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Arguing About Deferred Revenues
Hi, it's CJ Gustafson and welcome to Looking for Leverage.
Today's term: the deferred revenue haircut. It's the fight over how much a buyer gets to knock off your purchase price for money you already collected but haven't delivered against yet. And it always surfaces late… after the multiple is settled and everyone is tired and ready for this process to be over with.
Setting the scene
I was talking with Rick Smith, who wrote Six Months to the Sale, about what tends to blow up in the last few weeks of a sale process. Rick has sold multiple companies as a PE backed CFO.
He vividly remembered a buyer who came back and wanted the purchase price adjusted down by the ENTIRE deferred revenue balance. Why should the seller keep cash for subscriptions that the buyer has to go deliver on after close?
Somewhat of a good point, I suppose…
My argument back centers around gross margin. It’s what I used when the same thing happened to me when we were selling my most recent company. If we're running at 80% gross margins, then adjust for 20%, because 20 cents on the dollar is actually what it costs to serve those customers for the rest of the term. You didn’t spend the CAC to make the sale, but I agree you will have to make them successful after the fact.
So how should you approach it?
The dumb version
You know this part. A customer prepaid, you haven't performed yet, so the cash goes in the bank and the obligation sits as a liability (a contract liability, if you want the name your auditor uses) that releases into revenue as you deliver.
Nobody argues with any of that… well, until somebody tries to buy you.
Making it real
Deals get done on a cash-free, debt-free basis, which means you sweep the balance at close, including the December cash from every January renewal you billed in the remaining days. The buyer shows up on day one owing eleven months of service to a customer who already paid somebody else in full, and no cash arrives to fund delivering it until the next renewal perio. So they put deferred revenue in the purchase price bridge, call it debt-like, and ask for a dollar back for every dollar in the account.
Yikes!
The trouble with calling it debt is that debt gets discharged at a hundred cents and a subscription obligation gets discharged at cost to serve, which on a software business is hosting and a support team the buyer is (probably) acquiring in the same transaction. Plus, they’re applying a multiple to recurring revenue from those exact customers and modeling the renewal behind it. So which is it?
Nobody is really arguing about whether there’s an adjustment. The argument is two questions that get mashed into one, and pulling them apart takes a lot of work when people are already tired. Here are the component parts you should be dissecting the deferred debate into:
What percentage: On one end of the spectrum is total value of the contract, and on the other end is nothing. The answer changes depending on who has the most negotiating power at the time, and what you can credibly argue based on what’s sitting in the balance. Because unearned implementation and professional services can run 50 to 70% cost to deliver because somebody has to staff it. But pure subscription runs at a much higher gross margin.
Where it lands: Deferred revenue is a current liability, so it sits inside net working capital unless someone carves it out. If the buyer also treats it as a debt-like item in the bridge, the same obligation hits your proceeds in two places. Have counsel read the Net Working Capital definition and the Indebtedness definition side by side.
For all the accounting history buffs, buyers tend to reach for an old definition of how this gets treated out of muscle memory (and it doesn't do you any favors as a seller).
Acquired deferred revenue got written down to fair value in purchase accounting, so a chunk of the revenue just evaporated the day the deal closed and the acquirer recognized less of it post-close than you would have on your own. Something called ASU 2021-08 ended that. Acquirers now measure acquired contract liabilities under ASC 606 as if they had written the contract themselves, effective for fiscal years beginning after December 15, 2022 for public filers and after December 15, 2023 for everyone else. So the buyer keeps the revenue. If they're arguing about their own reported top line, ask them which guidance they're reading. Their cash argument still holds up, and that one you settle on cost.
The math (with numbers)
Say you’re a $40M revenue software business at 80% gross margins, carrying $9.0M of deferred revenue at close, and the buyer opens by asking for all $9.0M off the price.
Run it against what’s in the balance:
Subscription: $7.5M at 20% cost to serve = $1.5M
Unearned implementation: $1.5M at 65% cost to deliver = $975K
Cost to wipe out the obligation: $2.5M
That leaves $6.5M of proceeds in dispute.
Now check where it’s being counted. If your peg was built on a trailing twelve month average while deferred revenue ran around $7.5M, and you close carrying $9.0M, the extra $1.5M of liability drops your net working capital below the peg and comes out of your check dollar for dollar.
If you concede the $2.5M in the bridge on top of that, you’ve paid for the same dollars twice (once in the working capital true-up and once in the bridge).
When it clicked
A somewhat related version I lived through was employee annual bonuses. We were supposed to close in November, but the deal slipped to late February, and the buyer came back asking why they should be paying annual bonuses for a performance year that happened entirely on our watch.
Accrued bonuses, commissions, PTO, and deferred revenue are all part of the same argument about who funds obligations that straddle the closing date. Same same but kinda different.
What separates deferred revenue from the rest of that list is the discharge cost. A bonus really does cost a dollar to pay, so the buyer’s ask there is fair and you either settle it at face or pay it out before close. Deferred revenue costs you twenty cents, or whatever your gross margin is, so you have some rope to argue.
What to do Monday
Build the schedule before anybody asks for it: Deferred revenue split by type, subscription versus implementation versus prepaid credits, with a cost-to-serve percentage on each line and the margin math behind it. The first schedule on the table sets the frame of the argument, so don’t let it be theirs.
Read your own definitions against each other: Find deferred revenue in the Net Working Capital definition and in the Indebtedness definition of the draft purchase agreement. If it shows up in both, that’s your first redline.
Ask which standard they’re citing: If a buyer argues the write-down on accounting grounds rather than cash grounds, ask them to point you at the guidance. Since ASU 2021-08 there isn’t any, which puts the conversation back on cost to serve.
Line your billing calendar up against your close date: A big annual renewal cohort invoicing the month before close spikes the balance right when it gets measured. Worth knowing which way that cuts under your peg mechanics before the invoices go out and subsequently relitigated upon closing.
Wishing you a deferred revenue balance valued at what it costs you to deliver,
CJ
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