Deferred revenue looks harmless on a balance sheet. It is also one of the fastest ways to overstate earnings and overpay if you do not treat it correctly. When customers pay before you deliver, you record a liability called deferred revenue (or customer deposits). Cash comes in now, revenue comes later. If you underwrite EBITDA off billings or bank statements without adjusting for what is still owed to customers, you can buy profits that have not been earned.
This guide explains what deferred revenue really means, how it distorts EBITDA, why it belongs in your working capital and “debt-like” discussions, and how to price and structure around it before you sign an LOI.
What deferred revenue actually represents
Deferred revenue is a promise. The company has collected cash for goods or services it has not yet delivered. Until the work is complete, the liability remains. When the company performs, the liability is recognized as revenue.
Where buyers see it most
- SaaS and software maintenance: annual contracts billed up front, fulfilled over 12 months.
- Field services and maintenance contracts: prepaid service plans, installation deposits.
- Manufacturing and custom jobs: deposits for made-to-order work.
- Education and events: tuition or registration fees collected ahead of delivery.
In all cases, the accounting is telling you the same thing: part of today’s EBITDA may be tomorrow’s work.
How deferred revenue can inflate EBITDA
Two common patterns create inflated earnings in seller materials.
1) Billings masquerading as revenue
Sellers sometimes present “revenue” based on cash collected or invoices issued. If a service is only 50% delivered, GAAP revenue should be 50%, not 100%. The “extra” appears as deferred revenue. If you treat the full billings as revenue, EBITDA is too high.
2) Cost timing out of sync with revenue
Even when revenue is recognized correctly, direct costs may lag or lead. Example: a software firm books a full year of revenue evenly each month but incurs heavy onboarding costs in the first two months. If you annualize a strong month with little onboarding, EBITDA looks great. If you catch the wrong month, it looks terrible. Either way, you are underwriting noise without a contract-by-contract view.
Why deferred revenue matters for valuation
Deferred revenue touches price in three places: earnings quality, the working capital peg, and “debt-like” adjustments.
Earnings quality
If a business has high upfront collections but thin margins on the work to be performed, current-period EBITDA overstates true profitability. Your QoE should tie recognized revenue to performance obligations and match cost recognition to delivery. When that exercise lowers EBITDA, price should follow.
Working capital peg
Prepayments suppress accounts receivable and raise deferred revenue. If you set a working capital peg without normalizing for this mix, you can quietly overpay at close. The right approach is to define working capital clearly (often excluding deferred revenue from the peg) and handle it elsewhere in price mechanics.
Debt-like treatment
Many buyers treat excess deferred revenue as a “debt-like” item because it represents work you must fund post-close without receiving new cash. Not all deferred revenue is debt-like. The nuance is whether the cash collected exceeds the cost to fulfill. In software with high gross margins, $1 of deferred revenue may imply only $0.20–$0.40 of remaining cost. In field services, the remaining cost might be much higher. Calibrate, do not generalize.
The questions to ask pre-LOI
You do not need ASC 606 mastery to spot trouble. Ask for three views and you will be ahead of most buyers.
1) Revenue vs. billings
Request a simple rollforward for the last 12 months:
- Opening deferred revenue
- Plus billings collected in advance
- Less revenue recognized
- Ending deferred revenue
This shows whether growth is real or just earlier billing.
2) Performance obligations and service calendar
Ask for a schedule of major contracts with start and end dates, delivery milestones, and the revenue recognition pattern. In services, a calendar of prepaid jobs against scheduled labor is enough.
3) Gross margin to fulfill
Estimate the remaining gross margin embedded in the deferred revenue balance. You want to know “What will it cost us to deliver the obligation that the seller has already collected cash for?”
How to adjust EBITDA for a fair view
You rarely need an elaborate model. Two practical adjustments cover most cases.
Normalize revenue recognition
Confirm that recognized revenue follows delivery. If the company has been recording billings as revenue, restate the period to match actual delivery. Your QoE provider can do this formally, but even a rough adjustment in diligence can prevent a bad LOI.
Align direct costs with revenue
Map onboarding, installation, or delivery costs to the same period as recognized revenue. If costs are front-loaded, avoid annualizing a late-period margin you cannot sustain.
The goal is to see what EBITDA looks like without timing noise. That is the number to anchor in valuation.
Working capital and the peg: define it now, not at midnight
Deferred revenue makes working capital tricky. Here is a clean way to keep it fair.
Define working capital tightly
Use a clear formula: AR + Inventory – AP (and any other agreed current items), excluding deferred revenue. Prepayments do not belong in the peg if your price mechanics handle them elsewhere.
Use a collar and a true-up
Because deferred revenue can swing around renewals, use a trailing average for the peg and include a collar. Add a 45–60 day true-up window post-close.
Call out seasonality and major renewals
If the business renews many contracts in January, set the peg with that seasonality in mind or agree on a seasonally adjusted peg.
Debt-like or not? A practical framework
Treating deferred revenue as debt-like can be fair if done carefully. Use a simple framework the seller can accept.
When to treat as debt-like
- Short, low-margin services where most of the cost to deliver is still ahead of you.
- Large prepayments collected days before close for work that will be delivered post-close.
- Material renewals where cash has been received but delivery is mostly ahead.
In these cases, agree on a cost-to-fulfill percentage with the seller and apply it to the closing deferred revenue balance. Only that cost component is “debt-like.”
When not to
- High-margin software where the remaining cost is minimal and delivery risk is low.
- Small, steady balances that roll without large swings.
- Clear offsetting assets such as prepaid hosting already on the balance sheet.
The point is to avoid paying twice: once when the seller collected cash and again when you fund the work.
Sample LOI language you can use
Here is wording that keeps the discussion clear and collaborative.
Adjusted EBITDA and revenue recognition
“Purchase price is based on Adjusted EBITDA, which assumes revenue is recognized as services are delivered or obligations satisfied. Buyer’s QoE will validate recognition policies and related costs.”
Working capital peg
“Closing working capital will equal the trailing 12-month average of AR + Inventory – AP (and other mutually agreed current items), excluding deferred revenue. A ±$[collar] collar applies, with a 60-day post-close true-up.”
Deferred revenue mechanics
“To the extent closing deferred revenue relates to undelivered obligations, the parties agree to a cost-to-fulfill adjustment of [X]% of the related balance, treated as a debt-like item for purposes of the closing cash calculation.”
Transition cooperation
“Seller will provide schedules of performance obligations, revenue recognition policies, and related delivery plans, and will cooperate to ensure a smooth handoff for contracts billed in advance.”
A quick case to make it real
Facts
- $6.0M revenue, $1.0M EBITDA
- SaaS with annual prepayments; year-end deferred revenue is $2.4M
- Gross margin 80%; support and hosting are steady
- Two large renewals signed two weeks before closing
What your review finds
- Revenue recognition is straight-line.
- Support and COGS are matched to revenue.
- The two late renewals make the deferred balance unusually high at close.
Pricing and structure
- Keep EBITDA intact because recognition and cost matching are sound.
- Exclude deferred revenue from the working capital peg.
- Treat 20% of closing deferred revenue as debt-like based on cost-to-fulfill (80% gross margin implies ~20% cost), so $480k reduces the equity check.
- Add a small holdback tied to successful onboarding of the two late renewals.
Result
You do not penalize high-margin prepayments twice, but you also do not fund delivery that the seller already collected cash for.
Red flags and how to handle them
- Cash-basis “revenue” in the CIM: insist on accrual revenue and a rollforward. If it is not available, pause.
- Big quarter-end spikes in deferred revenue: look for timing games. Adjust valuation mechanics, not just price.
- Large customer deposits with vague scopes: push for written statements of work and delivery calendars.
- Refunds and credits trend up: future margin is at risk. Bake it into structure.
- High churn masked by prepayments: study renewals, not just billings.
Buyer checklist to keep you honest
- Get the rollforward: opening DR, billings, revenue recognized, ending DR.
- Tie revenue to delivery: sample a few contracts or jobs to confirm.
- Map cost-to-fulfill: estimate remaining direct cost on the closing balance.
- Set a clean peg: exclude deferred revenue; use a collar and a true-up.
- Agree debt-like logic: cost-based percentage, not the full balance.
- Paper the plan: LOI language that covers recognition, peg, and DR mechanics.
Final word
Deferred revenue is not bad. In many models it is a sign of customer trust and strong cash collection. The trap is mistaking cash for earned profit. If you separate billings from revenue, match costs to delivery, and isolate the true cost to fulfill at close, you will price the business on reality rather than float. Do that work pre-LOI, write the mechanics into your offer, and you will avoid paying today for work you still have to do tomorrow.
Contact us today or book a free consultation and learn how we can be a trusted partner on your next deal!
