Prepaid memberships, state health club rules and what lenders do with them

Selling twelve months up front is the best cash month a gym will have and the worst month to base a loan application on. The cash is real. The revenue is not yet earned, a share of it is legally refundable in many states, and an underwriter who catches the difference after issuing a term sheet will reprice the deal.

Cash receipts for January through June: 345,600 plus 720,000, which is 1,065,600. Annualise that half-year and you get 2,131,200. The true annual figure is 345,600 plus 1,440,000, which is 1,785,600. The half-year annualisation overstates the business by 19.4 per cent — and that is before anyone has done anything dishonest. It is just what happens when you annualise a period containing the whole of a once-a-year cash event.

At 30 June, 172,800 of that January cash is unearned. On an accrual balance sheet it is a liability. In several states it is also a refund obligation with a statutory formula behind it.

What the state rules actually do

Prepaid health club and fitness contracts are regulated at state level, and the rules are more substantial than most owners realise. Depending on the state, some or all of the following apply. This varies considerably; check your own state's current statute and the agency that administers it.

• A cooling-off period during which a new member may cancel and receive a full refund, commonly a few days from signing.
• A pro-rata refund right on cancellation for relocation beyond a stated distance, disability, or death, calculated from the unused portion.
• A cap on contract length, and in some states a cap on how far in advance a member may prepay.
• Registration or bonding. A number of states require clubs that sell prepaid contracts to register and to post a bond or security, sized in some cases by the volume of prepayments held, precisely so that members can be made whole if the club closes.
• Required contract language, including cancellation notice, in a specified form and sometimes a specified type size.

For a lender, the bonding and refund provisions turn unearned membership revenue from an accounting concept into a contingent claim with a statutory basis. That is why it is treated the way it is.

How an underwriter handles it

What to present, and how

Give the underwriter both views and reconcile them. Specifically:

1. A deferred revenue schedule. Opening unearned balance, prepayments received, revenue recognised, refunds paid, closing balance, by month, for twenty-four months. This single document resolves most of the ambiguity in a fitness file.
2. Membership counts, not just dollars. Active members at month end, joins, cancellations, and the split between prepaid and monthly. The churn rate is the number that predicts next year.
3. A refund history. Actual refunds paid over two years as a percentage of prepayments taken. If it is low and documented, the contingent liability argument weakens considerably in your favour.
4. Your state compliance position. Registration where required, bond in force, current contract form. An owner who volunteers this is telling the lender the regulatory risk has been handled. An owner who has not looked at it is handing the lender an open question.
5. A cash-versus-accrual bridge for the trailing twelve months, so nobody has to guess what the deposits mean.

The related trap: the sold-and-financed membership

Some clubs sell long-term contracts and sell the paper to a third-party finance company, receiving cash up front and retaining a recourse obligation on cancellations and defaults. That structure creates a liability that is easy to miss in the accounts and hard to miss in a default, and it affects the file twice — once as a contingent liability, once because the cash it generated made the deposits look larger than the membership base justified. If you have done this, put it on the debt schedule. It belongs there.

What changes if you are selling the club

A buyer's lender will treat unearned membership revenue as an assumed liability and will usually require it to be funded at closing, by a purchase price reduction or a cash escrow. That is the moment the number becomes concrete. A seller who has spent the prepayments discovers that 172,800 of the purchase price is going to sit in an account, not in their pocket. Plan for it two years out, not two months.

What to ask for and what to refuse

Ask any prospective funder how they treat deferred membership revenue in their covenant definitions — specifically, whether it is included in current liabilities for the purposes of a working capital or current ratio test. If it is, model the covenant against your own January before you sign, because January is when you will breach it.

Ask, on a revenue-based product, whether prepaid contract sales are included in the receipts the remittance is calculated on. If they are, a strong January sale increases your obligation without increasing the service revenue available to pay it.

Refuse to submit cash-basis figures as though they were accrual, and refuse to let a broker annualise a partial year that contains your prepay season. Both will be caught, and being caught turns a pricing conversation into a credibility conversation.