What is ‘deferred revenue’ and how does it impact M&A deals?

A guide for buyers and sellers on how to consider deferred revenue in M&A transactions

In M&A transactions, the determination of debt-like items (in net debt calculations) and the net working capital target, can impact the purchase price and outcome for the parties involved. As such, it’s an important element of the transaction.

During the due diligence process, adjustments to the reported working capital are usually related to items that are unusual or one-off in nature - or that do not reflect the business’ normal working capital pattern.

Similarly, an adjusted net debt analysis is usually done to help identify those items that may have a similar effect as debt i.e. the purchaser is acquiring a debt and there should be a corresponding adjustment to the enterprise value.

However, there is no definitive guidance (in AASB, IFRS, or GAAP) or consistent standard/legal definition for how to calculate the underlying working capital and adjusted net debt. So, the choice and measurement of adjustments, as well as what items to include or exclude, requires judgment.

It’s important to get a deep understanding of how the business operates as well as the method by which it accounts for its operations i.e. accounting policies. Once there is an understanding of the business operations and the accounting for those, it is then necessary to align with generally accepted industry/sector practices to arrive at a view on working capital and/or net debt classification.

What is deferred revenue?

A key area of debate in M&A transactions relates to deferred revenue. Deferred revenue is a liability that arises when a company receives payment in advance for goods or services that have not yet been delivered or performed. It represents an obligation to provide the customer with the agreed-upon value in the future. Deferred revenue is common in industries such as software, subscription, media, telecommunications, and professional services. 

Why is deferred revenue important in M&A transactions?

Deferred revenue can have a significant impact on the deal result, especially when it is material. The main issue is whether deferred revenue should be treated as working capital or debt-like in the deal dynamics. Working capital is the difference between current assets and current liabilities, and it reflects the operating cycle of the business. Debt-like items are obligations that reduce the equity value of the business, such as bank loans, leases, or pensions.

Buyers and sellers may have different views on how to classify deferred revenue, depending on their interests and perspectives. Buyers may argue that deferred revenue is debt-like because it represents a cash inflow that has not yet been earned, and the buyer will have to incur costs and assume risks to fulfill the obligations to the customers when the seller has already taken the cash benefit associated with those obligations.

Sellers may argue that deferred revenue is working capital, because it is part of the normal business model and cash cycle, and the buyer will benefit from the future revenue and customer retention. In addition, sellers may also argue that deferred revenue will only be settled as a ‘liability’ outside of the normal cash cycle in case of business liquidation.

At times, it may be prudent to find a middle ground, treating part of the deferred revenue as debt-like (using an appropriate metric to gauge the cost of delivery e.g. by applying a cost of sales percentage), and the rest as working capital. This is to effectively pay the acquirer for delivering the obligation.

How to deal with deferred revenue in M&A transactions?

As previously mentioned, there is no definitive standard practice on how to deal with deferred revenue in M&A transactions. It depends on the specific facts and circumstances of each deal. However, some of the key factors that can influence the treatment are:

• Cash backing: Is the deferred revenue balance backed by cash or trade receivables?
• Pattern of deferred revenue balance: Is the trend in deferred revenue balance consistent or irregular? How does it change during the year?
• Basis of enterprise value: Is the deal value based on future earnings or historical/current earnings?
• Terms of deferral: Does the deferred revenue balance represent short-term or long-term delivery? How does it affect the timing and certainty of revenue recognition?
• Cost-of-service delivery: Is the cost to deliver the obligations and resultant margin on deferred revenue high or low?
• Other:
  • Industry and business model: Is the deferred revenue typical or unusual for the industry and the business model (bearing in mind the competitive position and customer loyalty of the business)?
  • Contract terms and tax implications: Are there any associated refunds? Is the seller or the buyer liable for the taxes on the deferred income (determined based on the contract terms)?
  • Fair value measurement: What is the impact of fair value measurement on deferred revenue balance in business combinations (fair value may be based on cost to deliver plus a reasonable mark-up and discounted to present value)?
  • Business practices: What are the practices adopted by the business for advance billing compared to generally adopted practices in the industry?
  • Cash flow impact: What is the cash flow impact of deferred revenue? Is it effectively funding capital expenditure or operations?

Ultimately, subjective, and judgemental areas in a deal are heavily negotiated. However, gaining a thorough understanding and analysis of these areas can facilitate transparency, ease the discussions and provide alternate ways to settle differing perspectives. As a result, the deal teams can focus on the transaction’s benefits/strategic rationale for each party and a smoother execution of the transaction rather than being distracted by complicated accounting and financial matters.

BDO can assist with your diligence requirements

BDO’s deal advisory team is experienced in providing financial/vendor due diligence services on complex transactions, reviewing SPAs and completion accounts, and acting as independent accountants in IPOs. Get in touch to discuss how we can assist with your transaction requirements.