Corporate trends: the return of deferred consideration and earn-outs. The UK economy has faced several major challenges in the last decade, including Brexit, the aftermath of Covid-19, rising inflation and interest rates, along with instability in the banking sector. Higher interest rates have made securing lending more difficult and costly for buyers, while market uncertainty has driven companies to prioritise maintaining liquidity. As a result, the M&A market has seen a shift towards deal structures that emphasise deferred consideration and earn–outs. What is deferred consideration? Deferred consideration is a payment structure where the buyers offer a portion of the total purchase price to be paid to the seller at a future date, or in instalments over a set period rather than upfront at completion of the sale. The deferred payments might be conditional on certain legal and/or financial factors being fulfilled but can also be guaranteed sums. This structure allows buyers to manage their cash flow better by spreading the financial burden over time. What are earn-outs? Earn-outs involve the buyer agreeing to make additional payments to the seller based on future performance targets being achieved post completion. They are a method of bridging the valuation gap between the buyer and seller where there are concerns over future earning potential and turnover levels of the business that is being acquired. Commonly, they also operate as an incentive to drive performance for sellers who remain involved in the business. Are there advantages for buyers in using deferred consideration? The primary advantage for buyers in using deferred consideration and earn-outs is that it allows them to minimise the upfront cash commitment and carry out an acquisition without straining their resources. By tying part of the payment to future performance, buyers reduce their financial exposure. Another major benefit for buyers is the risk mitigation that comes in hand with these payment structures. By using earn-outs, a buyer can reduce the risk of paying too much for a company that underperforms, which is an increasing concern in uncertain economic times. In addition to that, earn-outs align the incentives of the seller with the long-term success of the business and can help to ensure a smooth transition into new management. For sellers, there is a potential for higher overall returns on their sale. While the payment may be delayed, there is an opportunity for sellers to finance part of the deal and/or the reap enhanced payments if the financial conditions or performance targets are met. In a volatile economic environment, buyers may simply not be willing to provide the same consideration upfront, so sellers who are confident in the future success of their businesses can utilise deferred consideration and earn-outs as a means of closing deals while still securing a favourable exit. What are the challenges when using deferred consideration? Drafting deferred consideration and earn-out provisions can be complex. The performance targets require clear metrics and a process for verifying them, meaning deals may be subject to additional negotiation. Careful drafting is needed to ensure that the figures that are achieved through the earn-out periods can’t be manipulated in a way that is unfair to sellers. Another key risk for sellers with deferred consideration and earn-outs is the uncertainty of receiving the full purchase price. The payments may be affected by external factors like a downturn in the market or supply chain issues, as well as operational changes or disputes over the measurement of performance. Sellers who agree to pure deferred consideration arrangements (i.e. seller financing) often require further assurances that they will receive their owed payments. As a result, they may oblige buyers to secure those payments to protect their interests. This can be carried out using guarantees, escrow accounts, debentures or other charges. For the buyer this can create higher costs and financial strain and may also present obstacles in securing future lending until their obligations have been satisfied. Conclusion These mechanisms offer advantages to both buyers and sellers by mitigating financial risks, promoting liquidity, and aligning incentives. They can also present challenges, such as the complexity of structuring deals and the potential for disputes. The requirement for buyers to secure deferred payments further ensures seller protection but adds an additional burden on buyers. As economic volatility continues, these flexible deal structures are likely to remain prevalent in M&A transactions, balancing risk and reward for both parties. How can Morr & Co help? If you are considering buying or selling your business and would like to discuss any of the points raised above, please contact our Corporate and Commercial team on 01737 854500 or by email info@morrlaw.com and a member of the team will be happy to help. Disclaimer Although correct at the time of publication, the contents of this newsletter/blog are intended for general information purposes only and shall not be deemed to be, or constitute, legal advice. We cannot accept responsibility for any loss as a result of acts or omissions taken in respect of this article. Please contact us for the latest legal position. Authored by Greg Vincent Partner, Head of Department Message Tags Insights Corporate Insights On this page Related Stories Insights Corporate Insights Autumn budget impact on M&A View more Contact our team today Contact Us
