Risk v Reward
A guide to deferred consideration and earn-outs

04 May 2021

Most of the time it will be preferable for a share or business sale to result in a clean break with all consideration being paid on the completion date. However there are situations where this is not possible or even the best way to structure the deal. These include scenarios where:

• The buyer does not have sufficient funds at completion;
• The seller is to remain with the business on completion and the buyer wants to keep him or her incentivised;
• The parties cannot agree on the value of the business and want the final price paid to recognise performance post completion; and
• An external event, such as the Covid-19 pandemic, creates a risk averse attitude in the buyer towards the transaction.

In these circumstances considering deferred consideration or an earn-out can be a great option for both the buyer and seller. Structuring a deal in such a way can help to redress the risk relating to the deal in a way which can give the parties enough comfort to get it over the line. It is key, however that the balance between risk and reward is not skewed too much and naturally each side of the transaction will have different concerns and considerations in mind.

What are they?

Deferred consideration is, as the name suggests, consideration which is not paid on completion but is rather delayed until a particular milestone. This can be a set date or the occurrence of an event. Typically the parties will have agreed the price but some or all of the consideration is deferred in accordance with the provisions of the relevant transaction agreement. As this type of deal allows the purchaser to defer the acquisition cost, this can be a real benefit to both the buyer and seller as it helps get the sale completed.

Earn-outs are a type of deferred consideration arrangement under which all or part of the purchase price on the sale and purchase of a business, or the shares in a company, are calculated using reference to the future performance of the company or business that is being purchased. They are commonly used when an owner-managed business is sold but the managers continue to work for the business for an agreed period of time after completion. This can be a positive for both a buyer and a seller, as it allows the buyer to make sure the company growth is on track and incentivises the seller. It also allows for as smooth of a transition as possible.

Key considerations

When agreeing to deferred consideration each party to the deal will need to take into account some key points. From the buyer’s perspective the risk is reduced but there should still be some safeguards in place to protect the deferred sums payable. For example, it will make sense for the share purchase agreement or asset purchase agreement to include provisions for retentions of the deferred consideration in the event of a breach of warranty by the seller. Such a clause will protect a buyer from having to pay the deferred consideration while simultaneously pursuing the seller for monetary damages. Without properly draft provisions a buyer may otherwise need to pay the deferred consideration regardless.

From the seller’s point of view, there are a few key things you can do to protect yourself including carrying out extensive due diligence in order to ascertain the buyers ability to pay the deferred consideration. Furthermore, this will help you to see how the deferred consideration will be paid and allow you to establish provisions to ensure you receive payment. Such clauses could include provisions to reduce the risk of non-payment and afford clear remedies in the event of the same. In a share sale this could involve transferring the shares in tranches commensurate to the deferred consideration as it is paid. Alternatively a seller may wish to include an option in the share purchase agreement to purchase back and shares for which payment is not received. In an asset sale protections may include security over key assets.

In addition, where the deferred consideration is payable upon the occurrence of a certain event this should be clearly defined. The parties may also want to include a sensible dispute resolution clause in regards to any disputes over deferred consideration, such as referral to an expert.
In regards to earn-outs it is important that the criteria is very clear in order to ensure that both parties fully understand what needs to be achieved. This is an important consideration for both buyer and seller. It is also important to again consider dispute resolution in regards to calculation of an earn-out.

Pros and Cons

Both deferred consideration and earn-outs have advantages and disadvantages for both buyer and seller. In regards to deferred consideration the advantages for a buyer are clear and they include:

• Allowing the buyer to purchase the business even if they don’t have the means to the full purchase price upon completion, meaning the cost is spread;
• Affording the buyer the opportunity to spread the risk over a longer period of time;
• Deferred consideration can be used to the buyer’s advantage if they find that post-completion there are some issues with the purchase which arise from the seller’s breach of warranty.

For a seller the main advantage is that it opens up the pool of potential buyers who may otherwise not be able to purchase the business. The main downsides of deferred consideration rest with the seller, however, as such a deal structure will invariably leave a seller exposed to some extent. This exposure can be mitigated, as discussed above, but it is a key disadvantage.
Earn-outs also help to spread the risk of a transaction and assist a buyer in funding the purchase but in addition they benefit the buyer by:

• Enabling them to purchase a manger owned business in a manner which affords a smooth transition;
• Essentially allows for payment of the purchase price from the profits of the business; and
• Incentivises a seller to hit performance targets which in turn benefits the buyer.
From the seller’s perspective there are also a number of benefits which include:
• Maximising its ability to earn income over a longer period of time; and
• Earn out provisions can afford seller the ability to earn consideration above and beyond what would have been achieved in a normal sale
• Sometimes a seller can ask for interest to be paid on the remaining purchase price, this is something that can be negotiated and is not standard practice for every transaction.

The same disadvantages apply to earn-provisions as general deferred consideration clauses in that there is a clear risk to the seller.
The key take away is that neither deferred consideration nor earn-outs should be perceived as a negative, and can actually have significant benefits for both a buyer and a seller provided they are properly thought out and sufficient protections are included in the relevant agreements. They afford the parties flexibility and comfort and can be a great tool in negotiations aimed at getting a deal agreed.

As always early advice is key, however, as a party to a transaction needs to understand the benefits and pitfalls of the proposed deferred consideration provision or earn-out. Certainty is also crucial in reducing the risk of a transaction falling apart and so input from legal and accounting advisors aimed at ensuring that comprehensive heads of terms are drafted is advisable.

If you are looking to buy or sell a business and want to discuss potential ways in which to deal with payment of the purchase price get in touch by calling 01237 447 065.

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