Deferred consideration is common in business sales. Buyers use cash and or shares to defer payment often linked to business performance post acquisition. We solve problems relating to both the commercial and taxation implications and in particular preserving Entrepreneurs Relief.
Using deferred consideration
Deferred consideration – the risks
Transactions for the sale of shares often include earn out elements. The deferred consideration can take the form of cash, shares or loans. These allow the purchaser to delay payment until profits are actually achieved. Generally deferred consideration is great for the purchaser, but creates risk for the seller, who may never see the money. After all, the purchaser may not be a particularly competent manager.
Break down of the risks
The risks for a seller usually break down into:
- The risk of increased taxation; and or
- Commercial risks.
We have explained below the risks in greater detail.
Taxation of deferred consideration
One of the biggest risks with deferred consideration is the potential for a higher capital gains tax liability payable by the selling shareholders. The 10% Entrepreneurs’ Relief rate on capital gains applies on a disposal of shares or securities by an individual where, during the 12 months ending on the date of disposal, the seller:
- Holds 5% or more of the ordinary voting share capital of a trading company or holding company of a trading group; and
- Is an officer or employee of the company.
Cumulative life-time capital gains qualifying for Entrepreneurs’ Relief is capped at £10m.
Losing the ability to qualify for Entrepreneurs Relief
Unfortunately, deferred consideration may not qualify for Entrepreneurs Relief. The seller may not satisfy the above conditions, perhaps because:
- He is no longer employed when the deferred consideration is paid;
- His shareholding has dropped below the 5% requirement.
Similar rules apply on the disposal of interests in a partnership or limited liability partnership. Here the position maybe simpler, as the 5% shareholding requirement does not apply to partnerships.
Preserving Entrepreneurs’ Relief
Advance planning may avoid the problem of losing Entrepreneurs’ Relief. In some cases, the seller could pay capital gains tax based on the whole value of the transaction and claim 10% Entrepreneurs relief for the tax year of completion. The point from a tax perspective is that as at the time the shares are sold the seller is still employed in the business.
The downside is, the taxable amount is calculated on the full deal value, even though the buyer has not yet paid the earn-out element.
If Entrepreneurs’ Relief is not available any deferred consideration paid to the seller, it will be assessed to capital gain tax at the normal rate of 20% for higher rate tax payers or 18% for lower rate tax payers.
Estimating the earn out element
We work with shareholders to calculate the amount of capital gains tax that should be paid for the tax year of completion to secure Entrepreneurs’ Relief. The earn-out element may not be precisely ascertainable and we provide work around solutions for tax payers. We also deal with the tax reporting required to HMRC.
The timing of when capital gains tax is payable is a factor. We will look to see if we can negotiate a deal which means that the deferred consideration will have been paid by the time the capital gains tax is payable. If that is possible there is more certainty for the tax payer.
Refunds of capital gains tax
Because the earn-out may not be paid or may not be capable of precise quantification there are cases where a refund of capital gains tax arises. HMRC will process refunds in many cases and another area of our expertise is in dealing with refunds to secure repayment.
Commercial considerations with deferred consideration
Our experience indicates that the seller will be in a stronger position if the commercial implications are considered and planned from the start of a transaction. For that reason we do recommend heads of terms are agreed.
Common commercial actions required when dealing with deferred consideration
The areas we discuss and negotiate include:
- Putting yourself in the best position to secure the earn-out – the ability of the buyer to pay, and fall back in the event of non-payment requires consideration.
- Being very precise about the earn-out conditions – the targets to be satisfied to receive the deferred consideration due on an earn-out need to be clear. We will look to draft the targets carefully and use easily identifiable measures to avoid ambiguity. We will think about what could go wrong and draft to address the risks.
- The percentage of consideration paid on completion compared with the percentage of deferred consideration – where we are acting for the seller we will push for a greater percentage to be paid on completion as that will help to de-risk. In cases where the buyers and sellers are connected, for example under a management buy out the need to de-risk may not be so great.
- Share deals – where any element of the consideration includes shares additional protections and due diligence is needed as of course shares are more risky than cash. We take you through the due diligence required as if you where buying a business, as you are investing into another business if you accept shares.
- Protecting employment status to preserve entrepreneurs’ relief for future payments – this can work if shares are sold in tranches.
- Limiting the number of shareholders subject to earn out – if there are employee shareholders acquiring shares under employee share schemes for example it may be possible to exclude them from the earn out.
- Impact on warranties and indemnities – if there are caps placed on liability for the sellers under the warranties and indemnities the extent of the cap needs to be linked to the risk an earn-out will not be achieved.
Dealing with non-payment of deferred consideration
The more due diligence a seller can do on the buyer’s ability to pay the deferred consideration the better. Once the buyer is running the business the cash position may not be as promising as hoped. In a worst case there isn’t the money to settle the deferred consideration.
What sellers can do to help themselves
A seller needs to identify how the deferred consideration will be provided and what assets does the buyer have which can be used as security?
Making the directors of the buyer personally liable
The seller should look through the company assets and consider the personal assets of the buyer. Ultimately, the buyer’s directors can be personally liable in the event that the company does not meet its deferred consideration obligations. But, the seller needs to make sure the sale documentation reflects intentions.
Right to appoint an administrator or a receiver
The seller should ensure that in the event of non-payment of the deferred consideration that it can appoint an administrator or a receiver. An administrator will basically sell the business to the highest bidder. A receiver will run the business to see if enough assets and or cash can be salvaged to pay off the deferred consideration outstanding. The seller should retain the right to choose between administration or receivership as what is best will depend upon the facts at the time.
Charge over assets until the deferred consideration is paid off
The seller can take a charge over any company assets and or personal assets of the buyer’s directors. The charge could include a charge over shares in the buyer.
Securing priority payment
The seller needs to have confirmed in the sale documentation that it has the first priority as a debtor over the deferred consideration in the event of administration or winding up.
Stopping the buyer setting up a new business in competition
It is not unheard of for a buyer to default on payment of deferred consideration and let the business go into administration. The idea is the buyer then sets up a new business similar to the business it bought often taking customers, suppliers and staff. But leaving the deferred consideration as an unpaid debt. A good deterrent is the risk of an injunction to prevent the buyer from competing. If the documentation is clear there should be a good chance of obtaining an injunction. If a restriction is not expressly included there can be difficulties.
In addition to rights to stop competition reserved in the sale agreement, the buyer’s directors do have duties to the company. However, the ability to secure an injunction under the sale agreement is usually stronger for the seller.