How did you handle deferred revenue in the LOI? - Searchfunder

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by a searcher
in Vancouver, BC, Canada

1yr ago

How did you handle deferred revenue in the LOI?

Hi all - I’m working through an LOI for a software company and would love to hear how others have handled deferred revenue in their deals.

In this case, the business has collected maintenance and support payments in advance that will be delivered post-close.

Would really appreciate any examples or advice you’re willing to share. Thanks in advance!

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reply by a searcher 1yr ago
from Harvard University in Toronto, ON, Canada

Having completed several transactions in software over the last dozen years, I don't necessarily agree with all the above answers. You can try and have the seller reduce purchase price - if you succeed, great. I doubt you will. My approach would be to look at the degree to which that deferred revenue creates an abnormal working capital state. Make it clear that you expect to be buying the business with a normalized level of working capital, and the current level won't be normal (say average of the lastredactedmonths across the relevant working capital accounts). To be more blunt, and simpler: if the target just collected $1M of deferred revenue - basically the full contract value for all their customers on Dec 31 for the upcoming year, their average deferred revenue for the prior year will have been something like half that. So the normalized level would be half that. Ask the buyer to leave an amount of cash that brings the overall working capital level back to the normal level ($500K). You are NOT paying for this cash in your purchase price (do not add the cash to the purchase price). The case is there to offset the deferred revenue imbalance. That will almost more than certainly cover the expense of the maintenance, and is a reasonable way to find middle ground with the seller. Likely the buyer will be more amenable to this kind of a solution.

reply by a searcher 1yr ago
from University of Pennsylvania in Chicago, IL, USA

Estimate the deferred revenue amount prior to LOI, as this is a common deal-killer. Put that high-level estimate in the LOI, and state that it is a 1:1 reduction in purchase price, and that the exact amount will be calculated in diligence (and then reconciled post-close). The 2nd-order adjustment (not everyone does this b/c it gets complicated and can tank valuation), is to restate the income statement on accrual basis (so deduct deferred revenue from reported income over your valuation period, and add-back any deferred revenue that was serviced). The point here is that deferred revenue is not just a debt-like item, it also is a contra add-back to EBITDA (so a double hit).

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