Customer Deposits: Unearned Revenue
When selling a business with a significant amount of customers who pre-pay a deposit prior to receiving goods or services, it is imperative to accurately define and fairly allocate the customer deposits at closing. Customer deposits are considered a current liability or unearned revenue (held in cash on the balance sheet), and is only converted into revenue when the service or good is earned or delivered to the customer. The disposition of customer deposits (yet to be recognized as revenue) and whether they are transferred in full to the buyer at closing is subject to negotiation and largely depends on whether the buyer wishes to assume the liabilities or obligations of fulfilling the customers’ orders after the closing. If the buyer desires to assume the liabilities associated with fulfilling the outstanding jobs, then the customer deposits are typically transferred to the buyer at closing.
When are Customer Deposits Recognized as Revenue?
In many cases, a business may receive the customer deposit and convert the deposit into revenue well before the overall job is done. This happens frequently in large construction or renovation projects when payment is due from the customer in stages to cover different aspects of the job such as permitting, engineering, electrical, plumbing, and excavation. In these instances, the initial customer deposit – especially when non-refundable – may be quickly converted into revenue as soon as the business completes the initial stage of the job which the deposit is meant to cover (often permitting and engineering). Although an unfinished and ongoing customer job is still considered a Work in Progress (WIP) with outstanding work yet to be completed, the customer deposit may already have been earned by the business after completing the initial phases of the job.
Pre-Closing Reconciliation
- Accurately recording and tracking the customer deposits in relation to current customer orders is essential for a smooth business sale.
- Buyers will not want to purchase a business with the possibility of future lawsuits or liability from customers who have given deposits but have not fully received the promised goods or services.
- The seller always has the option of refunding the customer deposits or completing the jobs themselves after the sale.
- However, this is likely to interfere with the buyer’s retention of the customers and thus likely to lower the overall valuation of the business.
- It is far better for the seller to reconcile their deposits prior to closing by matching each deposit with the customer job.
- The total amount of unearned deposits should be treated as ‘restricted cash’ on the seller’s balance sheet, and transferred to the buyer at closing.
- The reconciliation statement may also show the costs that the seller incurred in partially performing the jobs.
- The parties to the deal may agree to deduct the costs that the seller incurred in partially servicing the jobs from the net amount of transferable deposits.
- The net amount of transferable customer deposits transferable to the buyer may be used to offset the amount owed the seller at closing, so long as the liability of servicing the customer jobs is entirely transferred to the buyer at closing.
- This may be accomplished through a traditional ‘asset sale’ whereby the buyer forms their own corporate entity while assuming certain certain assets and liabilities of the seller’s corporate entity as described in the asset purchase agreement.
Formal Due Diligence
During the formal due diligence phase of a business transaction for a company with a significant amount of customer deposits, the buyer will examine the quality of the customer accounts. This includes scrutinizing the payment history and credit-worthiness of the customers as well as the scope and timing of the obligations promised to each customer. The buyer will want to purchase a diversified customer base with a solid payment history, along with reasonable obligations to deliver the promised goods or services in an economical way. For example, a buyer may discover during formal due diligence that a construction-related business has several customer deposits for jobs not scheduled to begin for six months or more. Those jobs may not be profitable for the buyer unless the customer contracts account for the rising costs of goods and services that the buyer may face when completing the job.
Clarify Customer Contracts
A good tip for business owners hoping to maximize the value of their business is to have clear contracts with their customers that describe the nature and purpose of a customer deposit. The customer contract should specify whether and under what circumstances the deposit is refundable as well as the specific task that the business will fulfill in relation to the deposit. This assures the seller that the deposit is properly converted to revenue when the task is fulfilled and does not become transferable to the buyer. Further, the customer contract should affirm the transferability of the customer contract to another corporate entity so that the buyer may retain the job after the sale. The overall scope of work in the contract should be clear to all parties and have clauses to account for future increases in material and labor costs necessary to complete the job.
Business owners should always remember that customer deposits are unearned revenue and remain a liability on the balance sheet until converted to revenue. An experienced business broker should guide the business owner in accurately defining and reconciling their customer deposits prior to closing. The quality of the customer accounts and clarity of the customer contracts will mainly decide the extent to which the buyer will want to assume the liabilities and obligations of performing the contracts.
Give Martin at Five Star Business Brokers of Palm Beach County a call today at 561-827-1181 for a FREE evaluation of your business.