Revenue Recognition and M&A Transactions

How the New Revenue Recognition Standard Affected a Recent M&A Transaction

In late 2017 vcfo Houston Practice Manager, Russell Naisbitt, enjoyed the opportunity to serve as transaction CFO for the sale of a small SaaS software company to a much larger publicly-traded company.  The Seller had wisely put together a deal team to represent them in the transaction that included an investment bank specializing in the sale of software companies, an attorney experienced in M&A, and a team from vcfo which also included a controller and an HR specialist.

The investment bank did a masterful job of playing two very eager public company bidders against each other to extract a price that was 2 – 3X what might have been presumed attainable based on prevailing multiples for such a deal.  Likewise, the attorney did a thorough job of protecting the seller to the maximum extent possible in the negotiation and documentation of such things as the representations and warranties.

vcfo’s role prior to closing was largely routine comprising a thorough overhaul of the last 4 years of financial statements to make them GAAP compliant and the preparation of numerous schedules required for due diligence and the closing.  These included providing to both potential acquirers a statement of accounting policies, which included the basis of revenue recognition, and calculations of estimated net working capital at close calculated in accordance with the slightly different formulas set forth in the sale and purchase agreements drafted with each of the respective buyers.

After the close, the Seller received a claim from the buyer for adjustments to the net working capital calculation.  The claims were all de minimis except for a claimed adjustment to the deferred revenue balance that ran into the hundreds of thousands of dollars.  The claim asserted that the seller had understated the deferred revenue balance, and thereby overstated the net working capital, by recognizing revenue from the sale of perpetual software licenses and paid proofs of concept up front rather than pro-rating over the expected life of the customer.

The contract required that, unless otherwise specified in the agreement, the calculations be in accordance with US GAAP.  In making their calculations, the buyer applied their own revenue recognition policy, which comported with GAAP as defined in ASC Topic 605.  However, the revenue recognition policy we adopted on behalf of our client, which we had set forth in our statement of accounting policies, was based on the new revenue recognition standard, ASC Topic 606.  While adoption of the new standard was not mandatory for either public or non-public entities, early adoption was permitted at the time the sale.  Due to the unique circumstances surrounding the transition from old GAAP to new GAAP, we were able to choose the option that most benefited our client.

Early adoption of the new revenue recognition standard in this case had two effects both of them detrimental to the buyer:

i.         It effectively increased the net price received by seller.

ii.       It reduced the future reported revenues of the buyer by the same amount.

The moral of this story is that both buyers and sellers should pay careful attention to the potential impacts of the new revenue recognition standard on M&A transactions. If you would like vcfo’s team of experts to review the potential impact of the new standards on your business or for more information about compliance, connect with a vcfo consultant today!