Feel the Churn: Understanding Recurring Revenue as the New Collateral

March 31, 2016 – Some lenders are now creating Borrowing Base structures that rely on Recurring Revenue in support of revolving lines of credit, instead of traditional A/R and Inventory collateral backed loans. Under this form of collateral, a prospective borrower can utilize a legal, binding contract – over potentially several years – to serve their lending needs. The logic behind Recurring Revenue is this: A customer agrees to take on a set billing schedule in exchange for services to be rendered. As long as the services are indeed rendered, and the business can remain solvent, the customer will continue paying based on the originally agreed billing rate.  This begs the question as to how much more risk does reliance on an ongoing recurring revenue (and therefore cash) schedule represent compared to a traditional A/R invoice?

Benefits of the Recurring Revenue Model

My personal exposure to recurring revenue deals has varied in both line of business and collateral structure; however, the most common borrowers under this structure tend to be software and IT service providers. They oftentimes will enter a multi-year service contract with customers, which will authorize monthly billings for, say, a variable number of software licenses. The contract will outline when billings are to be generated, when a customer/provider can terminate the contract, and the pricing arrangements. Because these contracts are so well-arranged in advance, customers anticipate billing times and will have payment ready soon after invoicing – sometimes even immediately! If so, it’s unlikely they’ll have A/R (given the quick turnover) and services obviously don’t rely on inventory… hence recurring revenue collateral. Lenders will give the company line availability for revenue ranging from 3, to 6, to 12 months.

Deal Specific Procedures

Major lenders typically rely on that stereotype we discussed earlier, which can mean due diligence involves putting the square peg of contract testing into the round hole of a receivables/inventory exam template. This, in turn, leads examiners to start scratching heads and wonder if they entered an alternate universe where they entered a different career. Fret not! The parallels between both forms of ABL are simpler than you may think. The key forms of recurring revenue testing model other facets of traditional ABL, with two prime factors…

First comes a review of recurring revenue contracts for authenticity. Rather than chasing after a bill of lading or freight tracking number, examiners can trace an invoice charge to what was agreed upon when the customer put pen to contract paper. This ensures that the invoicing schedule, pricing plan, and thus the reported revenue, is accurate. Terms can be presented in a qualitative manner on the workpapers, and disclosure caters to an obvious audit trail.

Second – and this is one you’ll hear quite a bit about from the lender – is churn rate testing. This is simply the recurring revenue version of dilution. Since there’s no A/R roll-forward to generate, how does an advance rate come about? Churn is quantitatively defined as cancellations (be it number of customers or total revenue amount) as a percentage of total revenue. Sounds familiar, right? The borrower can provide a listing of cancellations, and ideally, they are outlined by time and contract amount. When calculated over a lender-provided period of time, you have a game plan to determine how much recurring revenue is actually being paid out. For a deeper audit trail, the examiner can trace noted cancellations to contracts, in order to ensure the cancellation policies are being adhered to.

Conclusion

These audit strategies come with risks, however. Many contracts can have dozens of amendments to adjust billing policies. Borrowers may not disclose cancellations, which could lead to a mismatch of financial revenue to reported revenue, and throw off churn. Poor contract writing could lead to lengthy red tape in a liquidation scenario, especially if the billings are authorized before the contract is legitimately fulfilled. However, where these hypothetical risks burden the examiner, the lack of many additional tests and data entry will give them time to sort out wording, help provide an accurate report of the billing process, and maintain a simple yet effective audit trail.

While unorthodox, recurring revenue ABL collateral should never be intimidating to either lender or examiner. It’s all in the contract, with no law degree needed! Contact Joseph Heim at jheim@dopkins.com to continue the discussion and / or learn more.

About the Author

Joseph A. Heim CFE, CPA

Joseph Heim has over 25 years' experience investigating matters involving white-collar crime, fraud and corruption. He provides forensic accounting, litigation support and expert witness services to businesses, attorneys and commercial finance lenders. He is the Partner in charge of Dopkins Asset Based Lending Consulting Services.

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