Deferred consideration on business sales

Deferred consideration is increasingly  common in the sale of businesses (mergers & acquisitions). Buyers use cash and/or shares to defer payment often linked to business performance post acquisition.

The difference between deferred consideration and earn out is that with deferred consideration the sale price tends to be fixed whereas with an earn out, the final amount paid is not fixed and will typically depend on how the business performs or other agreed milestones. In some transactions there will be a mixture of deferral and earn out.

Given that sellers of businesses will not want to agree deferred payment of the purchase price or an earn out, much will depend on the strength of the respective parties bargaining position, timing and often creative commercial solutions.

Whether we are acting for the buyer or seller on a company sale transaction we guide clients through the options where part of the sale price is deferred or subject to an earn out.  Please do call or email us. 

Tax risks of deferred consideration

Deferred consideration can take the form of cash, shares or loans. The risks for a seller usually break down into:

• Taxation of deferred consideration – One of the biggest risks with deferred consideration is unplanned tax liabilities. The traps which arise in practice can include HMRC assess the deferred consideration to income tax rather than capital gains tax.
• Losing the ability to qualify for Business Assets Disposal Relief (Entrepreneurs Relief) -Unfortunately, deferred consideration may not also qualify for Business Assets Disposal Relief (Entrepreneurs Relief) even though the payment made on completion did qualify.
• The timing of when capital gains tax is payable  – it may be possible to 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.

How can sellers protect themselves?

Our experience is that sellers will often 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 and negotiating points to consider as a seller if the buyer demands part deferral of the purchase price include :-

• Personal guarantees – A seller may try to negotiate that the buyer’s directors agree to be personally liable in the event that deferred payments are unlawfully not made. 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 over the business. 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 company.
• 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 buyer may plan to set up a new business similar to the business it bought, often taking customers, suppliers and staff. If the documentation is clear there can be a good chance of stopping such behaviour.

• Ensuring the deferred part of the payment is as small as possible – 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 in the buyer, additional protections and due diligence are 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.

What to do if the buyer doesn’t pay?

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 pay the outstanding consideration.

Where a buyer doesn’t pay deferred consideration, the seller will then need to decide whether to take action for breach of contract. However strong the seller may believe the legal position is, this does not always translate into recovering money.

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 at the time the deferred consideration is negotiated.