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Deferred consideration vs earn-out

Deferred consideration vs earn-out: This article exlains the key differences…

When selling a company, the negotiation and structuring of the deal involve various components aimed at aligning the interests of both the buyer and the seller.

In some deals, the expectation of the seller can differ from what a buyer is prepared to pay – we sometimes call this the ‘value bridge.’

Two common mechanisms used to overcome the ‘value bridge’ are deferred consideration and earnouts, each serving distinct purposes in managing risks and fostering a mutually beneficial agreement.

What do the terms ‘deferred consideration’ and ‘earnout’ mean?

Deferred consideration and earnouts are financial arrangements that allow for flexibility in deal structures, especially when there is uncertainty about the future performance of the business being acquired.

Deferred consideration refers to a portion of the purchase price that is not paid upfront at the closing of the deal. Instead, it is postponed to a later date, usually contingent on the fulfilment of certain conditions or milestones. This mechanism allows the buyer to mitigate risk by ensuring that the seller delivers on specific promises or that the business continues to perform as expected post-acquisition. The deferred payment may be linked to financial targets, strategic goals, or other predefined metrics. This approach provides the buyer with a degree of protection, as they only pay the full purchase price if the seller meets the agreed-upon criteria.

On the other hand, an earnout is a performance-based mechanism where a portion of the purchase price is contingent on the future financial performance of the acquired company. The seller earns additional payments based on achieving predefined milestones or financial targets over a specified period.

Earnouts can be useful when there is uncertainty about the business’s prospects or when the parties have differing opinions on its valuation. This arrangement incentivises the seller to contribute to the ongoing success of the business post-acquisition, as their financial gain is directly tied to the company’s performance.

While both deferred consideration and earnouts serve to bridge valuation gaps and align the interests of the buyer and the seller, there are key differences between the two.

Deferred consideration focuses on the timing of payment, deferring a portion of the total purchase price until certain conditions are met. This allows the buyer to have more control over the release of funds based on the seller’s performance. In contrast, an earnout primarily hinges on the achievement of specific performance metrics, linking the seller’s pay-out directly to the business’s post-acquisition performance.

The choice between deferred consideration and earnouts often depends on the nature of the business, the level of risk involved, and the negotiation dynamics between the parties. For instance, in industries with high volatility or where the success of the acquisition depends on uncertain future events, earnouts may be more suitable. On the other hand, deferred consideration might be preferred when the buyer wants to ensure specific conditions are met before releasing the full payment.

A skilled negotiator will aim to bridge the goals of both seller and buyer. Whilst any seller will want to be paid in full at completion (and it is possible), both deferred consideration and earnouts are valuable tools in structuring M&A deals, providing flexibility and risk mitigation for both buyers and sellers.

We are often asked whether earnouts deliver? In our experience, yes. But this is often the result of a careful negotiation that ensures (a) the financial metrics of the earnout are reasonably achievable and (b) that the maths applied to calculate the earnout (e.g. certain level of EBITDA) are clearly understood by both parties.

The appropriate choice depends on the specific circumstances of the transaction, and careful negotiation and drafting of agreements are crucial to ensure a successful and fair outcome for all parties involved.

To discuss which deal mechanism could be most suitable for your company exit, contact us here to book a confidential appraisal.

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