Structuring Earn-Outs and Deferred Payments in Smaller Mergers and Acquisitions

The general expectation is that complex drafting or deal structuring is reserved for larger mergers and acquisitions (M&A). On the whole this is true, however smaller M&A deals can often require creative payment structures to bridge valuation gaps, align incentives, and manage risk.

Among the most common mechanisms for structuring the purchase price are earn-outs and deferred payments. These tools offer a way to tie a portion of the price to a future point in time and/or future performance, while seeking to ensure alignment of end-goals between buyers and sellers.

Structuring such mechanisms can depend on the bargaining position of each party. However, having alternative structures in mind allows for more ways to reach agreement on the overall consideration both parties are hoping to pay or receive.

This article explores structuring earn-outs and deferred payments in smaller M&A transactions, looking at key considerations such as duration, metrics, and negotiation dynamics.

Understanding Earn-Outs

Earn-outs are contingent payments made to the seller based on the target business’s post-transaction performance. They are particularly useful in situations where:

• buyer and seller have different views on the business’s future potential;
• the seller remains involved in the business post-completion and can influence its performance;
• market or operational uncertainty makes payment of the full price upfront a risky deal for the buyer.

Earn-outs are commonly tied to metrics such as ongoing revenue, EBITDA, net profit, or customer retention. They incentivise the seller to maximise post-completion performance, but they can introduce issues down the line if the relevant metrics are disputed.

Understanding Deferred Payments

Deferred payments (without any linked performance element) are simpler in comparison. A portion of the purchase price is withheld and paid at a later date, often regardless of performance. These structures are typically used to:

• spread financial risk for the buyer;
• ensure the seller’s continued involvement during a transition period;
• address potential liabilities or unknowns partly uncovered during due diligence.

Deferred payments may include interest to compensate the seller for waiting, although this point is negotiable.

Key Considerations for Structuring Earn-Outs and Deferred Payments

1. Duration of Payment Structures

The length of time over which earn-outs and deferred payments are structured is a critical factor and cuts to the core of the parties’ expectations and own future planning. A balance must be struck between giving the business (and effectively the seller) enough time to achieve agreed-upon targets while avoiding prolonged uncertainty.

• Shorter-Term Structures (usually 1-2 years):
  • Advantages: Shorter durations reduce uncertainty and simplify administration. They are suitable when performance can be measured quickly or when the seller’s continued involvement is brief.
  • Disadvantages: Sellers may argue that short periods do not reflect the time required for targets to realistically be achieved, especially in industries with longer sales cycles or development timelines.
• Longer-Term Structures (3 years +):
  • Advantages: Longer earn-outs can capture sustained performance and are more appropriate for businesses requiring significant time to stabilise or see expected results following the buyer’s acquisition.
  • Disadvantages: Extended durations increase the risk of disputes and complicate integration, particularly if the seller and buyer have different priorities.

2. Defining Performance Metrics

The metrics tied to earn-outs are best placed when they are clear and objective, avoiding ambiguous or overly complex formulas. Metrics like EBITDA, gross revenue, or specific growth milestones work well if they are precisely defined, including clearly defining what source or reference material will be used and who will prepare the same.

Metrics should be easily measurable using available financial or operational data to limit the potential for disputes. Further, suitable metrics should also be aligned with the business’s strategic priorities post-acquisition, ensuring they reflect key objectives the buyer wants to achieve.

3. Payment Timing and Instalments

For deferred payments, instalment structures provide flexibility to the parties, reduce risk for the buyer and can address cash flow concerns.

Common approaches include structuring payments with lump sums, periodic instalments (shorter gaps between payments being more reliable for sellers), or linking instalments to milestones.

More detailed structures that go beyond a simple passing of time for the next payment to be due, can potentially include adding interest on to deferred amounts or provisions to only releasing payments upon achieving key milestones, such as anticipated regulatory approval.

4. Protecting Against Disputes

If not suitably drafted, earn-outs and deferred payments can become a source of friction in M&A deals. To limit disputes:

• Include Clear Definitions: Avoid ambiguities in contract language, especially around metrics, reporting requirements, and adjustments.
• Establish Audit Rights: Whoever prepares the relevant information and date, allow both parties to review performance calculations to ensure transparency.
• Use Escrow Accounts: Hold a portion of the purchase price in a specified account to cover potential disagreements or indemnities and remove the risk of the funds not being readily available when due.
• Dispute and Arbitration Clauses: Include mechanisms for resolving disputes efficiently, such as third-party arbitration or alternative expert opinion.

5. Seller Involvement Post-Sale

Earn-outs often depend on the seller’s active participation following the acquisition, making it essential to address several key considerations.

It is crucial to clearly define and agree upon the seller’s roles and responsibilities during the earn-out period to avoid ambiguity and ensure a smooth transition. Additionally, buyers should be transparent about their plans to ensure the seller’s goals work with the buyer’s broader strategic objectives.

As a very general approach, a seller who no longer wants to be hands-on may be better suited to agree a simple passing of time and a simplified deferred consideration. Substantial performance requirements are often more appropriate for a seller that is ready and willing to stay more heavily involved to be able to back their own influence on the business achieving the relevant targets.

Negotiation Dynamics – Balancing Risk and Reward

Both parties must assess the trade-offs that come with deferred payments and earn-outs.

From the seller’s perspective, simplicity is a key priority. When first deciding to sell, they likely just wanted all money upfront and it is sensible to keep this in mind. Earn-outs and deferred payments can help secure a higher valuation. However, they can introduce additional burdens during the deferred period. There is also the inherent risk, as future payments depend on performance or the buyer’s solvency. Sellers should negotiate safeguards to their financial interests, such as; minimum payment guarantees, director or other suitable party guarantees if the buyer is a company, interest on deferred amounts or accelerated payments in the event of a subsequent sale of the business.

Another concern for sellers is maintaining control. The more complex the performance targets, the more a seller should concern themselves with negotiating for assurances that they will have the necessary resources and authority to achieve the agreed-upon targets.

Buyers usually prioritise minimising the risk of overpayment. They want to pay the right price and only allow for further payments if their preferred targets are met. These structures reduce upfront cash outlays and mitigate risks tied to overpaying.

Buyers should recognise that setting realistic performance targets is a solid starting point for productive negotiations. They may also seek the flexibility to adjust these targets if circumstances change significantly. Additionally, buyers should always remember the importance of the immediate post-completion period in setting the tone for a successful takeover and long-term success beyond any deferred payment period. Buyers should design earn-out offers that promote harmony for their relationship with sellers during the deal and afterwards. The parties’ relationship during the deal and beyond can knock on to the culture of the business and happiness of any retained staff.

Conclusion

Earn-outs and deferred payments are indispensable tools for smaller M&A transactions, allowing parties to bridge valuation gaps, align incentives, and manage risk. However, their success hinges on thoughtful structuring, clear definitions, and careful negotiation.

Parties should add these options to their negotiation arsenal, while always keeping in mind their own personal plans. For example, a seller that is selling because they are looking to put less time in to the business after completion, will have a different view and desire to ensure earn-out goals are achieved compared to a seller that is happy to remain hands on for a specified period until they have received the additional consideration.

By addressing key considerations – such as duration, metrics, and seller involvement – buyers and sellers can agree collaborative terms and minimise future disputes. Whether looking to use a short-term deferred payment, a multi-year earn-out tied to strategic milestones, or anything in between; when designed with care these structures can create win-win outcomes for all parties.

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This article is intended for general information only, applies to the law at the time of publication, is not specific to the facts of your case and is not intended to be a replacement for legal advice. It is recommended that specific professional advice is sought before relying on any of the information given. © Jonathan Lea Limited.