Selling a business is often a milestone achievement for an owner, marking years of hard work and dedication. Yet, the process is rarely straightforward, and one of the most common features of a business sale – especially for small and medium-sized businesses – is the use of deferred payments. These arrangements, while often necessary to bridge gaps in valuation and buyer affordability, come with their own set of risks that sellers must navigate carefully.

This article explores the practical and legal considerations of deferred payments in business sales, explains why they’re so common, identifies key risks for sellers, and offers practical guidance on how to mitigate those risks through careful drafting and negotiation.

Why deferred payments are so common

Deferred payments (also known as deferred consideration) are a frequent feature of business sales, particularly in the SME sector. At their core, these arrangements involve the buyer paying part of the purchase price at a later date or subject to certain conditions being met. There are several reasons why deferred payments have become so common.

Firstly, they often bridge the gap between what the buyer can afford to pay upfront and what the seller expects as fair value for the business. In times of economic uncertainty or when buyers have limited access to funding, deferred payments can make deals possible that might otherwise stall. There are also a lot of buyers who think they can buy a business with no money.

Secondly, deferred payments can help align the interests of the seller and the buyer in the post-completion period. For example, if part of the deferred consideration is linked to the business’s future performance (an earn-out arrangement), the seller has an incentive to ensure a smooth transition and continued success of the business.

Thirdly, deferred payments can provide a level of risk-sharing between the parties. If the buyer is concerned about potential liabilities or underperformance, agreeing to pay a portion of the price later – once certain conditions are met – can help manage that risk.

While these commercial reasons are entirely valid, sellers should understand that deferred payments also shift a significant amount of risk from the buyer to the seller. It’s essential to identify those risks and address them in the sale agreement.

The different forms of deferred payments

Deferred payments can take several forms, each with its own legal and practical implications. The most straightforward structure involves the buyer paying a fixed sum after an agreed period, often six or twelve months post-completion. This kind of arrangement is relatively simple but still carries risks if the buyer defaults.

More complex structures involve earn-out provisions, where payments depend on the future performance of the business. These are particularly common when the seller is staying on in the business after completion, whether as a consultant, director, or employee. Earn-outs often involve metrics such as turnover, gross profit, or EBITDA, with the seller receiving additional payments only if those targets are met.

Another option is a promissory note or loan note structure, where the buyer issues a formal debt instrument to the seller. These can provide some additional security if drafted carefully, but they also require the seller to understand the buyer’s creditworthiness and the enforceability of the debt.

Each structure has different tax implications, legal risks, and practical considerations. Sellers should take detailed advice to ensure the structure chosen aligns with their commercial objectives and risk appetite.

The main risks for sellers

Despite their popularity, deferred payments expose sellers to several key risks that need to be carefully managed in the sale agreement. Understanding these risks is the first step towards mitigating them.

The most obvious risk is non-payment. Once the business has been handed over to the buyer, the seller’s leverage is often significantly reduced. If the buyer fails to pay the deferred consideration, the seller might find themselves chasing payments with limited practical options.

There’s also the risk of the buyer’s insolvency. If the buyer’s financial position deteriorates after completion, the seller may become an unsecured creditor, competing with others for payment from what may be limited remaining assets. This is particularly problematic for earn-out structures, where payments depend on the future performance of the business.

Control is another issue. Once the buyer takes over the business, they may make decisions that affect its performance – decisions that might not align with what the seller would have done. This is especially relevant for earn-out arrangements, where the seller’s payout depends on the business hitting certain targets.

In addition, deferred payments can complicate the seller’s tax position. For example, while Business Asset Disposal Relief (formerly Entrepreneurs’ Relief) might apply to the sale proceeds, certain conditions must be met. If payments are contingent or subject to adjustment, the timing of when the gain is realised—and therefore taxed—can be uncertain.

Lastly, disputes can arise over how performance metrics are calculated and verified. Earn-outs are notorious for generating disputes, as they often require detailed accounting provisions and dispute resolution mechanisms to avoid endless wrangling.

How to mitigate the risks

Given the risks involved, sellers should be proactive in negotiating robust contractual protections in the sale agreement. These protections can take many forms, depending on the specific circumstances of the transaction.

One of the most effective protections is security for the deferred payments. This might include a charge over the business’s assets, a personal guarantee from the buyer (or its directors), or an escrow arrangement. Security arrangements give the seller priority over unsecured creditors if the buyer defaults or becomes insolvent.

The sale agreement should also set out clear terms for the deferred payments, including the timing, amount, and method of payment. Sellers should avoid overly complicated structures unless they are absolutely necessary and well understood.

Where an earn-out is involved, the agreement should specify exactly how performance will be measured and what accounting standards will apply. It’s also wise to include clauses preventing the buyer from making material changes to the business that could artificially depress the earn-out payment. These might include restrictions on asset sales, changes to accounting policies, or excessive management charges.

In some cases, sellers can negotiate the right to audit the buyer’s records or appoint an independent accountant to determine performance metrics. This can be a valuable safeguard against manipulation or disputes.

Tax advice is also essential. Sellers should understand how and when they will be taxed on the deferred payments, particularly if Business Asset Disposal Relief is being claimed. Timing issues can be complex, and getting this wrong can lead to unexpected tax bills.

Finally, dispute resolution clauses should be included in the agreement to provide a clear mechanism for resolving disagreements. These might include referring disputes to an expert accountant or using alternative dispute resolution before litigation.

In summary:

• Sellers should ensure deferred payments are properly secured to reduce the risk of non-payment.

• Sale agreements should contain detailed provisions on the timing, amount, and method of payment.

• Earn-out structures need clear definitions and accounting provisions to avoid disputes.

• Sellers should take specialist tax advice to understand the timing of taxation on deferred payments.

• Dispute resolution clauses can help avoid costly litigation if problems arise.

Alternatives to deferred payments

While deferred payments are common, they are not the only way to bridge valuation gaps or buyer funding challenges. Sellers might consider alternative deal structures, such as vendor loans, partial sales, or even third-party financing solutions that allow the buyer to fund the purchase price upfront.

Each alternative has its own risks and benefits, and sellers should explore all options with their legal and financial advisers before committing to a particular structure.

Conclusion

Deferred payments are a useful tool in business sales, enabling deals that might not otherwise happen and helping bridge differences in valuation. However, they are not without risk, and sellers must approach them with their eyes open.

By understanding the different structures, identifying the key risks, and implementing appropriate safeguards in the sale agreement, sellers can significantly reduce their exposure to non-payment and disputes. Due diligence is essential, as is specialist tax advice to ensure the deferred payments are treated appropriately for tax purposes.

For small business owners looking to sell their business, my advice is clear: don’t treat deferred payments as an afterthought. With the right advice and a carefully negotiated agreement, you can protect your hard-earned value and make sure that the rewards of your sale are realised in full.

If you’d like to discuss deferred payments or any other aspect of selling your business, I’d be happy to offer practical, plain English advice tailored to your needs.