In Part 1 of our e-book on Valuation Considerations When Buying or Selling a Business, we discussed the use of contingent consideration and earnouts in M&A deals. You might recall that we spent some time discussing the pros and cons of the financial metrics that are often used in calculating earnout payments. We noted that profit-focused metrics (e.g., EBITDA or net income) are more susceptible to manipulation by the buyer than metrics “higher up” on the income statement such as revenue. The reason these metrics can be manipulated is that there are a host of different expenses and other factors that can impact post-transaction profits of the entity. Because earnouts can be negatively impacted by deterioration in post-transaction profits, it is important that both buyers and sellers understand the drivers of the acquired company’s profitability.
In many cases, when reported income immediately declines after an acquisition, integration costs and customer attrition are the primary causes. In general, these factors are typically anticipated by the parties and therefore do not cause disputes when computing earnout consideration. So, let’s ignore those factors for the purposes of this discussion. Even in the event that an acquired company operates at the same exact level of activity pre- and post-acquisition, the reported income in those two periods can differ significantly as a result of two lesser-known culprits: deferred revenue and inventory.
Deferred revenue is an accounting term for cash that is received as a prepayment for a product or service – the related revenue is not actually recognized until the goods are shipped or the services are rendered.
- In an acquisition, deferred revenue is typically adjusted down from its originally recorded amount to its “fair value,” which is based on the cost to deliver the related product or service (not the amount of cash collected prior to the related revenue being recognized). Because of the reduction in the deferred revenue balance to “fair value,” there is a portion of revenue (for which cash has been received) that never gets recorded on the company’s pre- or post-transaction books. Poof! That revenue basically disappears and never gets recognized. For companies that receive meaningful prepayments (think of any company that generates earnings through annual subscriptions), this can have a material impact on the amount of revenue that is recorded post-acquisition when the deferred revenue is reversed and recognized as revenue.
- For every dollar that deferred revenue is reduced when it is adjusted to “fair value” on the opening balance sheet of the acquired company, that equals one dollar of revenue and income that will never be reported or realized.
As you can see, even if an earnout were based on revenue, the accounting treatment for deferred revenue can significantly distort the company’s performance and resultant earnout computation. Of course, the existence of deferred revenue would not only impact revenue-based earnouts, but also any profit-based earnouts as revenue also drives any profit metric. Therefore, buyers and sellers must be mindful of the impact deferred revenue can have on the company’s financial statements when developing an earnout formula.
Deferred revenue is not the only sneaky perpetrator that can hamper post-acquisition earnings – inventory also impacts an acquired company’s financial results.
- Inventory is typically carried on a company’s balance sheet at cost. In an acquisition, however, inventory is written up to “fair value,” which represents the selling price of the inventory less any sales/completion costs. This means that even though the acquired inventory items had the same cost as those sold just before the transaction closed, the profit on post-transaction sales is artificially deflated due to the write-up in inventory value on the acquired company’s opening balance sheet. This write-up in inventory value reduces the company’s income and profitability during the period of time that the acquired inventory is sold.
- Again, for every dollar that inventory is increased when it is adjusted to “fair value” on the opening balance sheet of the acquired company, it equates to one dollar of income that will never be reported or realized.
Between the reduction in revenue (from deferred revenue) and decrease in gross profit (from inventory), an acquired company’s reported financial performance can look significantly worse during its first post-acquisition year than its underlying activity would actually indicate. Due to the unique accounting provisions related to deferred revenue and inventory that are triggered when an acquisition occurs, a company operating at the exact same level both pre- and post-acquisition could have materially lower profitability levels for the first year or two after an acquisition while the impact of the deferred revenue write-down and inventory step-up is felt. Therefore, it is important that the parties to the transaction anticipate these issues so that they can design an earnout formula that is consistent with their wishes and not distorted by accounting treatment.
Learn more about the important topics you should be aware of during M&As in our free e-book: Valuation Considerations When Buying or Selling a Business – Part 2. For more information on the various approaches to valuation or our Valuation and Litigation Advisory Services, contact Sean Saari via email or by calling 440-449-6800.