When you're buying a business, what are you buying?

I was recently discussing an M&A deal with a client involving a business they were considering purchasing.

My client owns a related business, and we were exploring acquisitions to expedite growth.

We'd looked at a lot of interesting businesses, warts and all, but one in particular sticks in my mind as a great lesson:

There was something really funky about this one business we looked at:

• They had high forecasted revenues of $5M for the next 8 months.
• They were basing their valuation on a multiple of these revenue numbers.
• But they currently had almost zero cash in the bank, a couple hundred thousand in AR,
• They had some big bank & investor loans to pay on the balance sheet and a large interest expense,
• And they had $8M in deferred revenue.

Anyone see what's wrong here?

I often talk to founders about the difference between cash and revenue.

When I do, I say that revenue is what you have earned

(Some of which people owe you, and some of which they may have already paid)

And cash is what is actually going into your bank account.

And this is an important distinction, because of timing:

If you need to pay cash, but you only have revenue and no cash to pay it with, your business goes under while you wait.

But that revenue still has value: If it's not actual payment, it's the promise of an owed payment.

So what is deferred revenue?

Deferred revenue happens when the customer pays you BEFORE you actually earn the revenue.

And as business operators, we normally LOVE deferred revenue because...

We LOVE getting paid early!

It frees up cash for operations and investment,

And as long as our business is running well, it's great.

Because all we need to do is run the business as we normally would,

And that deferred revenue depletes or grows proportionally to the growing business.

No big deal.

Now, let's consider this M&A client:

How do we think about deferred revenue now? Do we like it?

NO!

If we're acquiring a company with a ton of deferred revenue, we're essentially buying a huge debt of service to their customers!

We will need to earn that revenue, deliver those services,

But if the cash is already gone, we're not going to get PAID for that.

It means we need to decrease our predicted return on this investment,

Because some or all of that projected revenue isn't turning into an asset;

It's paying off a debt.

We as the new owners will never see the money, the value from that revenue.

There is no more pre-paid cash,

Because the old owner already spent it.

I have to say, helping evaluate businesses to buy is super fun.

It's one of my favorite roles as a strategic finance advisor.

But man, if I'm ever thankful for paying attention in accounting class,

It's during those deals.

You really need to know what you're buying!

Your Daily CFO,

Lauren