When selling a company, it is not always the case that you will receive the full purchase price that you have agreed for your shares on the day you complete. Quite often, buyers will structure offers in a way that includes an initial payment followed by periodic payments thereafter. These further payments are known as “deferred consideration”.
There is no set rule on how deferred payments are made. They could be weekly, monthly, quarterly or yearly payments. There may be just one deferred payment or there may be many.
Seller’s Point of View of Deferred Consideration
The main consideration for a seller when agreeing to such terms is the risk of not getting paid. Deferred consideration is usually a set agreed amount of money, but this does not mean it is guaranteed to be paid. The deferred consideration is a debt from the buyer but if the buyer does not have the funds available at the right time, then it may default. This means the seller must pursue the buyer for what is owed and potentially issue proceedings. If the buyer legitimately cannot pay what is owed, it may enter an insolvency process such as liquidation or bankruptcy. This means a seller that is unsecured will rank alongside all other unsecured creditors that the buyer owes money to. The seller will not be given any priority.
The Solution
If the proposed deal must involve some element of deferred consideration, then how can the seller best protect their position? One of the most common ways is to try and secure the deferred consideration against an asset or have the payments guaranteed by a connected party that is more likely to have the funds to ensure payment.
This approach requires analysis of the parties involved and their financial standings. It also usually takes good negotiation to reach a point that is acceptable to all involved.
Buyer’s Point of View of Deferred Consideration
It is beneficial for a buyer to have part of the purchase price payable on a deferred basis. This is because it does not need to have the full amount of the price ready to pay on day one. By deferring some of the price to the future, it can assist a buyer’s cash flow position and perhaps remove the need for third party finance.
In addition to cash flow benefits, there is a certain comfort of having some funds deferred as it can usually mean easier access to payment in the event of a successful warranty claim or other claim under the purchase agreement. Without any deferred payments, enforcement of a warranty claim would need to be made, by which point the sale proceeds may have been moved into other assets, projects or businesses, making it harder to realise.
Earn-out
Earn-out is a form of deferred consideration but, unlike deferred consideration, is based upon performance of the target business. It involves the making of deferred payments, but the amount of those payments is not known from the outset and are dependent upon the financial success of the acquired company after the sale is completed.
An earn-out structure involves the parties agreeing on some form of a commercial target (such as a threshold of EBITA or sales revenue) and a corresponding payment made based on the achievement of that target. Sometimes the earn-out payment is a single payment made on the achievement of a set target, other times it may be a payment that is on a pound for pound basis on anything above a certain threshold.
Seller’s Considerations for Earn-out
Buyer’s Considerations for Earn-out
The details of whether deferred consideration or earn-out are suitable, and how they should best be structured, will vary from deal to deal.
Please contact our Corporate Law team by email or phone 0113 207 0000 if you need any assistance in understanding these structures.