Suppose an offer is made to buy a software company. EBIDTA is in the $400-500k range, purchase price in the letter of intent is $2.2M.
Software company was on a cash basis, and during due diligence deferred revenue is computed to be $400k with an NTA of -$250k (basically $150k minimum cash minus the $400k DR). Normal for software companies that sell lots of annual subscriptions but require payment upfront.
Would a reduction in purchase price be expected given this discovery? The sellers will essentially keep all the cash of the annual licenses that the purchaser will need to service, which doesn't seem fair. On the other hand, the cost to service those existing licenses is very, very low.
What's typically done in these situations?
Interesting question.
Depends on the purchaser's reasoning for buying in the first place.
What can you tell us about the IP/technology? Is purchaser looking to scale the current tech platform? Maybe they're looking to do an aqui-hire and really just want to buy the talent pool? Is this a build vs buy decision?
$2.2m isn't a huge number for a software deal so the real deciding factor will likely be the tech/IP potential, build vs buy analysis, team, and/or larger implementation strategy.
The purchaser is a large engineering firm that owns several smaller engineering companies, including companies that produce engineering software. They basically have a "toolbox" of independently operated companies that can target a ton of industries/problems. There is very little overlap, so a merge of products or services between any of the small individual holdings wouldn't really make sense.
Obviously a huge cost savings is realized since the large acquiring company handles benefits, 401k, legal, etc. at cost far lower than what a small company would pay.
The acquiring company's goal is to buy small companies and help them grow, but they generally never sell off their holdings. If a holding is floundering for an extended period of time, they'll generally turn it into a cash cow and milk it dry.
It doesn't typically impact headline value, but it's got to make its way into the proceeds analysis. Depends how the SPA is drafted but it's typically included in the definition of indebtedness or working capital, so the deferred balance is a negative to the TEV - all else equal, a 2.2M TEV would lead to proceeds of 1.8M wired to the equity holders in this scenario.
As you mentioned, this is a very common issue for subscription businesses, which is why it's normally handled the above way, but if of real concern for some reason I'm not understanding you could perform an analysis akin to what's often done for lifetime subscriptions (i.e. a business offered a lifetime subscription, collected cash upfront in the past, now the buyer doesn't want to be saddled with ongoing cost to serve). This can be handled and negotiated many ways, but may include: a) haircutting purchase price by proportion of total revenue or EBITDA contributed by long-term subs, b) haircutting price by calculating a cost to buy-out the existing long term sub base (some may have already churned their usage so unnecessary for those) and convert them to shorter term subscribers, c) if valuation was largely determined or negotiated based on multiples, you could exclude long term subs from the revenue total, calculate a growth-adjusted multiple, and haircut by the difference to the original growth adjusted multiple, or d) just haircutting price by lifetime cost to serve as a % of revenue and accounting for an annual long term sub churn rate (this is probably the most common)
The real issue here, in my eyes, though goes to "c" above - why would a software company entertain an offer in the ~5x EBITDA range? I know there's inherently lower multiples on small companies as scaling is really difficult, but software companies are trading ~20x currently. This seems like a huge delta to consider.
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