Earn outs and deferred consideration are often presented as solutions to valuation gaps. In practice, they are compromises. They allow deals to proceed where buyer and seller expectations do not fully align.
Understanding the implications is critical.
An earn out links part of the sale price to future performance. This can be attractive where there is uncertainty about how the business will perform post-sale. Buyers reduce their upfront risk, while sellers retain the potential to achieve a higher overall price.
However, the key issue is control. Once the business is sold, the seller may no longer control the factors that drive performance. Decisions made by the buyer can influence outcomes in ways that affect earn out payments.
This creates a misalignment. The seller is financially exposed to performance but may not have the ability to influence it.
Deferred consideration presents a different type of risk. Instead of receiving the full purchase price upfront, the seller receives payments over time. This can assist with deal structure, particularly where funding is limited.
However, it introduces credit risk. The seller is effectively lending part of the purchase price to the buyer. If the business underperforms or the buyer encounters difficulties, payment may be delayed or reduced.
The structure of these arrangements is critical. Performance targets must be clearly defined. Ambiguity leads to disputes. Metrics should be objective, measurable and aligned with how the business operates.
There is also a behavioural dimension. Buyers may make decisions that are commercially rational for them but impact earn out outcomes. Sellers need to consider how these decisions may affect their position.
Security should also be considered. Where payments are deferred, sellers should assess whether any form of protection is available. This may include guarantees or other forms of security.
One of the most common mistakes is focusing on the headline price rather than the structure. A higher price with significant deferred elements may carry more risk than a lower price with full payment upfront.
These arrangements are not inherently negative. They can facilitate transactions that might not otherwise occur. However, they require careful negotiation and a clear understanding of the risks involved.
A well-structured deal balances risk and reward for both parties. A poorly structured one creates ongoing tension long after the transaction is complete.
Disclaimer: This article is based on publicly available information and is intended for general guidance only. While every effort has been made to ensure accuracy at the time of publication, details may change and errors may occur. This content does not constitute financial, legal or professional advice. Readers should seek appropriate professional guidance before making decisions. Neither the publisher nor the authors accept liability for any loss arising from reliance on this material.
