What is deferred revenue in a SaaS business? And is the cash in the bank all mine when I try to sell my software business?
Subscriptions to software charged on a yearly or quarterly basis upfront are typical for most SaaS-type businesses. Therefore, when selling a SaaS business, we often come across companies with a large amount of cash on the balance sheet at various times of the year.
Cash and revenue seem to be the two most straightforward metrics for any business to record. I sell a product or a service, money from the customer comes into my bank account. The cash belongs to me now. But is the cash all mine right away when I sell a yearly subscription to a software, before I have provided the software for a year?
This question becomes even more pertinent when selling your SaaS company. Usually business owners expect the amount of cash on the balance sheet to be added to the purchase price under the assumption of a cash-free debt-free company sale. Sellers often argue that the cash on the balance sheet, when paid upfront for a future subscription service, does not belong to the business owner until the service has been delivered.
When deferred revenue comes into play…
If you are correctly accounting for revenue, your balance sheet will include a liability called deferred revenue. This is the proportion of the yearly subscription which your business has yet to earn, despite having received the cash upfront – thus balancing out the cash asset held.
By way of an example; you are charging £1,200 for a yearly subscription running from January to December in advance. In January, your customer pays £1,200 to your bank account for the service. However, you have to deliver the service for the coming 12 months in order to have earned that money. If you happen to stop providing the service halfway through the year, your customer might demand his money back. To reflect this situation, you create a deferred income liability on the balance sheet in January and release this liability against revenue in the P&L on a monthly basis as you earn it. The amount of deferred liability for this service will be zero in December once the business has delivered the software to the customer for the full year.
How does deferred revenue impact the cash received at the point of a SaaS business sale?
Following this logic, typically the amount of cash recorded on the company’s balance sheet at the point of transaction, less the amount of the outstanding deferred revenue (also called deferred income) liability, is attributable to the Seller. The Buyer receives the benefit of cash in the amount of the deferred income liability as he will be responsible for delivering the service to the customer after the change of ownership. This ‘outstanding’ cash would (if applicable) count towards any performance or earn-out targets, so potentially be paid to the Seller at a multiple, rather than £ for £.
As with every situation, there is always room for negotiation and taking into consideration various elements of the service that is provided, as for example set up costs, consultancy or product customisation, different pricing structures, etc. which might enable the revenue to be recognised earlier and leave the opportunity for creating additional value for the Sellers when presented correctly.