Net working capital and deferred revenue, SaaS Deal.

Hey all, we are closing on a SaaS acquisition and one of the key sticking points in the PA is regarding working capital as it relates to deferred revenue.  

Targetco  bills 100% of revenue upfront on a cash basis, they do not book it as deferred revenue.  

When we pushed back on the owner he argues that the cost to deliver the service is simply server costs, some maintenance, but he should be able to keep any revenue booked prior to closing.  

To calculate what could be considered deferred revenue we broke everything out into MRR, subtracted CaC and Sales.   The owner is claiming that all development done prior should be considered in the cost as well, and we should accept that any revenue collected prior to purchase goes to the sellers.

When looking at the timing, revenue is quite lumpy.  Their biggest month is October (Last month of course!) which makes up about 14% of sales.  Some months they lose money, some moneys they make money.

Refunds are about 1% or revenue so that isn't a risk.  There is some service revenue which certainly should be considered, however we are talking about almost 30% of ARR currently sitting in what should be deferred revenue.  

We think this should be adjusted from the WC peg, and should impact the purchase price.  Original WC peg we set was 100k.

Any experienced SaaS PE buyers that have tackled this issue?  How should we argue a change in purchase price, or change in WC here?

Comments (21)

Nov 15, 2021 - 10:48am
kuf135, what's your opinion? Comment below:

A couple ways that I've seen before;

- note, very rarely will sellers accept all deferred revenue being treated as debt w/r/t the wc adj

- I've seen all long term deferred revenue (so >12 months from closing date) treated as debt

- have also seen all deferred revenue balance x (1-software gross margin); e.g. $1.5M of def rev x 20% software COGS % = $300k of def rev balance treated as debt

  • Associate 2 in PE - LBOs
Nov 15, 2021 - 11:00am

I've always been a fan of gross margin affecting your deferred revenue so x2 on that point

Nov 15, 2021 - 11:18am
Blinkers, what's your opinion? Comment below:

Gross margin is so hard to tell in this one.  

40% of costs are tech staff+servers.  Which are obviously needed to service the client, but could be considered they are already built into the product.

Marketing/Sales is about 10%.  We are fine removing all marketing and Sales considering those CaC.  

Nov 15, 2021 - 2:01pm
kuf135, what's your opinion? Comment below:

What was the GM % the company went to market with? If that's the number they showed, and it's not a crazy figure, you can use that and say it was in the CIM

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Nov 15, 2021 - 11:04pm
Bullet-Tooth Tony, what's your opinion? Comment below:

kuf135

A couple ways that I've seen before;

- note, very rarely will sellers accept all deferred revenue being treated as debt w/r/t the wc adj

- I've seen all long term deferred revenue (so >12 months from closing date) treated as debt

- have also seen all deferred revenue balance x (1-software gross margin); e.g. $1.5M of def rev x 20% software COGS % = $300k of def rev balance treated as debt

I've only dabbled in SaaS, but these seem practical and are similar to my experiences (sell side). 

I don't know the model, but I'm not sure why you would factor in CaC or marketing costs into deferred revenue. We've always viewed it as the cost required to serve that customer - CaC/Sales/Marketing are really for NEW customers or revenue streams.

Practically, the question for you is, what is your true risk on the deferred revenue? Ignore the dollar amount for a second and think about what are the actual costs to service that revenue (sounds like servers + some allocation of the tech support staff). If that is the case, at most, your exposure is 40% of ARR (per your post below). In reality, it's likely well-below that (for a quality software platform). 

Another analysis you can do to triangulate is around average number of tickets + average costs to service tickets. To the extent you can drill down further to critical or functional tickets, it further narrows your actual risk.

Using this information, you need to decide how hard you want to push for some quantity to be: A) debt-like and deducted from purchase price and/or B) treated as debt in the working capital methodology (may require a larger escrow, etc.). 

Nov 15, 2021 - 11:41am
Blinkers, what's your opinion? Comment below:

We were not aware of deferred revenue before going under LOI.  Basically took last 18 months working capital averaged it out and placed 1 month as peg.  

Not random, but also not super exact.  We didn't have a lot of clear visibility into the company as it's a software co, owners have never done M&A and they ran no process.

Nov 16, 2021 - 7:49am
OwwMyFeelings, what's your opinion? Comment below:

I work in SaaS buyouts and buyouts in services. I've gotten deferred revenue classified as debt on services businesses because they still have services to deliver but for SaaS?... The product has already been created.

Since you're already in the debate you may as well roll with it and try to figure out what the true cost to deliver that revenue is on a cash basis going forward and argue for that as a deduct, but otherwise I think the seller is right here.

Deferred revenue being classified as debt for a SaaS company only makes sense if it is long term (>12 month) deferred revenue since that's just eating into what would have been your annual renewal cash flow.

Nov 16, 2021 - 9:56am
Bullet-Tooth Tony, what's your opinion? Comment below:
OwwMyFeelings

Just read that you already submitted an LOI. If he agreed to it, did it address how this would be treated? Easiest response is to just say "that's what we agreed to" and move on even if it's in your favor...

Not OP, but my guess is that since he is working directly/proprietarily with the owners, working capital wasn't specified (perhaps a target was, but not a methodology) at time of signing the LOI.

Nov 17, 2021 - 6:06am
skyline_77, what's your opinion? Comment below:

One alternative to simplify the working capital discussion is to have a lock-box method instead of a peg. The mechanics are, you pick a date, let's say 11/30/2021, and after that point, the Company cannot make any distributions out of the business (you calculate debt and excess cash as adjustments to EV as of the date as well). Buyer would assume the balance sheet as is at close, no working capital adjustment. My opinion in the LMM is that working capital can be a difficult topic to grasp as you get into theoritical debates as to whether your purchase price is inclusive of the cash flow generating assets (both past and present), how you may or may not be valuing future cash flow, etc. By having a lock-box method, you essentially force the business to prove its "normal" operating cash flows. The risk you are taking is that if between the lock-box date and closing, the company isn't profitable, you are assuming those losses. Conversely, if they make profits, you are getting the benefit from it. It isn't perfect, but typically it gets the seller a lot more comfortable. This specifically doesn't address your question on whether deferred is debt, ordinary course liabilities, or a mix of both as the previous responses cover that. 

Mar 17, 2022 - 5:07am
Rover-S, what's your opinion? Comment below:

We have different views on how locked box transactions work.

On the effective date (locked box date) you DO make an adjustment for actual NWC versus a normalised level (for example LTM average). So this does not solve the problem. 

Next to that: you always take a FYE to lock the box, as those are audited numbers. On those numbers you get your warranties. So preferably it's not a random date. 

Nice memo on this from PWC: https://www.pwc.com/ca/en/transaction-service/publications/pwc-introduction-locked-box-closing-mechanism-2014-01-en.pdf

Dec 10, 2021 - 11:29am
choubix, what's your opinion? Comment below:

1 month as a WC peg seems a bit random: if the company is growing or is cyclical you are short changing yourself and you could use a forecast to set your WC peg. 

If there is concentration of revenue in 1 particular customer which has just renewed (and cash has been collected) you are also short changing yourself, especially if there is high uncertainty the said customer will renew again next year (perhaps the seller has given the customer a significant discount to close the sale for instance) 

In the absence of proper financials (since you had to rebuild), you could triangulate WC peg against OPEX and try to have 2-3 months of OPEX covered with the peg. 

Mar 15, 2022 - 8:53pm
SaaSmaster, what's your opinion? Comment below:

There's a few pieces to call our here. First is the fact that they have a cash based rev rec. Given a material portion of ARR is deferred this means that on an accrued basis (which is how one should look at these types of business) the real revenue is lower. That said perhaps you valued it on an ARR basis, but if you did not then this is the first point to call out as your are paying a multiple on revenue that has not yet been delivered. This also impacts the true revenue timing in your model and so this could be an argument for a purchase price reduction in itself.

The next point is how you account for the deferred revenue, which can take a few different forms. The most buyer friendly approach is to deduct 100% of this but it is a difficult argument to make and is off-market. The middle ground is typically either (I) a deduct for any long term deferred or (ii) deducting for the cost to serve. On deducting the cost to serve you need to look at this on a fully burdened gross margin basis. In other words reported gross margins typically only account for hosting and some other ancillary costs. Fully burdened means including the costs to deliver (I.e. you need to reallocate support, implementation, delivery personnel costs into COGS). The reason why you do this is because you are already paying dollar for dollar for the cash on the balance sheet reflecting revenue you have not yet delivered, but this is not reflective of the true cash balance when looking through the delivery of these contracts. Therefore you need to account for the cost to deliver.

The last approach is to treat it as a NWC item, which btw is also not necessarily an unreasonable place to end up.

The reality is that it's a negotiation and you need to look at the net impact your equity purchase price under these different approaches to figure out what you want to propose, but the above outlines the parameters / arguments I would think about.

Mar 15, 2022 - 8:59pm
SaaSmaster, what's your opinion? Comment below:

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