Why use deferred payments at all?
Buyers and sellers often disagree about value. The seller points to growth plans; the buyer sees risk. Deferred payments help close the gap by:
- reducing the amount the buyer must fund at settlement
- letting the seller share in future success
- keeping the seller motivated to support the handover
- reducing the buyer’s risk if the business underperforms
Deferred consideration: the simple version
Deferred consideration is a fixed amount paid on set dates after settlement.
Illustrative example. Price $900,000: $700,000 at settlement, then $100,000 at 12 months and $100,000 at 24 months.
For the buyer: less funding needed upfront. For the seller: the full price, but with some risk that the buyer cannot pay.
Earn-outs: payment linked to performance
An earn-out makes part of the price depend on results.
Illustrative example. Price $700,000 at settlement, plus up to $200,000 over two years if annual gross profit exceeds an agreed figure.
Choosing the target
| Target | Pros | Cons |
|---|---|---|
| Revenue | Simple, hard to manipulate | Ignores profitability |
| Gross profit | Reflects pricing and cost of sales | Needs clear cost definitions |
| EBIT or net profit | Closest to true value | Easily affected by buyer’s decisions on overheads |
| Customer retention | Measures goodwill transfer | Harder to define and verify |
For most SMEs, revenue or gross profit targets cause fewer disputes than net profit targets, because they are less affected by the new owner’s spending decisions.
Drafting essentials
- Precise definitions of the measure, including accounting policies
- Who prepares the numbers and when
- The vendor’s right to review accounts and records
- What happens on a sale or restructure during the earn-out period
- Restrictions on the buyer’s actions that could affect results
- A dispute resolution process, such as an independent accountant as expert
Security for the vendor
A vendor owed money after settlement wants protection. Common approaches:
- a general security agreement over the business’s assets
- a security interest over the shares sold
- a personal guarantee from the buyer
- a mortgage over property
Each can conflict with a lender’s requirements. The lender funding the upfront portion will normally require first-ranking security. A deed of priority sets out the order. See vendor finance versus lender finance.
How earn-outs fit with lender funding
A typical structure for an established SME acquisition:
- Buyer’s contribution: cash or equity.
- Lender finance: funds most of the settlement amount, often secured on the buyer’s property. See funding to buy an established business.
- Deferred consideration or earn-out: paid to the vendor from the business’s future cash flow.
The key test is affordability. Model the combined repayments to the lender and the vendor against maintainable earnings, after a fair salary for the buyer, including a slower-than-expected first year. If it only works in the best case, the structure needs rethinking.
Tax and legal considerations
Deferred and contingent payments can have tax consequences for both parties, including how the purchase price is allocated between goodwill, plant and stock, and the timing of income for the vendor. Both parties should take independent tax and legal advice.
Earn-outs in succession
Earn-outs are common in family and management successions, where the incoming owner has limited capital and the outgoing owner wants to be paid fairly. They can work well if the outgoing owner’s role is clear and the targets are realistic. Our succession planning guide covers this in more detail, and partner buyout and succession funding explains how lender funding fits in.
Common pitfalls
- Vague definitions of revenue or profit
- Targets set too high, making the earn-out a source of resentment
- No restrictions on the buyer changing the business
- Ignoring affordability of combined payments
- Security arrangements that conflict with the lender’s
Summary
Deferred consideration and earn-outs are practical tools for bridging price gaps in SME sales. Used well, they align buyer and seller. Used badly, they create disputes. Clear drafting, realistic targets, sensible security and a funding structure that works in a slow year make the difference.
Quick answers
How long do earn-outs usually run?
Commonly one to three years for SMEs. Longer periods increase uncertainty and the risk of disputes.
Should the vendor stay involved during an earn-out?
Often, for a defined period, because their involvement may affect the results. The agreement should set out their role clearly.
What if the buyer changes the business and the targets are missed?
This is the classic earn-out dispute. Agreements often include protections for the vendor, such as restrictions on major changes during the earn-out period.
Can I use lender finance and an earn-out together?
Yes. A lender funds the upfront portion and the earn-out is paid later from the business's performance. The lender will normally require its security to rank ahead of any vendor security.