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Understanding Earnouts, Deferred Payments and Vendor Loans in Mergers and Acquisitions


In episode three of our M&A Deconstructed Series Two, mergers and acquisitions experts Nick Davies and Justin Levine discuss the specifics of a hot topic when selling a business: getting paid.

As they continue on their mission to demystify every aspect of selling a business, Nick and Justin cover the numerous ways an M&A deal can be structured and explain why receiving cash on completion of an acquisition isn’t necessarily the most common result and take a deep dive into earnouts, deferred considerations and vendor loans.

Take a look at this in-depth discussion in the video or read through the transcript below…


Video sub-topic timestamps:

00:00 – Introduction
01:02 – Cash on completion of an M&A transaction
02:15 – EarnOuts and Deferred Consideration
02:50 – What is an earn-out in mergers and acquisitions?
03:34 – How does an earn-out work?
07:30 – What is deferred consideration in mergers and acquisitions?
08:51 – What are the risks of deferred consideration?
10:47 – What are vendor loans and vendor take-backs in M&A?
12:03 – How do vendor loans differ from loan notes?
13:19 – Rollover and consideration shares


Video Transcription

Justin Levine:
Welcome back, Nick, in our M&A Deconstructed series, where we are unpicking, step by step, the process of selling a company.


Justin Levine:
Today’s discussion is over something that, I think, is going to be really of interest to sellers, and that is how you get paid.

Yes, very important.

Justin Levine:
It’s very important. In M&A speak, we use a term called consideration. So, most of the sellers will think of price. But the question is, how does that get delivered? In other words, when I sell a business, what do I get at the end? And of course, most people think in terms of cash; I simply sell my business for 10 million and at the end of the process, I sign the pay, the check arrives, I got 10 million pounds. But of course, in reality, it doesn’t often go that way. There are forces at work, if you like, in the sale process that sometimes mean that it gets structured in a different way.

Cash on completion of an M&A transaction

So I think if I just briefly talk about the cash element, that’s easy. So, I’ll take the easy topic. So typically, a seller will want 100% cash on completion. It does happen, but with the caveat that rarely does a deal happen where there is not some retention at the end of it.

I think we talked about in the process. But if people haven’t seen this, when you sell a business, a buyer will do due diligence. They’ll look at the business forensically, usually in considerable detail and typically, stuff comes out. And to guarantee against potential stuff that comes out, the buyer will often say, “Listen, we need a certain amount of money retained-

Held back. Yeah.

Justin Levine:
… held back because we found some stuff.” There are some tax issues, or there might be an IP claim or there’s some labour claim, or whatever it might be. But it’s typical that there is a retention. And of course, the amount that’s retained is negotiable.

Always. Yeah.

Justin Levine:
It’s always negotiable. If you’ve got an experienced corporate finance lead negotiation for you, you can get it down to a minimum. But typically, there is and there can be retentions at the end.

But it can be the deals, and we’ve done deals together, where the large proportion of the cash has been delivered at completion.

Earnouts and deferred consideration

But it’s in particular, I don’t know how you feel about it since the COVID-19 pandemic, my view is that there’s an increasing focus on other types in structuring a deal so more of the money comes later. And we use terms like an earn-out, deferred consideration, it could come with a vendor loan or vendor take-back, or it could have some rollover shares both in the existing entity or even in another legal entity. So, I think let’s just talk briefly about those.


What is an earnout in mergers and acquisitions?

Justin Levine:
An earnout, would you explain an earnout?

Okay. An earn-out is where part of the payment of the price payable to the sellers is paid out over a period of time. The sellers normally stay involved in the business and the amount that is paid or payable can vary depending on the target’s performance, if the target business does very well, reaches its objectives for the next 12 or 24 months, whenever the earn-out period is, then the sellers can do very well and potentially achieve their maximum earn-out. If the business does less well, they will receive less.

How does an earnout work?

So quite often, earn-outs are used by a buyer as a way of keeping sellers involved in a business, those sellers are the people who know the business the best, and as a way of delivering whatever the seller’s forecasts or predictions might be for the future business. Earn-outs can be very successful. There is inevitably some risk and some friction on an earn-out because a seller needs to have the authority to run the business, to make decisions that affect the business and which affect the ability to achieve the earn-out.

The friction may be that the buyer may say, “Well, I don’t want you to run the business like that. I want you to run it like this.” And so, it’s very important that you address and capture in the SPA, how the earnout period will work.

There will be other things in the earn-out schedule, such as how the earn-out’s calculated and there are many different methods. Typically, the earnout has to be agreed. One party, the buyer or seller will produce their earn-out statement. The other party will say, “Yes, we agree or no, we don’t.” You can have some independent referral if necessary. That’s how an earn-out typically works.

Justin Levine:
Yeah. It’s interesting, because when I go out and speak to potential clients and clients, there is a universal feedback when it comes to earnouts. And that is, there’s a received wisdom, usually starts anecdotally with my mate in the pub that says he sold his company or her company and they didn’t get their earnout, and therefore it’s a bad thing.

And actually, what I counsel my clients is, it’s not necessarily the case because often an earn-out can be used to bridge a value gap. Because when you have an SME, particularly a family run business, might be first, second, third generation, the exit value that they often attribute, the owners of those businesses, is often very high.

Higher than the market may attribute.

Justin Levine:
Correct. And that’s where the market might say, the buyer might say, “Well, okay, we’re going to either agree the same value or close to it, but you need to help me bridge the gap.”

That proportion of it will come to you via the earn-out when you achieve the objectives you say that are achievable.

Justin Levine:
Correct. And if you say, if there’s an art in this, if you like, rather than the science, the art is in the negotiation, the corporate finance lead, the M&A lead that is negotiating that on the seller’s behalf. Because of course, the key thing, the real interesting part in what you say is how that earn-out is calculated. And of course, there’s ways that buyers can manipulate it to their advantage and there’s a way a seller can manipulate it to their advantage. And the key thing is to have a very experienced negotiation lead to negotiate it. But my view is earn-out to not necessarily a bad thing.

They don’t have to be a bad thing. I mean, I think there is a natural nervousness on the part of any seller when they hear or learn about an earn-out. I think the key thing to remember is that actually the buyer and the seller do have a mutual interest for the target business to do well. The buyer wants it to do well because it’s the business they’ve bought and they want to see it succeed. The seller wants it to do well so they can maximise their earn-out.

So actually, if you can capture in the earn-out schedule that the parties will work in such a way which enables the seller to make the decisions they think need to be made, which protects the buyer’s investment in the company, which enables the parties to work towards the maximum earn-out. Most buyers, if they have to pay at the maximum earn-out are probably quite happy because it means the underlying value of the asset they’ve bought is higher than what they paid for at completion. And the earn-out cash will be funded by the target business.

I mean, it’s an opportunity as you say, to bridge that gap to engineer a bit more value out of the deal. So, I think that people should have an eyes-wide-open approach to it, not necessarily close their ears straight away and say, “Well, I’m just simply not going to do an earn-out.” I think, explore it, look at the detail.

What is deferred consideration in mergers and acquisitions?

Justin Levine:
So, the opposite, not the opposite, sort of value would be deferred consideration. Deferred means that the payment comes later. There’s after the deal is completed, the deferred payment or part of the consideration, part of the price comes later. And it can be conditional or unconditional, those payments. But of course, the difference between a deferred consideration and an earn-out is the deferred, if it’s unconditional means you’re going to get the money.

Yeah, that’s right. There’s just a scheduled payment for, I don’t know, you’ve got a 10-million-pound deal. Nine million is paid on completion. You get 500K six months after and another 500K 12 months after. It’s not conditional on hitting targets, it’s not subject to performance, it’s just that money is paid to you. And the buyer might want to engineer the deal like that for a number of reasons, one might be cashflow.

The second might be, and this is a point you alluded to earlier is a retention in other words. That means that if the buyer that brings the claim against the seller and they reach some sort of agreement rather than having to try and get the cash out of the sellers to settle that claim, the buyer can say, “Well, we’ll just net that off your deferred consideration.” So I think that’s the risk to the sellers is that the buyer has control of the cash at that point, unless it’s put in some sort of joint escrow or something else, which we do see from time to time.

What are the risks of deferred consideration?

A key point about deferred consideration of that type, which is unconditional, is what’s the risk for the seller? And the risk is that you don’t get that money for whatever reason if the business becomes insolvent, if there is some other problem, then how are you going to recover that money? And what you should be looking at is what security can you have for it? And that means what can the buying company or the buying individuals offer you. And it might be that you could ask for a charge of shares, you could ask for a charge over some company assets, you could ask for a personal guarantee from some individuals.

It’s quite often quite hard to securitise those deferred payments because most businesses are funded banks or financial institutions, which means that most of their assets are normally charged to the bank. Therefore, you can’t say, “Well, why don’t we have a charge over that lovely piece of machinery or that property?” Because the bank are already there. So those are some of the things you’ve got to think about when looking at deferred consideration.

Justin Levine:
Yeah. And that can make sellers a little bit nervous in terms of how do I secure my earn-out? How do I make sure in a lot of the deals that we do, the buyer is a large legal entity? It’s a successful well capitalised entity. And very rarely in my experience, will they give those PGs, those personal guarantees, the directors of a company with a market capital of 100 million or plus are unlikely to roll over and saying, “Yes, you can take a mortgage over my house. That’s fine.”

You have to form a view at that point, don’t you? Now, I think you’re looking at balance sheet strength, I think you’re looking at how long that business has been around, you’re looking at their trading prospects. And at the end of the day, you have to form a view. You have to evaluate the risk and you have to decide what you’re comfortable with and what you’re not comfortable with. There will be, or not be certain things on offer. And you need to decide, with advice, what’s the best route for you.

What are vendor loans and vendor take-backs in M&A?

Justin Levine:
So let’s talk briefly about vendor loans. Vendor take-backs, are something that actually in deals that I’ve done, we’ve done, I rarely see, but they do exist. And it’s the notion of a vendor loan effectively is a loan, it’s part of the consideration, that it’s a loan from the seller to the buyer for part of the money. And I suppose if you like, the foundation of it is that the business will be allowed sufficient time to generate the cash in order to pay the seller what is due on that balance and payment. What’s your take on vendor loans?

Sure. I think vendor loan, and vendor loans is a new piece of terminology which we’re seeing more of, it’s not a million miles apart from deferred consideration, which is not conditional. In reality, if you’re going to be paid a sum of money to sell your business but you allow the buyer to pay you some of that money later, that’s a vendor loan. How it’s captured and recorded in the docs is up to you.

If you’re going to say it’s not deferred consideration, it’s a vendor loan, you want some interest on it, you want some security on it, whatever else. The risks are the same. It’s money you are not getting at completion, you need to work out what the risks are, whether you’re going to get it.

How do vendor loans differ from loan notes?

Vendor loans are, of course, distinct from loan notes, which are a more formal form of consideration, which have different tax consequences, which I won’t go into today. Someone more qualified than me in tax can pick up on.

But loan notes will issue certificates to sellers often in a holding company, often with a coupon attached to them, meaning that you get some interest on a period, loan notes can be over a shorter or long term. And it might be something that a very large business is using to help them fund multiple transactions. It’s something people can look at. The risks are similar again.

The other risk with loan notes is that quite often they are expressed as being subordinated, which means that they are subject to the buyers or the buyer groups, other financial commitments. And those other financial commitments may say that they cannot repay other borrowing loan notes unless the company has hit its covenants or has sufficient headroom in the business in terms of profit and other things. So, there’s quite a lot to look at and quite a lot to understand in respective of those. But again, they are options that are on the table for how deals can be funded.

Rollover and consideration shares

Justin Levine:
Talking briefly one last part, which is very occasional and that’s rollover shares. And that is, instead of receiving cash or getting your money via an earn-out or deferred, the last component would be taking shares in either the same business or a new business or a holding company. How many transactions do you come across that have a rollover share?

Yeah, we do see those deals. I wouldn’t say that they are particularly common. I can think of, we’ve done a few in recent years. We’ve got one at the moment. There are a number of points in respect to roll overall consideration shares, as they’re often known. You need to understand what shares you’re getting. And we’ve done deals where the consideration shares have been in foreign entities, which is another layer of complexity.

And the key things you’re looking at are, what is the value of the issuing entity of those shares and what proportion of the shares are you getting? So are the shares, at least at completion, of equivalent value to the cash you would otherwise be getting? That’s point one.

The second point is how do you turn those shares into cash? How can you liquidate them? Are the shares restricted? Quite often in SMEs, there’s a limited pool of buyers. If you are a minority shareholder, you can’t just go and sell your shares to whoever down the road. There may be restrictions that say, they’ve got to be offered to the other shareholders pro rata, they’ve got to be valued in accordance with the way the company wants to value them, they may apply discount to a minority holding, et cetera. So, I think that there is a lot to look at.

They can work and we sometimes see it in private equity models who are going for a sort of buy and build strategy, where they’re bringing lots of businesses together to enable them to fund doing that. They’ll give you some rollover shares in their holding company. In that sort of scenario, the private equity buyer is probably trying to get to a critical mass point and then they’re going to sell the whole entity.

So if that’s the plan, you need to understand what the plan is, what the timeframes are, what the eventual future values might be. Some of those scenarios can work well, you get a second bite of the cherry, you get a second return of value. But it’s like many things in M&A, it’s just understanding the detail, looking at the key points, making sure when you sign up on the dotted line, you’re clear in your mind what you can and can’t do with your rollover shares.

Justin Levine:
And I think that’s in terms of, however the consideration is structured, having a strong commercial guide to, A, negotiating the best possible deal, but B, also modelling out the potential returns of those. Because of course it can be attractive to get, for example, a certain proportional of shares in a holding company, a top code, there’s a very big PLC that’s going to do extremely well, it aligns people’s interests. So, it can potentially deliver more value if the sums all add up.

Some sellers don’t want all cash, they might have got enough cash or whatever. And actually, having some rollover shares means that if there is a later disposal, it’ll be in another tax year, it’s another opportunity down the line, there may be some dividend or income stream off those shares in the interim period. So, it is an opportunity. It will depend on the sellers’ circumstances. Yeah, look at the detail.

Justin Levine:
We’ve covered the headlines. Always more to discuss-

There is.

Justin Levine:
… but I think that’s a great one, Nick. Thank you.

Pleasure. Talk again.

_ _ _ _ _ _ _ _ _ _ _ _

More from Series Two of M&A Deconstructed

Take a look at Series One of M&A Deconstructed

As part of this in-depth series, other topics discussed include:

Connect with the M&A experts

Justin Levine, Managing Director, The NonExec Limited M&A Boutique 
Justin leads a boutique exit advisory firm specialising in manufacturing, technology, IT, digital, healthcare, wholesale and distribution markets. With the support of a 15-strong virtual team of analysts and researchers, he helps private business owners with growth and exit strategies. Connect with Justin >

Nick Davies, Partner and Specialist M&A Solicitor, Steele Raymond LLP
Nick acts for a wide range of business clients across various sectors, advising on complex corporate transactions including company sales, purchases and mergers. Nick also advises on on mergers, de-mergers and re-organisation. Connect with Nick >

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If you have any questions regarding your business, a business exit, a merger or any other corporate legal query, please contact Nick Davies on 01202 294566 or email [email protected] 

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