Three months into a sell-side engagement, the buyer’s quality of earnings team found $1.2M of revenue that shouldn’t have been recognized yet.
The deal didn’t die on the spot. It was worse: the valuation was recut by three times the adjustment. The owner lost more in that repricing than they’d spent on finance in the previous three years combined.
What revenue recognition actually means
Revenue recognition is about when you count revenue, not whether you earned it. Under GAAP, you recognize revenue as you deliver what the customer paid for, not when the cash arrives or the contract is signed.
If a customer pays $120K up front for a year of service, you’ve earned $10K a month. Booking all $120K in the month you signed makes that month look great and the rest of the year look worse, and a buyer will move it back to where it belongs.
Where it usually goes wrong
Revenue recognition is the most common issue I see kill or reprice middle-market deals. The owners involved always had good intentions. The usual causes:
- Annual contracts booked up front instead of over the contract term
- Implementation or setup fees recognized immediately when they should be spread over the service period
- Recurring and one-time revenue mixed on the same line, which makes the recurring base look bigger than it is
- Revenue booked on invoice, not on delivery, for projects billed in advance
None of it was malicious. All of it was expensive.
Why the discount isn’t dollar for dollar
Buyers and their accountants look for exactly this. A clean P&L gets you the multiple you earned. A messy one costs more than the error itself, for two reasons.
First, adjusted EBITDA goes down, and every dollar is multiplied by the purchase multiple. Second, buyers price in the risk of everything else they haven’t found. One error makes them question the rest of the numbers.
A self-check before you go to market
- Can you show revenue by customer, by month, tied to contracts?
- Is recurring revenue reported separately from one-time revenue?
- Are prepaid contracts recognized over their term, with deferred revenue on the balance sheet?
- Would your revenue numbers match if an outside accountant rebuilt them from the contracts?
By the time you’re in diligence, it’s too late to fix. Have someone outside your team pressure-test your revenue recognition 12 to 24 months before you go to market.
Common questions
Do private companies have to follow GAAP revenue recognition?
Not always for their own reporting, but buyers will apply it in diligence. If your books don’t, expect the buyer’s version of revenue to be different from yours.
What is deferred revenue?
Cash you’ve collected for work you haven’t delivered yet. It sits on the balance sheet as a liability and moves to revenue as you deliver.
How far back will a buyer look?
Typically the last two to three years, plus the current year to date. Problems in older periods matter if they affect the trend buyers are paying for.
Scorecard