Our clients pay annually in advance, creating high deferred revenue. How do we handle this in the working capital peg?

Question

Tyler Smith · Accepted Answer

If your business model relies on clients paying annually upfront, you likely have a significant balance of deferred revenue on your balance sheet. In a standard cash free, debt free transaction, buyers will try to classify deferred revenue as a working capital liability. This means they expect you to leave the cash in the business at closing to fund the future delivery of those services, essentially forcing you to work for free post close.

You must fight this structure. The cash received for deferred revenue is not free money; it represents performance obligations that you have already partially fulfilled through your sales and marketing investments.

To negotiate a fair solution, propose a working capital peg that accounts for the direct cost of fulfilling that deferred revenue, rather than the gross liability amount. If your gross margin is fifty percent, you should only be required to leave enough cash to cover the actual cost of delivery, plus a small buffer. The remaining cash margin belongs to you and should be distributed at closing.

Alternatively, negotiate a post closing adjustment mechanism. As the deferred revenue is recognized as earned revenue post closing, the buyer must release the corresponding cash to you.

Whichever method you choose, make sure your working capital definition in the letter of intent is explicit about how deferred revenue is treated. Leaving this to be decided during the final purchase agreement negotiations gives all the leverage to the buyer.