Deferred consideration is any part of the price for a business that’s paid after completion. It might be a fixed sum paid on a later date, instalments over a year or two, or an earn-out, where what the seller receives depends on how the business performs after the sale. On owner-managed deals it’s very common, as it lets a buyer pay a price it couldn’t fund on day one and lets the two sides bridge a gap between what the seller thinks the business is worth and what the buyer is prepared to risk.
I draft and negotiate these terms for buyers and sellers, as part of the share purchase agreement or asset purchase agreement. I’ve also written two longer articles, one on the risks for sellers and one for both sides.
The simplest is a fixed sum paid on a set date, such as £50,000 six months after completion, or instalments of an agreed amount each month or quarter. These are usually written into the sale agreement itself, with no need for a separate loan agreement, provided the agreement deals properly with interest, timing and what happens if a payment is missed. Sometimes the deferred sum is put into loan notes issued by the buyer, which is common on management buy-outs.
An earn-out ties the payment to the business’s results after completion, usually turnover, gross profit or EBITDA, over one to three years. Client bank and practice sales often use a variation of this, where the price is adjusted for the clients or fees that actually transfer and stay, either by holding money back until the position is known or by paying it and clawing some back later. I’ve explained how that works on my pages on financial services and accountancy practices.
Security for the seller
If you’re the seller, anything not paid at completion is a debt owed to you by someone who now controls the business you’ve sold, and without security you’re an unsecured creditor if things go wrong. A bank lending the same amount would want security, and it’s reasonable for a seller to ask for it too.
There are several kinds of security a seller can ask for, and on a larger deferred sum it’s common to take more than one.
A debenture is a charge over all the assets of the buyer’s company, which on a share sale will often be the business you’ve just sold. It means that if the company fails, you’re paid from its assets ahead of the unsecured creditors. It has to be registered at Companies House within 21 days of being created, and if it isn’t it’s void against a liquidator, an administrator and the other creditors, which is exactly when you’d need it. If the buyer is borrowing from a bank to fund the purchase, the bank will want to rank first, so your debenture will usually sit behind it under a deed of priority with the bank. That still leaves you ahead of the unsecured creditors, but it’s worth understanding how much is likely to be left once the bank has been paid.
A legal charge over property is a mortgage over land or buildings the buyer owns, whether that’s the business premises or something held personally or in another company. It’s registered at the Land Registry, and where the property already has a mortgage the existing lender may need to consent to a second charge. This is often the most valuable security available, as property tends to hold its value in a way that a struggling business doesn’t. A legal charge is dealt with by a property colleague at Nexa.
A personal guarantee is a promise by the individual behind a buyer company to pay if the company doesn’t. It’s common where the buyer is a newly formed company with no history or assets of its own, and it’s only as good as the guarantor’s own finances, so it’s worth knowing roughly what the guarantor owns before relying on it. Where the buyer is part of a group, a guarantee from the parent company can do the same job, and if the parent is substantial it may be enough on its own.
A charge over the shares you’ve sold lets you take the shares back if the buyer doesn’t pay. It’s often offered because it costs the buyer nothing, but it’s the weakest of the options, as by the time a buyer stops paying the business may be worth much less than when you sold it. It works better alongside other security than on its own.
Finally, part of the price can be paid into an escrow account held by a solicitor or bank and released to you on agreed dates, which protects you against the buyer not paying but means the buyer has to have the money at completion. Escrow arrangements are outside my standard scope and are quoted separately.
Alongside the security, the agreement should say what interest is payable on late payments and that the whole of the outstanding balance becomes payable at once if the buyer defaults, becomes insolvent or sells the business on. It can also restrict what the buyer does while money is still owed, such as paying dividends, taking out other borrowing or selling assets outside the normal course of business. Not every buyer will agree to all of this, and the security you can realistically get depends on who the buyer is and how the deal is being funded. I’ve written more about these options in my article on deferred payments for sellers and buyers.
Drafting an earn-out
Most disputes over earn-outs come from the definitions rather than the headline numbers. The agreement needs to say exactly how the profit or turnover is to be calculated, using which accounting policies (usually those used in the last accounts before the sale), who prepares the figures, what the other side can check, and how a disagreement is resolved, which is normally by referring it to an independent accountant.
It also needs to say what can be charged against the figures. A buyer’s group can allocate management charges, central costs and its own staff to the business, each of which reduces the profit the payment depends on, so a seller will want those excluded unless they’ve been agreed. If the target is missed by a small margin, the agreement should say whether the seller gets nothing (a cliff edge) or a reduced payment on a sliding scale.
Then there’s how the business is run during the earn-out period. A seller will want the buyer to carry on the business in broadly the same way and not to take steps aimed at reducing the earn-out, such as moving customers into another group company. A buyer will want the freedom to run its own business without asking permission. The courts are generally reluctant to read in promises about how a buyer will run the business that the agreement doesn’t contain, so whatever protection the seller has needs to be written down, and where it ends up is a matter of negotiation on each deal.
Staying on, set-off and tax
Earn-outs are most common where the seller stays on to run the business, and the earn-out then has to be read together with the seller’s service agreement. If the buyer can dismiss you during the earn-out period, the agreement should say what happens to the payments you haven’t yet received, and whether that depends on why you left.
Buyers usually want the right to set off any warranty claim against deferred payments, so that they can hold back money they say they’re owed. Sellers will want that right limited, for example to claims which have been agreed or decided, as otherwise a disputed claim can be used to delay payment. I’ve covered warranty claims separately on my page on warranties and indemnities.
The tax treatment of deferred and contingent consideration can be complicated, including when capital gains tax is payable and whether reliefs are available, and on an asset sale the deferred element can affect the VAT position. Those are questions for your accountant, and they should be answered before the structure is agreed in the heads of terms rather than after.
Acting for a buyer or a seller
If you’re the buyer, deferred consideration reduces the money you need at completion and gives you some protection if the business doesn’t perform as expected, and an earn-out keeps the seller interested in a smooth handover. You’ll want flexibility in how you run the business, a right of set-off and security that doesn’t tie up your other assets. There’s more on funding a purchase in my article on raising finance to buy a business.
If you’re the seller, the priority is making sure you get paid, which means security, clear definitions and protection against the figures being reduced by decisions you can’t control.
How long it takes and what it costs
The deferred consideration terms are negotiated alongside the rest of the sale agreement, during the two to three months a deal usually takes, and they’re part of my fixed fee for the transaction. Every quote is specific to the deal, but as a guide my fee will be between 0.5% and 5% of the deal value. Under £1m it’s usually 3% to 5% and over £1m it’s usually 1% to 2%, although it does depend on the business, the price and the commercial terms. The minimum fee is £3,500 plus VAT, and on lower value deals I can quote for a reduced, more standard service. Any legal charge over property is dealt with by a property colleague at Nexa and quoted separately.
Next steps
If part of the price on your deal is being deferred, send me the details, including the heads of terms, how the deferred payments are meant to work and whether you’re buying or selling. I’ll come back to you with a fixed fee and a scope of work.
