Why it matters
Many businesses are paid before they deliver: annual software subscriptions, gym and club memberships, course fees, deposits for building or made-to-order work, event bookings, gift cards, and client retainers billed in advance. Until the work is done, that money is owed back to customers in the form of goods or service.
If the seller has already spent the cash and you take on the obligation to deliver, you provide months of service with no matching income. Your cash flow in the first year can look much worse than the profit and loss account suggested.
Here is a fictional example. Larkspur Lane Fitness has 1,000 members who each paid £600 for a year in advance. At completion, members have on average half a year left, so £300,000 of service is still owed. If the seller has spent that cash, you deliver those months of membership with no income from those members until they renew.
How visible the problem is depends on how the books are kept. In accrual accounts, money received for work not yet done should appear as deferred revenue, a liability. Accounts kept on a cash basis often do not show it at all, and a listing built from cash receipts may count it as revenue already earned.
There are several common ways to deal with it. You can treat deferred revenue as a debt-like item and deduct it from the price in a cash-free, debt-free deal, have the seller pass over the matching cash at completion, or include it in the working capital peg. In an asset sale you may be able to decline some obligations, but turning away customers who have already paid damages the goodwill you are buying. Ask an accountant which approach suits your deal.
Deferred revenue is money customers have already paid for goods or services the business has not yet delivered. It is a liability until the work is done.
Cash-free, debt-free is a pricing basis in which the headline price assumes the business changes hands with no cash and no borrowings. The seller keeps the cash, repays the debt and leaves a normal level of working capital behind.
A working capital peg is the agreed level of working capital a business must contain at completion. The price moves up or down by the difference between the actual figure and the peg.
How to spot it
- The business records revenue when cash arrives rather than when it delivers.
- Annual, lifetime or prepaid offers were promoted in the months before the sale.
- The balance sheet shows no deferred revenue, although customers pay in advance.
- Customer deposits on open jobs are large while the cash balance is low.
- Gift cards or vouchers are sold, but no liability for unredeemed ones is recorded.
- Cash received from customers rose sharply in recent months without a matching rise in delivery.
Questions to ask the seller
- How much have customers paid in advance for goods or services not yet delivered, as of today?
- How is that amount recorded in the accounts, and how is it calculated?
- Where is the cash that corresponds to it?
- Did you run any annual, lifetime or prepaid offers in the last 12 months?
- How do you propose to reflect prepaid obligations in the price or at completion?
Documents to request
- A deferred revenue schedule by customer or contract, showing what remains to be delivered
- A billing or subscription system export with start and end dates for prepaid plans
- The customer deposits ledger and a list of open jobs
- Gift card and voucher liability reports
- Monthly balance sheets and bank statements for the last 12 months
- The revenue recognition policy used in the accounts