Deferred consideration is a term quite commonly used in the nursery buying and selling market – but what exactly does this mean?
Essentially it relates to an offer on a nursery, where a buyer agrees to pay a percentage of the asking price initially, with the rest to be paid at a later date. For example, where a purchase price is £500,000, the buyer may agree to pay £300,000 with the remaining £200,000 to be paid two years after the completion date. That £200,000 is known as ‘deferred consideration’.
So, why might a buyer want a deferred consideration? In this economic climate, buyers maybe struggling to secure finance with a bank. Deferred consideration bypasses the need for bank funding and buyers get an interest-free loan. A buyer would also have a level of comfort in not paying the whole amount for the nursery upfront so if any breach of warranty issues arose, the buyer could hold back payment from the amount of deferred consideration owed (known as set-off). A seller would only be ‘set off’ if the claim had been determined and agreed under an arbitral award. Without any deferred consideration, if there were a breach of warranty, enforcement of such a warranty claim would need to be made. The seller could have spent the sale proceeds, which could possibly thwart enforceability.
Paying it back
Deferred consideration could be paid back weekly, monthly, yearly or after a couple of years. It is negotiated between the parties.
Deferred consideration can sometimes be linked to performance of the nursery. That is to say, it is only paid out if a target is hit. This is called an earn-out (see below).
If a seller agrees to unsecured deferred consideration, there is a risk that they do not get paid some or all the consideration.
The reasons for default of payment can be numerous. Usually a buyer may be relying on the cashflow of the newly acquired nursery to pay the seller the deferred consideration. However, if a buyer does not manage the nursery well – or worse still there is an Ofsted safeguarding issue which results in negative PR – cashflow will decline.
Even a seasoned nursery operator may also be at the whim of the economic climate – energy price hikes, salary increases and cost of living having an impact on parents paying on time, and operating costs. The biggest risk is if a buyer enters an insolvency process such as liquidation or bankruptcy. That would result in a seller becoming an unsecured creditor queued alongside other unsecured creditors. The seller would not have any priority and would have to incur fees to issue legal proceedings without any guarantee of being repaid the deferred consideration.
Why would a seller accept deferred consideration?
If a seller is struggling to sell their nursery or wants to sell to a particular buyer who insists on deferred consideration then it forms part of the deal. However, a seller should take comfort that there are ways to protect themselves if deferred consideration must be given.
Mitigating risk
Here are some of the way we can protect a seller who has given deferred consideration.
- Personal Guarantee or Corporate Guarantee – A seller may request a personal guarantee from the buyer (if an individual) or a corporate guarantee (if the buyer is a company). A guarantee can be given by another entity, which may have more financial security. We would want to see financial statements to verify the creditworthiness of the guarantor.
- Security over assets or charge over shares – If you are selling the shares in the company, you could request a charge over shares. So in the event of a default of payment, you could claim the company you sold back. However, many sellers don’t want their company back; they want the proceeds of sale. Also, if the company had been run badly and loss-making, there would not be any value left in it.
- If you are selling the goodwill and assets of the nursery, you could request security over those assets. Or you could ask for a charge over the buyer's company and personal assets. We would also include a clause in the sale and purchase agreement to make the directors of the buying company personally liable if the buying company defaulted on the deferred consideration payments.
- Non-assignment clauses – This seeks to prevent assets being haemorrhaged from the entity giving security. Remember a seller's security is only worth as much as the guarantor is worth. If the guarantor's assets were stripped away then in reality the security provided would be worthless. This clause would stop any assignment of the assets, thus protecting the value of the guarantor.
- If a seller agreed to an assignment, then we would want the assignee to also accept the burden of the deferred consideration and perhaps request details to assess the creditworthiness of the assignee.
- Bullet clause– If any deferred consideration payment is not paid, it may be that the buyer, the guarantor or the target business is in financial difficulty. This clause would want all deferred consideration to be paid with immediate effect.
- Bank guarantees, letters of credit – A buyer may present a bank guarantee or a letter of credit to give the seller comfort of the buyer's financial creditworthiness.
- Escrow account – A seller may request the deferred consideration be held in an escrow account (usually held by the solicitor). However, a buyer may refuse this as they may not have the money to deposit in an escrow account.
- Given less as deferred consideration – A seller can negotiate for a lower percentage to be deferred consideration.
Earn-out
The other type of deferred consideration is called earn-out. This means that the deferred consideration is only paid or earned out if certain conditions or targets are met.
A buyer may want a seller to prove the worth of the nursery they have just acquired. Or it may incentivise a seller to keep the business operating profitably and there could be further money paid to the seller if certain targets are hit. Earn-outs usually work better if the seller is staying on in the nursery post-completion.
A seller should consider the following when providing an earn-out:
- A seller has sold their nursery so has no or limited control of the nursery. So how can they influence target figures and achieve the conditions set?
- Can the nursery realistically hit the targets set?
- What happens if the buyer deliberately jeopardises the nursery?
- Can you earn more if the business exceeds the targets set?
- If targets are not hit in one year, can they be made up in the next year?
How to protect the seller regarding an earn-out
In the sale and purchase agreement, we would want the following issues covered:
- The earn-out period is as short as possible.
- The targets set are achievable.
- The nursery continues to operate as it did before.
- The buyer does not encumber the nursery with excessive debt.
- Seller can control major decisions with the consent of the buyer on points which could adversely impact the targets set.
- A bullet payment should be made to the seller (irrespective of whether the seller has it target) if:
- the buyer sells the entire nursery or the majority of it
- there is a refinance and it may impact the earn-out
- the nursery cannot pay its debts as and when they fall due, i.e. insolvency.
As the economic downturn starts to impact business transactions, it may be that we see more deferred consideration and earn-out transactions. The key is to provide fair protections for both the buyer and seller.
It is imperative that the parties have good legal advice to strike a fair deal that both sides are comfortable with. That takes time, effect, skilful drafting and robust security documentation.
Helen Wong is a corporate solicitor at Setfords Solicitors specialising in M&A transactions in the education sector (day nurseries and schools). More information at hwong@setfords.co.uk
