How do buyers assess deferred revenue?

February 14, 2024

by an intermediary from University of Victoria - Peter B. Gustavson School of Business in Victoria, BC, Canada

I'm brokering a deal with a lot of deferred revenue. This makes the income statement appear terrible, but the cash flow statement is positive. Curious how the searcher community views deferred revenue in a business valuation?
More specific example: it is a fitness studio that sells punch passes, many of which are never redeemed. As a result, these never hit the income statement - straight to the balance sheet. Making revenue appear much lower than actual cash flow.

Do you take an average redemption % as your normalization of cash flow? Or do you simply look at the EV of the company to look at all balance sheet items?

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Reply by a searcher
from Quinnipiac College in Monmouth County, NJ, USA

Few things to consider here—- 1. Cash Flow vs. Revenue Recognition: Deferred revenue creates a timing difference between when cash is received (and recorded on the cash flow statement) and when revenue is recognized (on the income statement). This discrepancy is critical in FDD because it affects how the business’s profitability and cash generation capabilities are perceived. 2. Normalization of Cash Flows: To normalize cash flows, buyers often estimate the redemption rate of the punch passes based on historical data. This involves calculating what percentage of the passes are typically redeemed and recognizing this portion as realizable revenue over time. The unredeemed portion, or “breakage,” might also be recognized as revenue eventually, according to accounting standards and historical patterns. This normalization helps in understanding the business’s operating performance more accurately. 3. Enterprise Value (EV) Consideration: In assessing the EV, deferred revenue is analyzed as part of working capital adjustments. Buyers consider both assets and liabilities (including deferred revenue as a liability) to understand the net operating capital needed to run the business. This analysis provides a more comprehensive view of the company’s value, incorporating operational liabilities and assets. 4. Breakage Analysis: For unredeemed services (punch passes), conducting a breakage analysis can be insightful. This involves estimating the percentage of passes that will never be redeemed based on historical trends. Accounting standards allow companies to recognize revenue from breakage when it’s reasonably assured that the service will not have to be provided. This aspect can positively impact revenue recognition and profitability analysis. 5. Sector-Specific Benchmarks: Using sector-specific benchmarks for redemption rates and breakage can also be helpful. Comparing the company’s metrics to industry averages provides insights into operational efficiency and market positioning. 6. Future Service Obligation: Buyers assess the impact of deferred revenue on future cash flows and service obligations. This includes evaluating the capacity to fulfill these obligations without affecting the company’s ability to generate new sales and manage cash flows efficiently. 7. Historical Trends and Patterns: Analyzing historical trends in sales, redemption rates, and breakage helps in forecasting future revenues and understanding the business’s revenue generation cycle more accurately.

Reply by a searcher
from University of Virginia in McLean, VA, USA

There are a couple of ways to think about this.

1-from a valuation standpoint... if the Seller is thinking they should get a multiple on the CF as it comes through the door, they need to understand that isn't fair to Buyer, and it also isn't fair to the Seller if Buyer pays based reported earnings since they don't incorporate a fair non-redemption rate and therefore are likely understated. As you already pointed out, and I agree you would be wise to incorporate the correct historical redemption % into your model so your purchase price reflects a multiple on a fair earnings / EBITDA #, and that will help you get a beat on the debt-like considerations of deferred revenue.

2-from a debt perspective... since the Seller has a lot of cash on their B/S related to punch passes which may or may not be redeemed, Buyer should figure out what % of the cash that is on the B/s pertains to passes which may ultimately be redeemed and negotiate that amount be left behind as a debtlike item. This ensures that Buyer has received the proceeds for honoring these passes post-close. The aforementioned is the starting negotiating point for the Buyer. If Seller is sophisticated, they may counter with a debt-like item that only comprises the cost of service for those passes expected to be redeemed (as opposed to all the associated revenue), as Seller's argument would be that they earned the revenue in the pre-close period.

These are just some ideas based on how I've seem deferred capital negotiations play out in the past. I hope they help. Good luck.

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