Introduction
In the past, it had been well seen that recessions and credit crunch may lead to the non-availability of cash reserves to the companies even though they may have some prospective business opportunities.
This creates a mismatch between demand and supply of funds for business buyers and sellers. These situations have given rise to alternative payment methods and structures. One of those structures is deferred considerations.
Meaning of Deferred Consideration
Deferred consideration means a fixed sale price has been agreed between the buyer and the seller and any partial amount from the full consideration has not been paid till the completion of the transaction, but it is deferred until a future date. This kind of arrangement is being done when the buyer does not have sufficient cash funds to finance the purchase at the time of acquisition or transaction.
For example, the owners of seller limited are willing to sell their company to buyer limited for an agreed price of $10m. The owners of buyer limited could arrange for cash resources along with loans up to $7m.
Now the buyer Limited has a choice of leaving the acquisition project and continuing to operate its previous business or it can enter into a deferred consideration agreement wherein the remaining purchase price of $3m will be paid later on once buyer limited can generate sufficient cash. If this arrangement is taken upon, it’s a win-win situation for both companies.
Deferred Considerations and Earn-outs
When some of the purchase prices are calculated based upon future position and the company’s performance, this is known as earn-outs. this will be linked to the sales revenue or the profits of the company. Earn-outs are one of a kind of deferred consideration which is dependent upon a future event.
Benefits of Deferred Considerations
Deferred consideration drastically reduces the need for immediate cash. Some of the companies which have the least cash reserve in hand and want to enter into any significant deal can use this arrangement.
In many cases, deferred consideration is interest-free, so it is not restrictive as a bank borrowing or debentures or an overdraft.
This also provides a commercial advantage after the Purchase transaction has been made if there is any dispute between the buyer and the seller. For example, If the assets were overstated, then its advantageous for the buyer, and he can recover the cost in the form of warranty claims, other damages, or partial refunds.
Points to Remember While Entering into Deferred Consideration Agreements
Terms and timing of deferred consideration
The terms and conditions and the timing of deferred payment should be set out in the agreement so that the transaction can be judged objectively. In case of any discrepancy is found by the buyer after the purchase, the procedure for claims should be included in the agreement.
Incorporation of Interest clause in the agreement
In case of deferred consideration, the seller incurs the opportunity cost so he may ask for certain interest to be paid on deferred consideration. If such a condition exists, the interest rate and timing of interest payment should be laid down in the agreement.
involvement of seller after the transaction
Suppose the payment of deferred consideration depends upon the seller’s involvement as a consultant/director or employee in the organization. In that case, he should be protected against being forcefully resigned without any of his fault. In case of death or illness, this right shall still accrue to the seller.
Tax treatment of deferred consideration
The seller should always take expert advice for the treatment of the amount which they receive in a deferred consideration transaction. In many countries, gain on deferred considerations are charged as long-term capital gain tax.
Security arrangement for seller
Even though the deferred consideration deals are documented, still the seller is facing some risk that he might not get paid. In this situation, the seller may ask for some security for the payment of deferred consideration from the buyer.
For this purpose, the buyer can do hypothecation, mortgage of any shares, property, or any other assets. Also, any escrow account or bank guarantee can be opened in favor of the seller.
If the deferred transaction is not secured, the seller would be among all those unsecured creditors who can claim and enforce their contracts only through courts. Also, as per company laws, the ranking of the seller would be behind secured creditors in the event of default by the buyer.
Conclusion
Deferred consideration agreement should be carefully designed and implemented because after their completion, there may be significant disagreement between the parties which may lead to suing each other.
Also, if they are used appropriately, they can be very helpful for both the buyers and sellers. They can purchase the target company on the buyer front even though they may have a liquidity crunch or lesser cash reserves. On the seller front, they get a deal for selling their business at a fair value to the buyer.
In the case of conditional deferred considerations (earn-outs), it helps the buyer to calculate fair price business value based upon past performance of the business. Similarly, the seller also gets an opportunity to increase deferred consideration value as it depends upon future sales or profits after acquisition.
Along with positive impacts, disputes can also increase between buyers and sellers after these deferred consideration agreements are being entered.
In both ways, companies need to evaluate the best course of action for them.