Deferred Revenue Write Down in Acquisitions
Hi all,
Haven't really dealt with this so wondering if the following is correct:
Let's say you acquire a SaaS company that has a $100M deferred revenue balance. If it's gross margin is 80%, I guess we can assume that DR is written down to 20. Let's assume it's a 2-year contract.
Your pre-tax income is up by 80, assuming 20% tax your NI is up by 64, cash is down by 16, RE up by 64, the liability down by 80, the balance sheet balances.
What then happens to the pro forma revenue going forward?
Will you recognize only the 20/2 = $10m revenue per year?
Then 10m COGS = $0 gross profit ?
Doesn't that completely write off the taxes that you would have paid on the pre-acquisition revenue, or am I misunderstanding something?
Based on the most helpful WSO content, here's how this scenario would play out:
Deferred Revenue Write-Down:
When you acquire a SaaS company with a $100M deferred revenue balance and write it down to $20M (assuming an 80% gross margin), the remaining $20M represents the portion of deferred revenue that will be recognized post-acquisition.
Pro Forma Revenue Recognition:
If the $20M deferred revenue corresponds to a 2-year contract, you would recognize $10M of revenue per year ($20M ÷ 2 years). This is the revenue that will flow through the income statement post-acquisition.
COGS and Gross Profit:
Since the gross margin is 80%, the COGS associated with the $10M revenue would be $2M (20% of $10M). This results in a gross profit of $8M per year.
Tax Implications:
The taxes you pay post-acquisition will be based on the gross profit generated from the $10M annual revenue. Assuming a 20% tax rate, the tax expense would be $1.6M annually (20% of $8M gross profit).
Impact on Pre-Acquisition Taxes:
The write-down of deferred revenue to $20M effectively reduces the taxable income associated with the pre-acquisition deferred revenue. This means the taxes that would have been paid on the original $100M deferred revenue are no longer applicable, as only the $20M is recognized post-acquisition.
Key Takeaway:
The write-down does not "completely write off" the taxes on pre-acquisition revenue. Instead, it adjusts the revenue and associated taxes to reflect the post-acquisition recognition of the remaining deferred revenue balance ($20M). The taxes you pay going forward will be based on the gross profit generated from the $10M annual revenue recognition.
Let me know if you'd like further clarification!
Sources: Accounting question on Deferred Revenue, Net working capital and deferred revenue, SaaS Deal., Write Down of PPE by 100, Difficult Accounting Technical - IBD, How To Record Earnout Paid in LBO Context?
Up
Deferred revenue isn't the cost to service the revenue and wouldn't be impacted by gross margin. It is just the pre-payment of future services to be provided and future revenue to be recognized. So, a $100 deferred revenue balance with one-month remaining means that there is $100 of revenue left to be recognized and when you recognize the revenue, that balance goes down commensurately (resulting in a net zero cash impact). The COGS of 20% in your example would be the "cash impact" of servicing that$100. So, the cash impact is negative $20 but the deferred revenue and revenue are still the $100. Old accounting standards used to deal with the fair value of the full $100 at acquisition and that may reduce the book value substantially depending on a lot of factors, but COGS/gross profit don't have anything to do directly with deferred revenue balance. All of those components together help tell the story of cash flow. Software businesses typically have negative net working capital balances as deferred revenue is usually the largest component of WC as annual contracts are paid upfront and then serviced throughout the year.
Thank you,
I know what deferred revenue is but that didn’t really answer my question - in an acquisition where you have to reevaluate the balance sheet at fair value, how would deferred revenue be impacted on the PF balance sheet?
I’ve seen in many places that you need to write down deferred revenue to fair value, so how would you do that if not by using the cost of servicing this deferred revenue (ie the true value of the liability associated with this DR)?
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