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 (16)

Nov 15, 2021 - 10:48am

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 - 2:01pm

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

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

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

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

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

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. 

Dec 10, 2021 - 11:29am

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