This article was originally published for Care Markets on 08 August 2023, and the full article can be found here.
Deferred consideration in M&A transactions: bridging the valuation gap “sellers put your money where your mouth is….”
Mergers and acquisitions (M&A) transactions are complex endeavours that involve the coming together of two entities with different goals, expectations, and valuations. A significant challenge to deals happening is a disconnect between sellers’ and buyers’ price expectations – sellers want higher purchase prices than buyers’ valuations.
A powerful tool that can help address the valuation gap is the use of deferred consideration price structures. Monica Macheng explores deferred consideration and its potential to close the valuation gap.
Understanding deferred consideration:
Deferred consideration refers to a portion of the purchase price that is not paid upfront but is instead deferred to a later date or contingent upon certain conditions being met. It is a mechanism that allows buyers and sellers to align their interests and bridge the valuation gap. By deferring a portion of the consideration, the buyer can mitigate risks associated with uncertain future performance, while the seller can potentially achieve a higher overall price.
Benefits for sellers:
Higher total consideration: Deferred consideration allows sellers to negotiate a higher total consideration for their business. By accepting a portion of the payment in the future, sellers can potentially bridge the gap between their price expectations and the buyers’ valuation, leading to a more favourable deal outcome.
Alignment of interests: Deferred consideration ensures that sellers have a vested interest in the future success of the merged entity. By tying a portion of the payment to the company’s performance post-transaction, sellers are motivated to support the integration process and contribute to the long-term growth of the business.
Risk mitigation: By deferring a portion of the consideration, sellers can mitigate the risk associated with uncertain future performance. This is particularly relevant in cases where the business is in a transitional phase or undergoing significant changes. Deferred consideration provides a safety net for sellers, ensuring they receive fair compensation based on the actual performance of the business.
Benefits for buyers:
Flexibility in valuation: Deferred consideration allows buyers to bridge the valuation gap by offering a lower upfront payment and deferring a portion of the consideration. This flexibility enables buyers to structure deals that align with their valuation models and risk appetite, making transactions more feasible and attractive.
Performance-based payments: By linking a portion of the consideration to the future performance of the acquired business, buyers can align the interests of both parties. This incentivises sellers to actively contribute to the success of the merged entity, and hopefully leading to a smoother integration process and increased chances of achieving synergies.
Risk allocation: Deferred consideration helps buyers allocate risk appropriately. By deferring payment, buyers can protect themselves from potential underperformance or unforeseen liabilities that may arise post-transaction. This mechanism ensures that buyers pay a fair price based on the actual performance and value generated by the acquired business.
Challenges and considerations:
While deferred consideration offers numerous benefits, it is not without its challenges and considerations. Both buyers and sellers must carefully evaluate the terms and conditions associated with deferred consideration to ensure a fair and mutually beneficial agreement. Some key considerations include:
Performance metrics: Defining clear and measurable performance metrics is crucial to ensure transparency and avoid disputes. Buyers and sellers must agree on the specific criteria that will determine the payment of deferred consideration, such as revenue targets, profitability thresholds, or market share goals.
Payment structure: The structure of deferred consideration should be carefully designed to balance the interests of both parties. It can be in the form of earn-outs, milestone payments, or contingent payments based on specific events or achievements. The payment schedule and timeline should be clearly defined to avoid ambiguity and potential conflicts.
Legal and tax implications: Deferred consideration may have legal and tax implications that need to be carefully considered. Parties should seek professional advice to ensure compliance with relevant regulations and optimise the tax treatment of the deferred payments.
Deferred consideration can be a useful tool when used carefully to bridge the valuation gap for deals that might otherwise fall over at the first hurdle. By deferring a portion of the consideration, both parties can align their interests, mitigate risks, and achieve a more favourable deal outcome. However, it is essential to carefully structure and evaluate the terms and conditions associated with it to ensure fairness and transparency. When used effectively, deferred consideration can be a win-win solution that enhances the success of deals and creates value for all stakeholders involved.
For further information, please contact:
Monica Macheng, Hill Dickinson