Debating deferred revenue

By Nick Williams

Deferred revenue will more than likely be a cause of debate on every transaction on which it is encountered.  Whilst there is no hard and fast rule on whether to treat deferred revenue as working capital or debt, there are certain characteristics and industry norms that can add weight to arguments supporting the desired treatment.

The Basics

As with all balance sheet credit balances, sellers would prefer to treat deferred revenue as working capital whereas bidders would prefer to include deferred revenue in debt.

The rationale a bidder will typically use to justify including deferred revenue as a debt-like item is that the balance represents a liability for services to be provided post completion for which the seller has received the associated cash (and for which the bidder will pay on a £ for £ basis).

Timing

Sellers are likely to respond that deferred revenue is merely a timing difference, which would only crystallise as an absolute liability in the event of a winding up of the business.  As such the balance should be treated as a component of working capital.

However, given that the positions are so polar in nature, there are a number of characteristics that should be considered to tip the argument:

• Cash backed - as a seller, the first question to explore is whether the deferred revenue balance is backed by cash or by a trade receivable.  To the extent cash has not actually been received in advance of providing the associated service, the bidder will struggle to argue the item as debt.

• Profile - if the balance remains fairly stable throughout the year, this suggests that it is akin to a timing difference whereby cash receipts in advance in respect of deferred revenues are used to fund the costs of providing the current service. Conversely, a saw-toothed profile (e.g. subscription business with all 12 month subscriptions paid in advance at 1 January) suggests the balance is more akin to debt.

• Costs to be incurred - to the extent there are no further costs to be incurred in providing goods / services, it would also be difficult to justify deferred revenue as debt.  An example might be a publisher producing an annual book whereby, although significantly all costs have been incurred, stock increased and orders taken, revenue is deferred until the goods are despatched.

• Industry considerations - the nature of the industry may also impact the normal treatment.  For example, in package holiday operators there is often a significant deferred revenue balance as orders are taken and cash received well in advance of departure.  Whilst some of the operator's costs may have been paid in advance, such as block accommodation bookings, there may still be significant costs to be incurred.  As the balance is part of the nature of the business, it can readily be argued as working capital; however given the often annual build-up, costs to be incurred and magnitude, bidders will want to take a price deduction through debt. 

Clearly the end result will be a product of negotiation, and issues and arguments will vary by industry; however, in this example, as the seller has worked to secure the orders giving rise to the deferred revenue balance, if the bidder seeks to include the deferred revenue balance as debt, the seller may argue that the balance should be reduced by an amount equal to any costs prepaid in respect of providing the service and by the margin to be earned on such orders.

Deferred revenue is frequently a point of contention during a deal - in particular where the balance is material relative to the overall deal size. What I’ve covered above represents a fairly simplified approach.

Event

You can get more detail on this and other issues that arise during the sale & purchase agreement (SPA) at our forthcoming seminar on Thursday 25 June at 08:30 in London. Full details and registration can be found here.

What issues have arisen for you around deferred income on deals you’ve done? How did you get around them and what was the outcome. Share your thoughts below or schedule a meeting to discuss your situation in confidence.