Why and when do earn-outs or other deferred payments feature in business sale transactions?

While most business sellers and M&A advisors would typically favour an all-cash-on-completion transaction, this is not always possible. Earn-outs and deferred payments are both potential solutions to maintain both momentum and value in a deal.

They are explained in brief below:

Earn-out

An earn-out is a performance-related mechanism that can preserve the overall market valuation of the business for the seller, while at the same time managing potential risk for the buyer. For example, if a buyer has a concern regarding the renewal of a significant contract (and therefore the underlying profitability of the business in the short term), an earn-out may be a good compromise. Through an earn-out, the buyer can ensure that a proportion of the consideration is paid in the future. This would be contingent on a target level of profitability being achieved (or, in the above example, the contract being renewed, or replaced if lost).

An earn-out may also be used as a tool to help meet value expectations. If the seller is confident of the future performance of the business, and therefore looking for more value than the buyers see at present, a payment linked to future performance can often help bridge that gap.

Deferred Consideration

It is possible that the most strategically motivated buyer for your business may not necessarily be in a position to fully fund a competitive offer. In these circumstances, to help match other bidders and remain competitive, the buyer may decide to introduce an element of deferred consideration.

Unlike an earn-out, the deferred consideration is not linked to company performance. Instead, it is only time-bound and might be payable at, for example, the first and second anniversary of the transaction. This time-deferred consideration affords the buyer the opportunity to tap into the cash generation of his own and/or your business over time, to help fund any shortfall in capital available at completion.

It should be noted that the introduction of an Earn-Out or Deferred Consideration brings risk to any transaction. Control of the business is ceded at completion, however proceeds payable to the former shareholders remain outstanding. In such circumstances it is critical that appropriate additional legal provisions are introduced to protect the sellers’ interests.