASB guidance that such assets be treated as capital expenditures as opposed to operating expenses to the extent that a customer can classify their software spend as an intangible asset.

MuleSoft Specific Facts Relevant to Accounting for Software According to the FASB guidance we mentioned above, the subscription nature of MuleSoft contracts should not be the only basis to determine how to account for MuleSoft contracts. What really matters is the extent to which such contracts represent “intangible assets”. So, how do we establish how much of a MuleSoft contract constitutes licenses vs. PCS, and whether or not these licenses qualify for the intangible asset classification?

License to PCS Split First step should be to segregate the two elements contained within the subscription fee. As discussed, a subscription model inherently combines software licenses with PCS (post-contract support, aka Support and Maintenance). Since PCS is a service delivered over a period of time, companies are expected to carve out the PCS portion of their subscription fees as operating expense per GAAP. MuleSoft cannot provide official guidance on the License-to-PCS split percentages.

Maintenance and support fees are typically represented as a percentage of the underlying licenses with many factors driving the price determination (e.g. level of support, cost-to-service, initial contract pricing, length of the relationship with the vendor, etc.) Customers should determine a reasonable percentage that can be viewed as PCS expense by reviewing the maintenance fees commonly paid to other traditional software vendors and discussing with their auditors.

Establishing MuleSoft as an Intangible Asset Once a customer determines a reasonable split between software license (RTU) and PCS, the next step is to determine whether or not the license portion of the fees represents an intangible asset. FASB cites two criteria: Software has to be for 5

internal use only and customer should be able to take possession of software without incurring significant costs.

Internal Use Internal use in this context means: a. Software cannot be sold, leased, or otherwise marketed as a separate product to third parties. b. Software cannot be a significant part of a tangible product or process customer sells. c. Software cannot be used in research and development. d. Software cannot become a part of other software developed for others.

Based on this definition, one could argue that most of MuleSoft subscription agreements should satisfy the internal use requirement as long as the principal beneficiary of the software is the customer and/or its authorized affiliates with the exception of certain Hosted Service Provider Agreements and OEM Embedded Software License Agreements.

Taking Possession of MuleSoft Software MuleSoft’s Anypoint Platform™ is a leading solution for API-led connectivity that creates an application network of apps, data, and devices, both on-premises and in the cloud. This hybrid integration platform includes iPaaS, ESB, and a unified solution for API management, design, and publishing. MuleSoft products are packaged and sold as a complete platform and optional add-ons to fit the needs of a wide variety of customer use cases.

Because MuleSoft is a hybrid platform, our customers have multiple choices when it comes to deployment options: 1. Deploy runtimes on Anypoint Cloud that MuleSoft manages on AWS (Anypoint Cloud) 2. Deploy runtimes on customers’ premises (customer-owned data centers, colocation facilities under direct or indirect contract with the customer, private cloud environments procured and managed directly by the customer such as AWS, Azure, etc.)

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In the context of accounting treatment of MuleSoft subscriptions, customers are entitled to download our software - and therefore take possession - in two forms: 1. At the time of contracting, customer indicates all or a part of their runtime deployment will be on-premises. MuleSoft grants customer access to download software.

2. At the time of contracting, customer indicates all of their runtime deployment will be on Anypoint Cloud. However, customer purchases one of MuleSoft’s upgraded subscription levels (i.e. Platinum or Titanium level subscriptions).

These upgraded subscriptions entitle the customer to “Flexible Deployment”, which is the right change their runtime deployment model between Anypoint Cloud and on-premises anytime during their subscription without any contract modifications or additional costs (subject to some restrictions).

Customers should refer to their subscription agreements and/or contact their MuleSoft account executives, should they need any clarification on their specific entitlements.

Summary MuleSoft software subscriptions consist of the software term licenses and post contract support elements. Software license portion of MuleSoft contracts should qualify as intangible assets as long as the software is for internal use only and customers have the right to take possession of software any time during the term of subscription. Entitlement to take possession of MuleSoft software may come in the form of having at least a portion of the runtimes deployed on-premises or subscribing to Platinum or Titanium level offerings that contain flex-deployment rights so that customer is entitled to download our software even if the initial deployment at the time of contract signature was Anypoint cloud only.

This document does not constitute accounting or legal advice. You should consult with your own accounting experts, auditors and attorneys.

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