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Selling a Company: Deferred Consideration and Earn Outs.

Selling a Company: Deferred Consideration and Earn Outs.

In an ideal world, you would like to sell your company for a full upfront cash payment, book the flight to Barbados and relax with a cocktail on the beach. Sale deals, however, aren’t always structured in such a seller-friendly manner with Deferred Consideration or Earn Outs often used as purchase price mechanisms; so you might have to wait a while longer for the pina colada.

Can you take the money and run, or are you in it for the long haul?

In an ideal world, you would like to sell your company for a full upfront cash payment, book the flight to Barbados and relax with a cocktail on the beach. Sale deals, however, aren’t always structured in such a seller-friendly manner with Deferred Consideration or Earn Outs often used as purchase price mechanisms; so you might have to wait a while longer for the pina colada.

Deferred Consideration

This concept is quite straightforward in that a fixed sale price has been agreed between buyer and seller and part of the price is not paid at completion, but is instead deferred until a defined later date. One of the principal reasons for using deferred consideration might be that the buyer doesn’t quite have the cash to finance the full purchase price at completion. The seller might be happy with the overall fixed price and may be willing to agree that part of the payment is deferred. In exchange, the seller might ask for interest to be paid on the deferred consideration, as the seller is effectively “loaning” part of the purchase price back to the buyer, but this would be a point for negotiation.

While there will be a contractual obligation in the documentation on the buyer to make the deferred payment, in practice this could be used as a bargaining chip for buyers if they find that they are not completely satisfied with their purchase, or there is the possibility of a warranty claim being made. While the Deferred Consideration remains outstanding, there always remains the risk that the seller might not get paid.

To limit this risk, a seller might ask for security for the payment of the deferred consideration from the buyer, which might take the form of a charge over the company itself or security over property or a particular asset or a parent company guarantee.

What about Retentions?

Retentions are different from Deferred Consideration in that the Retention sum is actually paid, often to a solicitor or escrow agent, who holds the funds pending the satisfaction of a particular event or for a defined period of time. Retention amounts can be used to satisfy warranty claims giving the buyer the comfort that cash is there to meet a warranty claim should arise while the Retention remains in escrow.

Earn Outs

The content of Earn Outs will vary from deal to deal, but essentially, the price that a seller might ultimately receive is subject to the future performance of the company. A buyer might, for example, offer 60% of the purchase price at completion, with 40% subject to an Earn Out. The terms of the Earn Out might require that the Company’s turnover and/or profit is maintained or increased to a particular level by a certain point in time (which might be the next accounts date.)

The Earn Out criteria should be clear and objective so there is absolute certainty on what must be achieved. Also provision will need to be made to cover a situation where the Earn Out target is not met; in that scenario is no payment to be made to the seller, or is there a proportional reduction made to the price?

Earn Outs can be used not only to give the buyer comfort that the company it is acquiring is on a growth trajectory, it can also help with continuity of service if the company was as an owner-managed business. Where the sellers include key members of management, the Earn Out period might help smooth the transition to new ownership.

Those key individuals will generally be expected to stay with the company for the 6/12/24 month period of the Earn Out itself. This can sometimes be seen as having to prove yourself all over again and Earn Out periods can be trying times for sellers as the pressure to deliver will be on. It might be the case that the seller starts the Earn Out in a full-time role and drops down to a part -time role towards the end of the Earn Out period.  The seller will need to be appropriately protected under the terms of any service contract he has with the Company to ensure he can’t be dismissed for spurious reasons which might jeopardise his claim to the Earn Out.

The seller might ask for assurances from the buyer that certain things won’t happen during the Earn Out. This might include the buyer undertaking not to make a material change to the business, not to dispose of material assets or not to move the business out of the company by channelling it through another group company. In addition, the sellers would expect to receive management accounts and other pertinent management information during the Earn Out period so they are able to assess the financial performance of the Company.

Potential For Disagreement?

The buyer might look to push down the price if he can while a seller will want a degree of certainty about what cash he will be due. Accordingly, Earn Out clauses tend to be the provisions which are pored over most rigorously by the solicitors acting for both buyer and seller. On the buyer’s side, they will want to ensure that the company can deliver the projected stability/growth in the company financials. On the seller’s side, they will want to ensure that the targets are achievable and that seller will get paid if those targets are met.

It is worth bearing in mind that the Earn-Out period might take a similar time for the warranty period to expire, so there could be some form of interaction between the two if a warranty claim ends up being made. Accordingly, Earn-Out structures will need to be carefully considered as there can be significant scope for disagreement.

Taxation

Where Deferred Consideration or Earn Outs are being introduced, it will be very important for the seller to take expert tax advice on the treatment of any amounts he will receive. This will be an important factor in the structure of any deal.

This blog serves only as a basic introduction to some aspects of company sales. There are various other mechanisms which can be used in deal structures, such as the buyer issuing loan notes to the seller, payment being made by way of equity in the buyer and the use of completion accounts to determine the ultimate price payable. I will discuss these aspects in a future blog.

Are you in early discussions regarding any of the above matters? If you are thinking about buying or selling a business and wish to discuss how a deal might be structured, or if there are other topics you would like me to blog about, please do get in touch - stephen.clark@mbmcommercial.co.uk.

Twitter - @_stephenjclark

Call - 0131 226 8211

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