Many entrepreneurs who have not previously sold or purchased a company do not appreciate the importance of deferred consideration to a deal’s value, structure and the management of risk. In simple terms, deferred consideration is a portion of a business’s sale price which is paid after the initial completion date, rather than upfront. Paul Matthews, Director and Head of Corporate and Commercial Team, WHN Solicitors, discusses how deferred consideration works, its importance to the majority of sales and important legal consideration.
Deferred consideration can either be by reference to a fixed amount or conditional, for example contingent upon the company performing as expected for a period after completion.
From a buyer’s perspective, this improves cashflow and may reduce the amount of borrowing required. Where deferred consideration is contingent on future performance of the company, it can also be a means of giving the buyer greater confidence in meeting a higher company valuation than it would otherwise be comfortable with.
Conversely, if the seller is confident the performance thresholds can be met, this may be a means of achieving a better price. Performance-based additional payments are known as earn-outs.
While the proportion of the total sale price that is deferred is typically higher in a management buyout, deferred consideration has become more prevalent in recent years and is now relevant, to some extent, to almost every company sale.
If you are looking to sell your business, you will more than likely need to be receptive to some element of deferred consideration.
Managing risk
When part of the sale price is deferred, the element of risk a seller takes on is greater, given there is no guarantee the company will continue to be successful under its new ownership. If the company struggles after completion, that may affect the ability of the buyer to make the deferred consideration payments.
Part of a legal professional’s role in supporting a deal involving deferred consideration is to help the seller understand the risks involved and ensure there are protections in place so that both parties are happy to go ahead.
The seller’s legal team needs to ensure provisions are in place for if:
- The buyer does not meet its payment obligations
- The buyer and/ or the company experiences financial difficulties, which may lead to administration or insolvency
Legal considerations
There are several common ways that protection for the seller against non-payment can be agreed between buyer and seller, including:
Payment accelerator provision: This is a provision allowing the seller to demand immediate repayment of the whole of the deferred consideration if the buyer defaults on payments. It means that if the seller must take court action to enforce the buyer’s obligations, it can claim the full amount of the deferred consideration rather than just the amounts already overdue.
Default interest provisions: This compensates the seller for late payment and may incentivise the buyer to meet its obligations so as to avoid the cost of interest on overdue payments.
Debentures: Debentures over the assets of the buyer and/or company are common. These secure payments against those assets and mean the seller can require them to be sold and any proceeds after the cost of the enforcement used to meet the amounts owing to the seller. It gives the seller priority over unsecured creditors of the buyer or the company as the case may be. This can be important if the buyer or company is in financial difficulty. However, the availability of debentures is likely to depend on what other security the buyer or the company needs to offer. For example, if the buyer is borrowing to fund what is payable on completion, the buyer’s lender will likely require a first ranking debenture meaning there may only be a second ranking debenture possible for the seller.
Guarantees: Many company purchases, including management buyouts, involve the creation of a new company (newco) as a vehicle for the purchase. Relying on the covenant of a newco can present legal risks – it is likely its only assets will be the shares it is buying. In these circumstances, guarantees may be useful to help ensure payment, either against the buyer’s parent company or the directors or shareholders of the buyer.
Engaging an experienced legal professional
Whether you are buying or selling a business, instructing a legal professional at the earliest possible stage is key to identifying and managing risk.
Paul Matthews has over 30 years’ experience advising businesses across the North West on corporate transactions, including sales and acquisitions, management buyouts, company reorganisations, shareholder agreements, joint ventures and partnership law issues.
To speak with Paul on a corporate or commercial matter, contact him directly at Paul.Matthews@whnsolicitors.co.uk.
