How do buyers assess deferred revenue?

Few things to consider here—- 1. Cash Flow vs. Revenue Recognition: Deferred revenue creates a timing difference between when cash is received (and recorded on the cash flow statement) and when revenue is recognized (on the income statement). This discrepancy is critical in FDD because it affects how the business’s profitability and cash generation capabilities are perceived. 2. Normalization of Cash Flows: To normalize cash flows, buyers often estimate the redemption rate of the punch passes based on historical data. This involves calculating what percentage of the passes are typically redeemed and recognizing this portion as realizable revenue over time. The unredeemed portion, or “breakage,” might also be recognized as revenue eventually, according to accounting standards and historical patterns. This normalization helps in understanding the business’s operating performance more accurately. 3. Enterprise Value (EV) Consideration: In assessing the EV, deferred revenue is analyzed as part of working capital adjustments. Buyers consider both assets and liabilities (including deferred revenue as a liability) to understand the net operating capital needed to run the business. This analysis provides a more comprehensive view of the company’s value, incorporating operational liabilities and assets. 4. Breakage Analysis: For unredeemed services (punch passes), conducting a breakage analysis can be insightful. This involves estimating the percentage of passes that will never be redeemed based on historical trends. Accounting standards allow companies to recognize revenue from breakage when it’s reasonably assured that the service will not have to be provided. This aspect can positively impact revenue recognition and profitability analysis. 5. Sector-Specific Benchmarks: Using sector-specific benchmarks for redemption rates and breakage can also be helpful. Comparing the company’s metrics to industry averages provides insights into operational efficiency and market positioning. 6. Future Service Obligation: Buyers assess the impact of deferred revenue on future cash flows and service obligations. This includes evaluating the capacity to fulfill these obligations without affecting the company’s ability to generate new sales and manage cash flows efficiently. 7. Historical Trends and Patterns: Analyzing historical trends in sales, redemption rates, and breakage helps in forecasting future revenues and understanding the business’s revenue generation cycle more accurately.

As deferred revenue, it should be included in the valuation. Very similar to gift cards, at the same time, the seller should leave for the buyer an amount equal to the unused portion of the revenue (as they are basically holding it on behalf of the customer) as the buyer will need to provide services to these customers (perhaps less the selling costs, royalties paid, etc.). The challenge here seems to be, as it is for gift cards, is that a meaningful percentage goes unused. In similar situations, using redemption data, we have either (i) established a percentage of unused customer deposits that buyer and seller agree to that reduces the amount of the deposits turned over to the buyer, or (ii) if the data isn't conclusive, or the buyer and seller can't or don't want to agree on a settlement %, and if the customer deposits are trackable, a holdback is established on the buyer's behalf from which the buyer is reimbursed when the customer deposit is redeemed. Then the buyer and seller agree that after a certain point (6 months, 12 months, etc. -- what ever the history shows is a point when the are unlikely to be redeemed), the seller is disbursed the remainder of the holdback.