Deferred consideration is the amount of consideration which is not paid over at the completion date of a transaction. It is by definition, deferred until a future date. Deferred payments are guaranteed to be paid out and are not therefore usually contingent upon any metrics being achieved (compared to an earnout provision which is fully contingent upon a set of KPIs or metrics being achieved in order to trigger the earnout payment provisions). Deferred consideration allows the purchaser to defer some of the acquisition cost. Sellers therefore have a vested interest in the business in the future in terms of their deferred consideration being paid out to them.
Deferred payments with reference to SME businesses
Deferred consideration in the context a business purchase can be any amount which is agreed between the buyer and seller. It forms part of the formal terms and structure of the deal and as such, will be referred to specifically in the Heads of Terms (Heads) / Letter of Intent (LOI). In SME business purchases, and more specifically those under £5m value, a typical deferred amount would be anything over 50%. A seller would normally look for a minimum level of deferred payment and a buyer would look for the maximum possible. Deferred consideration is often delivered in the form of vendor loan notes at an interest rate of 2-4 percentage points over the bank base rate per annum, payable over a number of years. These loan notes will normally be subordinated to any debt taken on by the company to fund the initial cash consideration and all appropriate assurances for a transaction of this type will be offered to the seller through the share purchase agreement.
Deferred payment periods
A typical deferred period could be between 2-4 years but this is totally negotiable between the two parties. Again, a seller will wish to keep this period to a minimum and a buyer will wish to extend it out as far in to the future as possible. The main reason for this is due to cashflow considerations on the basis that the buyer (new owner) would look to pay the deferred out of cashflow post-purchase as much as possible, rather than having to find additional funding to cover it. The deferred can be paid in a number of ways, often quarterly or annually in arrears might be normal. The amounts would typically be split equally but again, this is by negotiation between buyer and seller. It might be that the buyer could negotiate a favourable term such that the first repayment of deferred consideration could be due six months after completion, with all subsequent payments due either annually or quarterly.
Amount of deferred
The percentage of deferred to be considered is often a feature of (i) the value of the business; (ii) the amount of the total purchase price provided by the funder based on their normal lending parameters and (iii) the amount of capital being contributed by the buyer(s) personally.
Defaulting on deferred
If the buyer defaults on paying any of the quarterly/annual deferred consideration (loan notes), it might be agreed between the seller and the buyer that the loan notes would be convertible back into equity at the equivalent value per share that the shares were originally acquired at. This is known as convertible debt. It is not standard practice to have convertible debt written into a deal for an SME purchase but there are circumstances where this is relevant.
Deferred consideration ranking
If no external debt is being raised to finance the purchase of the business, then the loan notes will have first charge over the company’s assets. If external debt is being raised from a funder to complete the transaction, then the loan notes would have second charge over the company’s assets and rank behind the providers of any external debt raised.