Deferred consideration and earn-outs, and how they are measured

Two different things that get called the same thing

Most acquisitions in these sectors pay part of the price after completion. The word "deferred" gets used loosely for all of it, and underneath the word there are two quite different arrangements that behave differently in a contract, in a dispute and in a credit assessment.

Deferred consideration is a fixed amount, paid on agreed dates. The number is settled at completion. The only thing outstanding is time, and possibly a set-off if warranty claims arise.

An earn-out is a variable amount, calculated after completion from how the business performs against an agreed formula over an agreed period. The number is not settled at completion. It is settled later, by measurement, which is why earn-outs generate arguments that fixed deferrals do not.

A third form, the loan note, formalises a deferral as a debt instrument with its own terms about interest, repayment and default. The tax treatment of each differs for the seller, which is a matter for their own accountant and is often the reason one form is preferred over another. What each of these is as a funding product is covered in vendor and seller finance. This page is about how they are measured and protected.

Why they exist at all

Deferral does three jobs at once, and it is worth being clear about which one is actually being solved.

• It bridges a price gap. The seller believes the business will keep performing. The buyer is not certain. An earn-out lets both hold their view and be paid according to which one turns out to be right.
• It manages transfer risk. Where the value is in customers or fees that might not survive a change of ownership, tying part of the price to what actually transfers puts the risk with the person best placed to influence it.
• It reduces what has to be borrowed on day one. Money paid in year three is money that does not need funding in year one. That lowers the debt, the repayment burden and the pressure on the acquired business in its hardest period.

The first two are commercial. The third is why the funding conversation and the price conversation cannot sensibly be held separately, and why heads of terms that fix a payment profile before anyone has tested the funding tend to be reopened. What belongs in that document is set out in heads of terms.

The measurement, which is where the arguments live

An earn-out is only as good as the metric it is measured on, and the choice of metric decides how much scope there is to argue afterwards.

Revenue or fee retention is the cleanest, because it is hard to manipulate and easy to evidence. In a practice or a contract book it is usually the right answer: fees billed to the transferred clients in the measurement period, against the fee list attached to the agreement. The weakness is that it takes no account of profitability, so a buyer who chases retention by discounting has hit the target and lost money.

Profit is the fairest measure of what the business is actually worth and the easiest to distort. Once the buyer controls the company, management charges, allocated overhead, a restructuring, a decision to invest, a change in accounting policy and the timing of expenditure all move the number. If profit is the metric, the accounting basis has to be written out in full and frozen for the measurement period.

Contract renewals or customer count works where the business is a book of agreements. Note that a count and a value are different tests, and they separate exactly when it matters, which is when the largest customers are the ones that left. Measure by value.

Three more things belong in the drafting and are routinely left out. Who prepares the calculation, and by when. What happens if the parties disagree, which usually means naming an independent accountant and agreeing that their determination binds both sides. And what the buyer may and may not do to the business during the measurement period, because a seller whose payment depends on performance has a legitimate interest in the business not being restructured underneath them.

Protecting the buyer, and making it actually bite

Deferred money is the buyer's main protection against everything that has been asserted rather than proved. It only protects if it is still unpaid when the problem appears.

The mechanisms in normal use are a retention, where an agreed amount is held back and released only if the measure is met; a clawback, where money already paid is repayable if it is not; and a right of set-off, allowing the buyer to reduce a future instalment against a warranty claim. Escrow, where the money sits with a third party rather than with either side, removes the question of whether the seller can pay.

The failure is almost always the same one. The measurement period is shorter than the risk. Customer attrition after a change of ownership tends to appear at renewal, and in a business with annual contracts or annual compliance work that can be a year or more away. A retention that has been released before the first full renewal cycle has completed protected the buyer against nothing at all. The measurement period has to outlast the risk it was designed for.

The second failure is a clawback against a seller with nothing left. A clause that requires repayment from someone who has spent the proceeds is a piece of paper. Set-off against money still owed is worth considerably more than a right to sue.

What it does to the funding

Deferral reduces the amount needed at completion, which is straightforwardly good. What it also does is create a second creditor, and the treatment of that creditor is not uniform across the market.

Some lenders will read a properly subordinated deferral as part of the buyer's own stake, on the basis that it is money at risk behind theirs. Others read it as debt competing for the same cash and size the facility accordingly. The same deal, put to two lenders, can produce a materially different answer for that reason alone, and what separates the two is the drafting rather than the amount. That is set out in vendor finance, which covers ranking, subordination and what a senior lender will and will not accept.

One consequence catches buyers repeatedly. Deferred instalments have to be paid out of the same cash that services the loan, and they usually fall due in a lump. A business that comfortably services its debt can still be short in the month a deferred payment lands, particularly if nobody funded the gap between paying staff and collecting from customers in the first place, which is what working capital is for. Model the deferred payments into the cash flow as though they were covenanted, because to the seller they are.

Worked exampleTake a purchase where a quarter of the price is deferred over three years and paid annually. In each of those three years the business has to produce the loan repayments, its own working capital, and a single deferred instalment falling in one month. On paper the annual cash flow covers all of it. In the month the instalment falls due, it does not, unless it has been planned for. The figures here are invented to show the shape of the problem, not taken from any deal.

The seller's side of it

A seller accepting deferred money is lending to the buyer, usually unsecured and usually behind a bank. It is reasonable for them to want something for that: interest on the outstanding amount, a shorter period, security, a personal guarantee, or restrictions on what the buyer may do with the business while it is outstanding.

Some of that a senior lender will accept and some it will refuse outright. Finding out which in the final fortnight is how deals stall. Establish the senior lender's position on seller security and seller acceleration early, then negotiate inside it.

A seller who has agreed to an earn-out and then leaves at completion is the combination most likely to end in a dispute, because they are being measured on a period they cannot influence. If the seller is going, a fixed deferral with a retention is usually the better structure for everybody. Where they are staying, the shape of that arrangement is covered in succession and retirement sales.

What a lender will want to see

• The full payment profile: how much at completion, how much deferred, on what dates, and on what conditions.
• The earn-out formula in full, with the accounting basis, who calculates it and how disputes are resolved.
• The subordination position, and whether the seller is asking for security or the right to accelerate.
• The retention or clawback, what it is measured against, and over what period.
• A cash flow forecast with the deferred instalments in it alongside the debt service.
• What the seller is doing after completion, and for how long.

Terms that appear in this part of a sale agreement and nowhere else are in the glossary. In accountancy practice purchases, where staged payment is close to standard, the sector page sets out how retention is normally measured.

Knowing how your structure will be read before you fix it

There is no published list of which lenders count a subordinated deferral in the buyer's favour and which do not. It is individual credit policy, it changes, and the only way to know is to have asked recently.

We know this market and we know specific people who fund these deals, which is why the useful thing we can do is tell you how the structure you have negotiated is likely to be read before it is signed. Tell us the shape of the price and we come back to you having spoken to them.

We introduce buyers who are acquiring through a limited company or a NewCo. If you are buying personally, as a sole trader or as a partnership, we will point you to an authorised firm directly instead.