Q: We sell monthly and multi-year annual pre-paid contracts. Our Deferred Revenue liability account scales consistently with our ARR. How should we expect this will affect any adjustments to the amount of money we receive as shareholders, when we exit?
A: When defending value on exit, our starting point is that it should not reduce shareholders' proceeds whatsoever: the deferred revenue that originates from pre-paid SaaS contracts is recorded as a liability on the balance sheet, but it isn’t a liability in the same sense as ordinary debt. Read on to learn more, and to calculate the expected level of deferred revenue on the balance sheet.
Deferred or Unrecognized Revenue can be a controversial topic when it comes time to apply closing adjustments in a SaaS company acquisition, or M&A transaction – but it needn't be: in the case of a typical B2B SaaS business with outsourced hosting infrastructure, the real costs incurred to retire this debt are equal to the incremental cost of hosting and delivering the platform at scale, which are typically minimal.
As nearly all Letters of Intent (LOIs) are written on what is termed a ‘cash-free, debt-free basis’, the buyer’s starting presumption might be that deferred revenue should be a dollar-for-dollar reduction in the shareholder proceeds at close. The easiest way to avoid this is to have the buyer explicitly agree to exclude deferred revenue from the definition of indebtedness when reconciling the proceeds due to shareholders at close. In other words, it’s not included in the adjustment math, period.
In our view, ensuring an explicit up-front understanding of how deferred revenue will be handled is in both parties' best interest, and we recommend (typically insist) including this term in the Letter of Intent, regardless of whether we are acting on behalf of a seller or buyer. A clear understanding avoids a potentially nasty battle post-exclusivity, once early drafts of the definitive documents are turning back and forth. In the worst case, it may not otherwise become a topic of conversation until the proposed Flow of Funds and Closing Adjustments are contemplated, shortly prior to close; sprung on the seller at this late stage for the first time, it could very well derail the entire deal.
Any large deviations from historical levels of unrecognized revenue are a reasonable exception to the above. Imagine, for example, that immediately prior to close, the seller signs a 5Y pre-paid contract and has a truck load of cash sitting in the bank and an equal uptick in the deferred revenue account; naturally, the seller should not expect a dollar-for-dollar credit for the increase in cash, with no offsetting decrease associated with the uptick in deferred revenue.
In order to get to the bottom of this math and the projected implications at the close of an M&A transaction, please take our calculator for a spin, below: