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Issues with Annual Accounts When Selling Your Business

A lot of hosting and other internet services companies offer prepaid annual/multi-year customer plans. These plans generally are not a problem when it comes to selling your business but they can create a few issues.  We're going to try to walk through some of those issues in this post.

The key in all discussions of valuation is to remember that the value of your business depends largely on the expected cash flow it will produce for the buyer and the risk to that cash flow. 

Renewal/Churn Risk.  Renewal/churn risk is the risk that customers will not renew their service at the end of their contract cycle.  Non-renewal is sometimes called churn. 

Buyers want the customers they acquire to stick around.  A customer base made up of customers that have been very stable over a long period of time gives a buyer more comfort than one that hasn't and would likely be worth more.

It can be a problem for buyers if a seller's customer base has a lot of new, prepaid annual contracts.  In this case the buyer would have to provide services to those customers for some time but may be uncertain about their churn risk.  It can be a huge problem if the base has a lot of new, multi-year customer contracts.  In these cases, the churn risk is even higher and the buyer would have to provide services for a longer period of time.  Our experience has been that a new, three-year, prepaid customer would likely have little to no value to an buyer.  (In fact, some buyers may subtract value because of the costs of maintaining the customer over the three years.)

Cash Flow.  We see a number of buyers concerned about the cash flow effects of buying a customer base made up of monthly vs. annual accounts.  As long as the customers are spread out evenly across the year, there are no revenue differences between annual and monthly customers bases, all other things being equal. (See this post for the math.)

The bigger cash flow issue is where a seller sells or renews a lot of annual or multi-year contracts just prior to putting their business on the market.  This has the effect of pulling future revenues out of the business and reduces the cash flow for buyers. 

Deferred Revenue. Deferred Revenue is the liability that is created when you take a payment today for services you are to provide in the future. 

For example, your customer pays for one year of hosting service in advance for $120 ($10/month). Under accounting rules, when you first make the sale and got the $120 there would be $10 of revenue (for the first month) and $110 of Deferred Revenue would go on your balance sheet as a liability (adds up to $120.)  At the beginning of the second month, a second $10 of revenue would be booked and the Deferred Revenue Liability would be reduced by that $10 to $100. And so on until the end of the year.

Why do you care? Deferred Revenue can have a major impact on a buyer's valuation of your business.  How buyer's look at Deferred Revenue can vary greatly from company to company.  We've seen buyers that (a) ignore it; (b) reduce the purchase price based on the cost of providing the service that has already been paid for; or (C) reduce the purchase price for the full amount of the Deferred Revenue Liability.

If you have mostly monthly or quarterly customers, Deferred Revenue isn't going to be a big issue for you.  As more and more of your base has annual, or longer, contracts, the issue gets bigger. If you have a base with a lot of annual or longer contracts, do the calculations and figure out how big an issue you may have.  It is a lot easier to deal with the issue now, before you plan to sell.

Summary.  We hope that this overview of some of the purchase/sale issues facing prepaid annual customers has been helpful.  Obviously we've had to be brief in our discussion and there are other nuances and issues that come into play. 

If you'd like to discuss these further or have any questions, please do not hesitate to contact us.

Cheval Capital, Inc.

Disclaimer: This post is for general information purposes and is not meant to be taken as financial advice, a recommendation to buy or sell the stocks mentioned above, a comprehensive discussion of valuation or how to do the calculations discussed. Please be sure to consult your financial advisors when valuing your company, considering the sale of your business or making other financial decisions