Working capital: the software M&A tripwire

Accrual accounting -> deferred revenue -> 💀?

Working capital sits right at the top of buy-side due diligence lists (what else is on that list? See this article). All the more confusing why this topic is so poorly understood in M&A transactions, causing so much aggravation between buyer and seller post-closing. 

In this article, I explain why working capital matters in software - and how to stop trippin’ over it. 

Most deals are done on a debt-free, cash-free basis. Meaning that the buyer expects the target to have a normalised level of working capital. Enough to keep the business running without having to put up additional cash.

Before closing, buyer and seller agree on this normalised figure, which is then included in the SPA. After closing, adjustments are made based on the actual level of working capital delivered.

Why software is special

Like most industries, a software company’s working capital can vary significantly due to seasonality or large customer orders. Crucial to set it at a level that truly reflects business needs. Several methods exist, all based on averaging: over the last 12 months, 2 years, or on a quarterly basis. 

So why the controversy?

In most industries, working capital ties up cash. Retailers keep inventory on hand. Pharma, carmakers keep ample supplies of raw materials. No wonder the capital obsessed Swedish serial acquirers stay away from these very industries! 

However, in software negative working capital is a feature, not a bug. 

How come? 

Having customers prepay annual contracts results in a significant deferred revenue liability. On the other hand, most running costs (salaries, rent etc.) are settled in monthly installments. 

To use an extreme example, Salesforce’s unearned (i.e. deferred) revenue was a staggering $19B in January 2024. The seasonality effect can be clearly seen from the chart below.

Source: Salesforce public filings

As software businesses grow, this situation is exacerbated, sometimes resulting in an EBITDA conversion (the ratio of free cash flow to EBITDA) in excess of 100%.

Most offline businesses I know would give their right arm to be in this enviable position! 

What bankers don’t (want you to) know

Most investment bankers I have dealt with, particularly those who have never worked in a finance function, treat negative working capital in software like positive working capital elsewhere. They calculate an average and set a “peg” - often a negative figure.

The issue is that in software, working capital is not a capex-like “float” (there is no inventory per se), but rather a liability arising from customer prepayments. Thus, the peg should be set at zero to ensure a fair, $-for-$ adjustment at closing.

Let me give you an example. 

Consider a loss-making software company that depends on external funds to keep going. Once equity is exhausted, it can either raise debt or effectively borrow from customers by collecting payments in advance. In this instance, deferred revenue is not that different to debt because it too comes with a (performance) obligation. 

Once again: negative working capital is akin to debt. 

People that overlook this concept in a rush to complete due diligence essentially account for revenue but not the corresponding cash inflow. Put differently, they lose the net present value (NPV) of cash inflow from revenue, which approximately equates to deferred revenue in present terms. 

Practical advice for serial acquirers

If you acquire businesses for a living, you can ill afford to get this wrong once, let alone systematically. 

Here is how I tackle this topic:

  • Separate deferred revenue from working capital calculation and treat it as a debt-like item, which I then deduct $-for-$ from the purchase price

  • Set working capital peg (excluding deferred revenue of course) at zero

Serial acquirers thrive on capital efficiency. If not reinvested, excess cash should be extracted at closing - to be used for more acquisitions, for example. By treating deferred revenue as a liability and setting working capital peg to zero, you will avoid having an under-capitalised, financially vulnerable business. 

Good luck!