Deferred consideration arrangements are an increasingly common feature of corporate transactions, offering buyers greater payment flexibility whilst enabling sellers to maximise the overall consideration received. However, these arrangements also raise complex legal considerations that benefit from close collaboration between corporate and banking specialists.
This article considers the key risks that arise where part of the purchase price is deferred and the practical steps that buyers and sellers can take to protect their respective positions.
Understanding the key risk
When part of the purchase price is deferred, sellers face a fundamental risk: the buyer may not pay on time, or at all. Without protective steps, the seller ranks as an unsecured creditor - a position that may offer little practical recourse in the event of the buyer's insolvency. Critically, a buyer's ability to pay may also be constrained by obligations owed to its senior lender(s), who may contractually restrict certain payments if a default under the buyer's facilities has occurred.
Risk mitigation mechanisms
The sale and purchase agreement should contain robust contractual protections as a first line of defense. These include:
- Payment acceleration: A well-drafted sale and purchase agreement would usually include a payment acceleration clause permitting the seller to demand the full outstanding amount of deferred consideration immediately upon the occurrence of specified trigger events. These typically include the buyer missing an instalment payment, entering into any form of insolvency or restructuring process, or undergoing a change of control without the seller's prior consent. The breadth and precision of these trigger events require careful attention - overly narrow drafting may leave gaps in the seller's protection, whilst overly broad drafting may be resisted by the buyer and its lenders.
- Default interest: The sale documentation may provide for an enhanced rate of interest to apply automatically to any missed or late payments of deferred consideration, incentivising timely payment and compensating the seller for the financial cost of delayed payment.
- Security: Where the deferred consideration is substantial, or where doubts exist about the buyer's ability or willingness to pay, the seller should consider taking security over the outstanding amounts. Security gives the seller a proprietary interest in the buyer's assets that will be protected in the event of insolvency, unlike an unsecured creditor. The key is that any security must be properly documented and, where applicable, registered promptly to ensure it is effective when needed.
Types of security
- Guarantees: Parent company or bank guarantees provide recourse against an entity with greater financial resources. Sellers should seek on-demand rather than conditional guarantees, to avoid the need to prove default before making a demand
- Security over assets: Sellers can take security over the buyer's assets, including the target's shares or any real property held, though this may require negotiating priority arrangements with existing lenders who may already hold security over those assets. Any charge must be registered at Companies House within 21 days of creation under the Companies Act 2006; failure to do so renders it void against a liquidator or administrator.
- Cash escrow: Ring-fencing funds at completion significantly reduces credit risk. The terms of the escrow - including release conditions, dispute resolution mechanics, and the treatment of interest on the funds - should be carefully documented in a tripartite escrow agreement between buyer, seller, and escrow agent.
- Loan notes: Loan notes are debt instruments issued by the buyer to the seller at completion in lieu of immediate cash payment. The seller becomes a creditor of the buyer, entitled to repayment of the principal together with interest at an agreed rate, on a specified future date or upon agreed trigger events. Whilst they offer flexibility in structuring the overall consideration, sellers should be aware that in leveraged transactions the terms will be heavily influenced by the buyer's senior lender(s) - who will typically require the loan notes to rank behind the senior debt, restrict cash interest payments in favour of roll-up interest added to the principal, and block repayment until the senior facilities have been repaid in full.
Conclusion
Deferred consideration can facilitate transactions that might otherwise prove unviable, but the arrangements must be carefully structured and documented. Contractual protections must be carefully drafted, security properly perfected, and the interaction with existing financing arrangements identified and resolved before completion. Please contact a member of our Corporate or Banking and Finance team if you would like to discuss further.
Important note: Before taking any of the steps discussed above, please make sure you get independent legal and accounting advice. The legal and tax implications will vary significantly depending on your specific circumstances.
