The deal has completed. The business has changed hands. But part of the purchase price is still sitting on the balance sheet.
Fixed-term deferred consideration is increasingly being used to bridge funding requirements and facilitate transactions where a buyer does not want - or is not able - to pay the full purchase price on completion. For a seller, however, agreeing to defer part of the consideration means that the transaction does not end with the receipt of the full purchase price. Instead, the seller becomes, in effect, a creditor of the buyer for the deferred period. We have seen deferred periods for as long as three years in recent transactions that we have advised on.
Fixed-term deferred consideration creates a different set of considerations for each side of a transaction. The seller’s priority is certainty of payment; the buyer’s priority is flexibility and avoiding unnecessary restrictions on its business and financing arrangements. In such cases negotiations should therefore focus not only on the amount being deferred, but on the protections and obligations that apply during the period between completion and payment of the deferred consideration.
Credit risk: protection for the seller, flexibility for the buyer
For the seller, the starting point is seeking comfort that the buyer is an entity of substance and has the ability to make deferred payments. The seller should consider the buyer’s financial position, funding arrangements and existing indebtedness. Where the deferred amount is material, the seller may seek additional protection through a parent company guarantee, security, escrow arrangements or other credit support.
For the buyer, such protections can materially increase the cost and complexity of the transaction and may restrict its ability to operate or finance the acquired business after completion. A buyer will generally prefer the deferred consideration to be unsecured and avoid restrictions that could interfere with future financing, disposals or restructuring.
The commercial question is therefore whether the seller is comfortable taking ordinary unsecured credit risk against the buyer, or whether the amount and duration of the deferred payment justify additional protection.
Payment mechanics
The seller will want certainty: a fixed payment date, clear calculation mechanics, interest on late payments and, potentially, acceleration if specified events occur.
The buyer will generally seek flexibility, including the ability to repay early without penalties being imposed. This may particularly be the case where the buyer expects to have access to surplus cash or refinancing before the contractual payment date.
Set-off and counterclaims
This is often a significant point of negotiation.
A seller will generally resist a buyer having a broad right to deduct amounts from the deferred consideration for breaches of any warranties, indemnities or other claims against the seller. Otherwise, the seller has essentially “banked” the deferred consideration but still faces uncertainty over when it will actually receive it.
A buyer, by contrast, will want the ability to protect itself against amounts it believes are properly due from the seller. From the buyer’s perspective, withholding disputed sums can be an important practical protection, particularly where pursuing a separate claim would be costly and/or time-consuming.
A common compromise is to permit deductions only for amounts that are agreed between the parties or finally determined by a court or other agreed dispute-resolution process. The appropriate approach will depend on the wider liability and claims regime in the sale agreement.
Interaction with warranties and indemnities
The interaction between deferred consideration and the seller’s liability under the sale agreement should be considered carefully.
From the seller’s perspective, the deferred consideration should not inadvertently operate as a security deposit against potential claims beyond the protections already negotiated in the sale agreement. The seller should seek to ensure that warranty and indemnity claims remain subject to the agreed caps, thresholds, time limits and procedural requirements.
From the buyer’s perspective, deferred consideration can provide a valuable source of recovery if a valid claim arises. A buyer may therefore seek express rights to deduct claims from deferred amounts.
The parties should be clear whether the deferred consideration is intended to provide any form of security for claims. If it is not, the drafting of the documentation should avoid creating that effect inadvertently.
Acceleration and insolvency
A seller may seek acceleration for all outstanding deferred consideration to become immediately payable if the buyer is sold, becomes insolvent or undergoes a significant change in ownership or control. The rationale is straightforward: the seller should not find itself an unsecured creditor of a financially distressed buyer or a buyer that has transferred its assets or business elsewhere.
The buyer, on the other hand, will generally resist broad acceleration provisions. In particular, a buyer may want freedom to refinance, restructure or sell the acquired business without triggering an immediate payment obligation.
Given this disconnect, it is advisable that both parties distinguish between legitimate corporate activity and events that genuinely increase the seller’s credit risk, and that this distinction is incorporated into the sale agreement. Broad acceleration provisions can have unintended consequences, particularly where the buyer requires acquisition finance or expects to undertake a post-completion restructuring, so careful drafting is required.
Interest and the time value of money
For a seller, a deferred payment without interest means that the seller is effectively providing financing to the buyer. The seller should consider whether the interest rate adequately compensates for the delay and associated credit risk of receiving a delayed payment of the total purchase price.
For the buyer, interest increases the effective acquisition cost. A buyer may therefore seek a low or zero interest rate, particularly where the deferred consideration payment period is relatively short or where the deferred consideration is contingent on future performance.
What happens if the buyer does not pay?
The enforcement position should not be overlooked.
A seller should consider what remedies are available to it if the deferred consideration is not paid on time, including contractual interest, default provisions, acceleration and the recovery of enforcement costs, where appropriate.
The seller should also consider whether the buyer is required to maintain sufficient assets or whether there are restrictions on disposals or distributions that could materially prejudice the seller’s position.
On the other hand, a buyer will generally resist restrictions that could interfere with its ordinary business operations or future financing. Any covenants should therefore be proportionate to the credit risk and the amount of consideration being deferred.
The wider deal dynamic
Fixed-term deferred consideration can be a straightforward and commercially useful mechanism. But it should not be viewed simply as the delayed payment of the purchase price.
For the seller, it is a period of credit exposure, and the main questions should be: How confident am I that the buyer will pay, and what protection do I have if it does not?
For the buyer, it is a financing tool of which the following questions should be asked: What flexibility do I retain after completion, and what restrictions will the deferred payment impose on my business and financing arrangements?
A well balanced sale agreement should reflect both perspectives. Sellers should focus on certainty, credit protection and enforceability, while buyers should seek operational and financing flexibility and avoid unnecessary restrictions.
Ultimately, the negotiation should ensure that the deferred consideration is treated for what it really is: not merely part of the purchase price, but a contractual payment obligation that sits between completion and the final settlement of the transaction.