The Challenges Brought By a Deferred Purchase Price

 
In the current climate of inflation and volatile lending, when acquiring a business (a “Transaction”), whether it be by means of a stock purchase agreement, asset purchase agreement, or merger agreement, a deferred purchase price (“Deferred Purchase Price”), often in the form of an earnout and representing either all or a significant percentage of the overall purchase price, has become increasingly popular with both sellers (“Sellers”) and purchasers (“Purchasers”).  Deferring a portion of the purchase price offers many benefits to both a Purchaser and Seller.  The Purchaser does not have to put down the full purchase price at the closing of the Transaction (the “Closing”), which in some cases may obviate the need for financing, and the Seller will often bargain for a higher upside on the total purchase price if a significant portion is deferred, particularly if there are heavy contingencies attached.  It should be noted that while a greater number of Transactions may also contemplate the Seller(s) “rolling over” equity in a Transaction, unless that rollover includes a deferral, it likely will not trigger the same issues as payment of a Deferred Purchase Price.  That said, there are risks related to the timing of the Closing and overall deal certainty for Purchasers that stem from a Deferred Purchase Price.
 
When considering how much of the purchase price to defer (and the contingencies that may make that deferred portion hard to obtain) the Purchaser should consider how quickly they want to close the Transaction.  The driving consideration for Sellers is often the cash received upon the Closing.  If a significant portion of the purchase price is deferred it may serve to disincentive a Seller to move towards a quick Closing. There are a few options for Purchasers to consider when structuring a transaction with a significant portion of the purchase price being deferred to preempt a Seller who may drag their feet: 
 

• Take a firm negotiating position while imposing a fixed timeline to close the Transaction from the onset;
• Make payment of the Deferred Purchase Price dependent on the achievement of calendar specific goals; and/or
• Make the realization of the Deferred Purchase Price more likely by softening or removing certain contingencies.

 
If the Deferred Purchase Price is based on, for example, a trailing 12 month period and that period can start at any time, then such a mechanism does not incentivize a Seller to move rapidly towards a Closing; often such a structure can lead a Seller to try and pick the 12 month period to tailor any earnout component of the Deferred Purchase Price to yield the highest upside to itself.  Two potential approaches to staving off that concern are as follows:
 

• Downward Adjustment of the Purchase Price.  When negotiating the letter of intent, the Purchaser should consider: (i) tying the Deferred Purchase Price to a fixed period of time notwithstanding when the Closing actually occurs; and (ii) pushing for a downward adjustment of the overall purchase price if a delay in the projected time frame negatively impacts their valuation.  A fixed period on which to base the Deferred Purchase Price may help drive the Seller to a faster Closing, even without a downward adjustment.

 

• Certainty of Realizing the Deferred Purchase Price.  If the Deferred Purchase Price is intended to function as a guaranteed payment with limited upside, rather than a true earnout, then certainty of realization of the Deferred Purchase Price may motivate the Seller to move quickly to close the Transaction.   If the optics around the Deferred Purchase Price are structured such that the Seller can feel confident that they will realize the Deferred Purchase Price, preferably in a tight time frame, it may motivate the Seller to move quickly to a Closing.

 
Using a Deferred Purchase Price creates similar issues for a Seller when the Purchaser does not have enough invested in the outcome of the Transaction because of the reduced capital expenditure at the time of Closing to prioritize it within their own deal flow.  This is increasingly an issue for a Purchaser who is a PE Fund, Hedge Fund, or institution active in the M&A space.  Sellers should be mindful of this risk and, while focusing on the upside that the Deferred Purchase Price can offer, be cognizant that too much of a deferral may delay their Closing and their receipt of funds at Closing.

If you have any questions about this article, please contact me at (212) 573-8030 or jbernstein@sadis.com.