For many reasons, business sales rarely proceed with 100% of the purchase price being paid in cash on completion. Often sellers are eager to bank their sale proceeds and jet off to somewhere exotic, as a well-earned reward for years of hard work, but buyers often seek to defer an element of the purchase price.
The three main reasons for this are:
- seller financing;
- buyer security; and
- to manage the risk of under-performance (and incentivise good performance) after completion of the acquisition.
Vendor Financing
Of the three, this is, conceptually, the most straightforward. A fixed purchase price is agreed, some is paid on completion and the buyer becomes a creditor of the seller for the balance. This usually bridges a funding gap and the concession from the seller allows him to maximise the purchase price.
Subject to negotiation between the parties, the deferred payment can be structured as tax-efficient loan notes and interest can be charged. It is not unusual in these circumstances for a seller to limit his risk by requiring security from the buyer in respect of the deferred consideration. This may take the form of a debenture over the target company’s assets, a legal charge over real estate held by the target or a guarantee provided by target and/or the parent company of the buyer (or its shareholders).
Security
Depending on a number of factors, a buyer may seek to retain some of the purchase price in order to provide security over potential future claims against the business.
This can be a helpful tactic to manage risk, particularly if there is a known potential liability that may rear its head over a quantifiable period of time following completion (such as a tax liability or pending litigation). Again, a concession by the seller to provide this security may result in the seller maximising the purchase price (rather than agreeing a price chip now on a liability that may never be realised).
If the parties agree that the buyer may withhold some of the purchase price for security purposes it is not unusual for the deferred sum to be held in a joint account and then later released to the seller / buyer depending on the extent to which the liability is realised.
Earn Outs
Depending on the commercial drivers of the deal and the facts underpinning the valuation, deferred consideration may also be paid via an “earn out”. Simply put, an earn out is a mechanism by which all or, more commonly, some of the purchase price is calculated by reference to the future performance of the target company.
Earn-outs can be tied to more than one metric, which may include a combination of financial and non-financial measures. For example, the earn-out could be payable if the target company satisfies a certain level of EBITDA and/or a revenue target and/or a retained percentage of customers or staff.
Whichever performance metric is agreed upon, the earn out criteria should be clear and objective so as to avoid any uncertainty on whether it has been achieved. A poorly structured earn out mechanism will lead to, at best, insecurity, and at worst, expensive litigation.
Additionally, careful consideration will need to be given to what will occur if the performance metrics of the earn out are not met and if the seller leaves the business. The buyer and seller must agree whether no payment will be made to the seller, or if the earn our payment will be proportionally reduced. It is important to take tax advice on how these provisions (particularly the mandatory retention of the seller) can impact the tax treatment of the payment.
As the seller will no longer be in control of the business, it is typical for him to require assurances (anti-avoidance provisions) from the buyer during the earn out period to reduce the risk of the buyer manipulating performance in order to minimise the earn-out payment. These include the buyer undertaking:
- not to make a material change to the business;
- not to dispose of material assets;
- not to pay excessive management charges to other members of the buyer group; and
- not to move the business out of the target company (or divert business) to another group company.
If you are considering buying or selling a business or would like to discuss any of the issues raised above, please contact the Corporate and Commercial team at Morr & Co by getting in touch with your usual advisor or emailing Greg Vincent at [email protected]