Whilst, the seller's best result would be to receive cash in exchange for its shares in the target company, this may not always be something the buyer is willing (or able) to provide. The buyer may, for example, need time to raise funds. There are various ways in which the buyer of the company may wish to structure the sale price (also referred to as the consideration), including cash, deferred consideration, loan notes and an earn-out.
When consideration is not paid wholly in cash on completion, certain risks are introduced. Firstly, there is the risk that the seller will not receive its money due to the buyer being unable, or unwilling, to make the deferred payment. Secondly, the purchase price has often been ascertained on the basis of certain assumptions and allowing payment to be deferred, retained or calculated at a later date changes the allocation of risk that these assumptions are wrong.
In order to reduce the risk of non-payment of deferred consideration, there are options open to the seller. These include requiring some form of security for the deferred consideration or entering into an escrow arrangement. If the buyer is raising finance to make the acquisition, their funder will undoubtedly take security over the buyer and the target company which will take priority over any other form of security. As such, the seller's security will stand behind the funder’s security and the funder may restrict the seller's ability to bring a claim, and so in these circumstances, it may be advantageous not to have any security.
In terms of the reallocation of risk, one mechanism that is often used, particularly in the case of owner-managed businesses, is an earn-out arrangement. A key advantage of an earn-out for a seller is being able to achieve a potentially higher return on the share sale where the future profitability proves to be higher than the buyer is willing to believe it will be at the time of the sale. However, it usually requires the seller to remain working with the business to ensure the performance targets are met.
Furthermore, there is always the risk that the company will not meet its targets, meaning that the seller will not receive all of his earn-out consideration (which may be one of the principal reasons behind the decision to sell). This is one reason why earn-out provisions can be difficult to negotiate as care needs to be taken that the purchaser is not in a position to be able to manipulate the running of the business in a way that negatively impacts the attainment of the set performance targets.
A buyer may insist on a "retention" of the purchase price to provide security for potential claims under the Share Purchase Agreement. We suggest that you agree to a retention as a last resort, as the buyer often uses the retention funds as a negotiation ploy to try and force the seller to accept a lesser deferred sum.
Since the introduction of entrepreneurs' relief in 2008, loan notes are less tax advantageous to sellers. Therefore, there is less incentive for sellers to accept them. However, buyers may still want to include at least part of the consideration as loan notes in order to assist with their cash flow, in which case you may wish, as a seller, to require the loan notes to be secured.
See also our Consideration Glossary.