Deferred Revenue - NWC peg

Hi, my firm is looking to acquire a SAaS company that has a high deferred revenue balance (20-30%) of revenues. One of the principals mentioned that we will have to decide later whether to treat it like debt or working capital adjustment. I have browsed many topics about the treatment of deferred revenue as it relates to SPA Negotiation, but I am still confused.

For simplicity, assume the business has AR of 2000, AP of 1000, and Deferred Revenue of 5000. Can someone please, please answer the following questions for me:

  • regardless of Whether DR is treated like debt or working capital, how does it matter for the seller? Won't he still receive the same amount of proceeds?

  • if classified as working capital, then the working capital balance will be really negative. What do you do in this case? How do you structure the SPA? Let's say that all the last 3-6-12 month average balances of WC are all negative and deferred revenue is a consistent part of the business model

I would really appreciate if someone can share a quick example with me as I am really really frustrated by all the readings on this topic (DR treatment). Mother f***king accounting and law firms who've published shit on this just jump around the question

I AM SUPER SUPER CONFUSED

Comments (8)

Most Helpful
Jul 18, 2020 - 4:42pm
Tamara_S, what's your opinion? Comment below:

I see that you find this issue annoying. I am not surprised - it is quite a typical point of negotiation between the buyer and the seller.

The buyer always wants to treat DR as debt and the seller wants to treat DR as WC. If DR is a consistent part of the business model, and is more or less constant throughout the year, then it appears to be just a timing difference, i.e. WC. If DR is large and then falls during the year, then it appears to be more debt-like. If cash is received upfront, then again, it is debt-like.

The accountants and lawyers typically help with completion accounts and triple check the lockbox mechanism. If you want to get into more detail, could you please PM me and I will guide you to sources that are useful and accessible for a non-accountant?

  • 6
  • Associate 2 in PE - Other
Jul 18, 2020 - 4:57pm

Could you please explain this point that as it relates to DR, why would the seller want to include it in the WC? Just sticking with the OP's example but assuming that the only thing on balance sheet is 5000 of DR (no AR or AP). if DR was included as WC, then NWC would be (5000). How would you have set a target NWC in this situation. If you ended up setting the peg at 0, doesn't that mean the seller would still have 5000 deducted from the proceeds of the purchase price?

On the other hand, If DR is classified as debt (as the buyer would like), we have debt now gone up by 5000 so equity proceeds to seller again go down by 5000.

Would really appreciate if you could guide me where I'm wrong

Jul 18, 2020 - 5:15pm
Tamara_S, what's your opinion? Comment below:

The seller wants you to pay for every dollar in the till. To the extent the cash is already received by the business, the seller would not want a liability to offset it.

Your example is too crude - typically, you would figure out 1) how much cash is received; 2) how much cost has been incurred in securing this DR; 3) how much future cost is expected to service this DR and 4) whether or not the customer can cancel and what happens then.

Also, there is a difference between a normalised WC and one-off completion WC.

It gets very, very nuanced. Would you like some links to read up on this?

  • 2
  • Associate 2 in PE - Other
Jul 18, 2020 - 5:39pm

Thank you for clarifying further. I have read a fair bit on this and like the OP have scoured many different sources. But I guess I may be too thick to understand it lol

I understand that the treatment of DR is a complex topic. I am trying to understand this in the context of a business that arranges, organizes and markets music concerts; since many ppl pay for concert tickets months in advance, it's recognized as deferred income on this company's balance sheet. I just don't understand that if DR was to be treated as a WC item, how could the seller expect to recieve cash for it? it's still a current liability (the concerts still need to happen) and so to your point about the seller wanting to recieve money for every dollar in the till, I am scratching my head

Jul 18, 2020 - 5:58pm
Tamara_S, what's your opinion? Comment below:

I think in your music concerts example, the DR is a liability. If your concert gets cancelled, you will need to issue refunds, so there goes your cash! Also, substantial costs will have to be incurred during the actual concert, i.e. in the future. In this case, it is hard for the seller to argue DR is WC. It seems to me that in this case the answer is quite clear cut and DR is a liability.

  • 3
  • Associate 2 in PE - Other
Jul 18, 2020 - 3:26pm

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