Deal Structuring

The concepts of “earn-out” and “deferred consideration” are often used interchangeably when a deal includes payment after completion. However, they work very differently, and the difference can have a real impact on the risk allocation between buyer and seller.

Deferred consideration is a fixed, agreed sum, paid on a set timetable after completion. This might be paid monthly, quarterly or annually and typically endures for 12 to 24 months. The amount doesn't move and isn't conditional on hitting certain targets. This means the seller takes on considerably less risk, with the main risk being what happens if the buyer is unable to make payment when the amount falls due. For this reason, a whole host of security mechanisms might be discussed as part of the transaction, ranging from parent company guarantees, to punitive interest rates, a charge over the shares, or use of an escrow account. The most appropriate mechanism will largely depend on the commercial specifics of the transaction, who the buying entity is and the legalities involved.

An earn-out is different; the specifics will vary from transaction to transaction, but in general terms means an amount of the consideration is contingent on the business hitting certain agreed performance targets. Commonly this will be based on an EBITDA threshold, but revenue or gross profit targets can also be used. Most commonly, earn-outs run over one to three years.

It's important to note that earn-outs are not inherently bad if they're structured properly and applied for the right reasons. For example, they can be used to pay real value for new, embryonic opportunities that have been cultivated under the old ownership, but where the fruits of that labour are yet to be reflected in the numbers. Or they might be used because the existing management team doesn't plan to exit in the foreseeable future after divesting the shares, and the earn-out gives them genuine skin in the game to earn more value during that time.

There are a multitude of reasons that might make an earn-out relevant. However, what you should never lose sight of if you're selling a business is that the company you're selling has a value now and you should be paid fair value for that business, unconditionally. Earn-out structures are inherently more risky from a seller's perspective, as a portion of the consideration is now pegged to an uncertain future outcome, in a business they have considerably less control of. Before accepting one, you should be prepared to ask yourself some honest questions:

  • Would I still be happy with this offer if I don't achieve the earn-out?
  • Why is the earn-out there, and does it fairly align both parties' objectives?
  • Are the metrics fair and actually achievable? Is there a sliding scale, or does my earn-out depend on a cliff-edge target?
  • Is the offer genuinely more attractive than other offers I might have on the table, which have a lower headline price but a higher day one amount?

If the answer to those questions is yes, then it might be reasonable to go ahead with an earn-out. But agreeing the principles is only half the battle; it still needs to be reflected in the legal documents. Here's where it is crucial to have both a legal and commercial advisor working in tandem to achieve your objectives. The earn-out schedule in an SPA may only run to 10 to 20 pages of the wider agreement, but it is by far one of the most complex to negotiate. It's important that whatever metric the earn-out rests on, the schedule clearly deals with how it is calculated and, more importantly, how it is controlled. Even a simple revenue target could be manipulated if the buyer is able to divert sales into another business. A well negotiated earn-out clause will lock in how accounts are prepared, restrict the buyer's ability to divert business away from the target, and set out a clear, independent process for resolving any disagreement over the final figures.

In summary, neither structure is inherently better for a seller. It depends on how big the valuation gap is, how much confidence you have in the business's near-term prospects, and how much post-completion risk you're comfortable carrying in exchange for a potentially higher total price. Getting the structure right, and the small print behind it, often matters as much as the headline number. If you'd like to talk through how a sale of your business might be structured, we're happy to have a no-pressure conversation.

This article is general information only and is not tax or legal advice. Deal structures should always be reviewed with your own tax adviser and solicitor before you agree terms.