Deferred Consideration and Earn Outs: The Devil is in the Detail

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What are deferred consideration and earn-outs?

It is an increasingly common occurrence on a practice sale for a buyer to seek to mitigate their risk of any post-completion drop in turnover by withholding a sum of money from the headline sale price.

Common terms used to describe such an arrangement would be “deferred consideration”, “deferred payment”, “growth payment”, “bonus”, “earn-out” and “retention”. The terms can be used interchangeably depending on how a buyer wishes to present this to a seller however, in practice, the terms attached to such an arrangement can vary drastically between deals, so it’s important to seek specialist advice both at the initial heads of terms stage and further down the line when the sale agreement and associate agreement are under review by the legal representatives.

How do they work?

The most common situation we encounter would usually entail a corporate buyer agreeing on a headline price with a seller but with the caveat that a percentage of that price will be held back for a set period against future income targets of the practice in the post-completion period. This would, more often than not, be linked to a requirement for the seller(s) to remain engaged under an associate agreement for that period. Typical retained percentages range from 20% up to 40% depending on whether the practice in question is perceived as a riskier proposition for a buyer or there is significant goodwill attached with the seller personally.

The terms attached to these arrangements usually involve the turnover on completion being delivered, often with annual inflationary rises, and the deferred sums being paid out in increments depending on whether each yearly target is met. Usually, it is the case that, for every £1 below the target that turnover comes in at, £1 of deferred consideration payable to the seller is deducted.

Such arrangements effectively constitute the buyer passing the risk of the future performance of the practice back onto the seller and ensure a situation where a seller still has “skin in the game” after the sale has completed. Firstly, it ensures that the seller has a vested interest in adhering to the terms of their associate agreement and remaining for the term of years they agreed to stay for and, secondly, it insures the buyer from sudden and unexpected changes in trading conditions that may or may not be within the ability of the seller to control.

Consider, for example, the sellers who sold under such arrangements before the COVID pandemic and suddenly found their practices closed and turnover adversely affected. Similarly, the significant inflationary pressures of the last few years have meant that sellers who agreed to targets linked to CPI or RPI have found themselves hit with significantly higher targets than they had initially expected.  It is an inescapable fact that an owner selling under such arrangements will find themselves with a significant investment in the future of a practice that they no longer own and have only minimal ability to control, particularly in key areas such as staff recruitment and retention which can be crucial to achieving targets in a post-completion earn-out period.

It is therefore imperative that the terms of any engagement as an associate post-completion are properly documented and advised upon.

We hear anecdotes from both sides of the fence, with sellers having sold under such arrangements and having reaped the rewards of the continued growth of their business and never having been happier than they were post-sale. We also hear of sellers who have disliked every minute of their post-sale experience yet had to stick with it due to the fear of forfeiting their deferred consideration as would be the case if they didn’t complete the terms of their associate agreement.

Areas of negotiation

Areas of negotiation where a degree of comfort can be attained when acting for a seller would be those such as ensuring that the definition of “turnover” and what is included in that calculation is sufficiently broad and all-encompassing to allow a seller the maximum opportunity to achieve their targets. Furthermore, it is beneficial to have the ability to carry underperformance and overperformance against target forwards and backwards across the tie in period. For example, if a seller underperforms against their target in year one and suffers a reduced payment but then overperforms against the target in year two, can that excess be credited back against year one to bring the seller back up to where they would have been?

Consider, also, with such an arrangement, what happens in the event of death or issues affecting a seller’s ability to fulfil the terms of their associate agreement. Would death or illness mean an immediate forfeiture of any deferred consideration? Or is the buyer happy to still pay it to the seller (or their estate in the event of death) provided targets are still met?

We also encounter circumstances where sellers agree to earn-out periods where they are unlikely to remain as an Associate for the duration. Our advice in such circumstances is to be as upfront and honest as possible with a buyer over future intentions. The last thing anyone wants is for a seller to breach their associate agreement and, if it is the intention to leave at an earlier point, we have seen examples of buyers being agreeable to the seller exiting early while maintaining their right to the earn-out payment, provided that they source and train up a suitable person to take their place. Once again, if this is a possibility then it should be discussed at the outset of the sale process, rather than left as something to try and negotiate after completion, when a buyer is unlikely to deviate from the agreed contractual commitment.

Deferred payments/earn-outs are a normal mechanism of apportioning risk between buyer and seller in the post-completion period in terms of the future performance of the business. They are not something to be put off by and invariably we find that buyers would far rather see the targets being met and pay out the deferred sums, rather than have a practice that has a declining turnover. That said, there is usually scope for negotiation in the drafting of such clauses that can make huge differences to the position of the buyer and the seller further down the line. For that reason, advice from dental specialist solicitors is imperative.

Thomas Coates is the Managing Director of Buxton Coates Solicitors, a specialist law firm providing legal services to Dentists and Dental Practice Owners. Thomas is a Corporate specialist with particular expertise in the sale and acquisition of practices.