Customers paid in advance, the cash went into the cash-free debt-free count, and the buyer has to deliver the service. Who pays for it depends on one question: will those prepayments keep coming?
Deferred revenue is debt-like only to the extent that it is abnormally high or will not renew. If customers keep prepaying at a normal level, it belongs in working capital against a peg, and only the excess reduces the price. On an illustrative €80.0m enterprise value with €15.0m of cash and €9.0m of deferred revenue against a normal €7.5m, that gives €93.5m for the shares; treating the whole balance as debt gives €86.0m, and counting it twice €84.5m.
Worked in full in Closing the Deal by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Deferred revenue is the cash a customer has paid for a service the company has not yet delivered: annual software licences billed up front, maintenance contracts, deposits, gift cards. In a cash-free debt-free deal that cash sits in the cash line and is paid to the seller euro for euro. The buyer inherits the obligation to deliver. That is why it is one of the most argued lines in an equity bridge, and why the number moves so much depending on which of four treatments the SPA adopts.
| Input | Value |
|---|---|
| Enterprise value agreed | €80.0m |
| Cash at completion, including prepayments collected | €15.0m |
| Financial debt | nil |
| Deferred revenue at completion | €9.0m |
| Normal level of deferred revenue, twelve-month average | €7.5m |
| Gross margin on delivering the service | 40% |
| Tax rate | 25% |
1. Working capital with a peg. Deferred revenue is a liability inside net working capital. The peg includes its normal level of €7.5m; the actual €9.0m makes working capital €1.5m lower than the peg. Price: €95.0m − €1.5m = €93.5m. In Excel: =EV+Cash-(DR_actual-DR_normal).
2. Cost to serve as a debt-like item. The buyer deducts what it will cost to deliver, not the revenue: €9.0m × (1 − 40%) = €5.4m. Price: €89.6m. After 25 per cent tax relief on those costs, €4.05m, price €91.0m.
3. Full debt-like item. The whole €9.0m comes off: €86.0m.
4. Both, by accident. Deducted as debt and left in the working capital definition: €95.0m − €9.0m − €1.5m = €84.5m.
| Treatment | Equity price | Cost to seller | % of EV |
|---|---|---|---|
| Ignored (seller's opening position) | €95.0m | €0.0m | 0.0% |
| Working capital with a peg | €93.5m | €1.5m | 1.9% |
| Cost to serve, after tax | €91.0m | €4.0m | 5.1% |
| Cost to serve, before tax | €89.6m | €5.4m | 6.8% |
| Full debt-like item | €86.0m | €9.0m | 11.2% |
| Double counted | €84.5m | €10.5m | 13.1% |
Nobody disagrees about the business. The €10.5m between the top and the bottom of the table is a disagreement about one balance sheet line, and it is 13.1 per cent of the enterprise value.
The answer turns on whether the prepayments renew. Follow the cash rather than the accounting.
| Deferred revenue at completion | Excess over norm | Peg | Cost to serve | Full debt-like | Double counted |
|---|---|---|---|---|---|
| €6.0m | −€1.5m | €96.5m | €91.4m | €89.0m | €90.5m |
| €7.5m | €0.0m | €95.0m | €90.5m | €87.5m | €87.5m |
| €9.0m | €1.5m | €93.5m | €89.6m | €86.0m | €84.5m |
| €12.0m | €4.5m | €90.5m | €87.8m | €83.0m | €78.5m |
Two things stand out. Under the peg the seller gains when deferred revenue at completion is below normal, at €96.5m in the first row: working capital is delivered above the peg. Under the debt-like treatments it never does: even at a normal balance the seller gives up €4.5m on cost to serve and €7.5m at full value, which is the whole funding benefit of a business whose customers pay first. A seller agreeing to debt-like treatment has, in effect, sold that funding to the buyer for nothing.
The other lever is timing. A seller who runs an early renewal campaign before completion swells both cash and deferred revenue. Under the peg the extra cash is neutralised by the working capital shortfall; under a regime that ignores deferred revenue the seller banks it.
The expensive error is the double count, and it is usually a drafting accident rather than a negotiated outcome. The net debt schedule lists deferred revenue because diligence flagged it; the working capital definition is lifted from the balance sheet and still includes it. On the figures here that costs the seller €1.5m on top of the €9.0m already given up. The working capital definition should carve out every item listed in net debt, and the peg should be recalculated without it. The wider set of arguable items, and how far each moves the bridge, is worked in how much disputed debt-like items move the price, and the peg itself in how to calculate a net working capital peg.
Diligence test: chart deferred revenue month by month for two years. A balance that is flat or seasonal goes in working capital. A balance that is rising into completion, or tied to a product that is ending, is the part worth arguing about.
Deferred revenue is customer funding, not debt, as long as it renews. Price the excess over its normal level through the peg, and argue for cost to serve only on the part that will not come back. The equity bridge with each arguable item on its own switch, one column for each side, is in the free workbook for this case.
In one of them, never both. If customers keep prepaying at about the same level, deferred revenue is part of how the business is funded and belongs in working capital, measured against a peg that includes its normal level. In the illustrative case only the €1.5m above the €7.5m norm then reduces the price. Treating the full €9.0m as debt-like is defensible only if the prepayments will not recur.
The buyer argues that it must deliver what customers have paid for, but only at cost, not at the revenue figure. With a 40 per cent gross margin, €9.0m of deferred revenue costs €5.4m to deliver, or €4.05m after 25 per cent tax relief. It is a compromise between the seller's zero and the buyer's full face value, and it implicitly assumes the prepayments run off rather than renew.
When it is deducted as a debt-like item and also left inside the working capital definition. The full €9.0m comes off as debt, and because the actual balance of €9.0m is above the €7.5m in the peg, working capital also comes in €1.5m short. The seller pays €10.5m for one liability. The SPA definitions should exclude from working capital anything listed in net debt.
This article is one calculation from Closing the Deal. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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