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Home > News > MBOs – how long should deferred consideration be deferred? And should interest be paid?

MBOs – how long should deferred consideration be deferred? And should interest be paid?

13 June 2022 | Paul Hardman

Paul Hardman, Director and Head of Corporate & Commercial Law, provides a detailed guide to deferred consideration in the context of MBOs, a topic he is often asked to explain.

MBOs and deferred consideration

The situation is that the owners of a company have agreed terms for the sale of their company to its management team.  There may be some available spare cash in the company (in excess of working capital requirements) and the management team may be able to raise some funds.  In addition, they may be able to borrow some money from the bank or other lenders but that may still leave a funding gap – see illustration.

The Funding Gap

In this illustration the total value of the owner’s shares in the company is represented by the large triangle.  The top slice of the triangle is the spare cash in the company and amount that the management team have available to fund the purchase.  The bottom slice is the amount that the company can raise from banks or secondary lenders.

 

Owner Support

There are a number of ways that the funding gap can be filled but all of them involve some degree of risk and that risk is that the management team that are taking over will make a success of the business they are about to take over.  With smaller businesses and untried management teams the person often best placed to make that call is the owner. 

The support takes the form of an agreement that the agreed price for the company can be paid over a period of time (deferred consideration).  There are two questions that arise at this point in discussion, the period of payment of the deferred consideration and whether interest is payable on the deferred amount.

We have done some analysis of recent deals on these questions and the picture is as follows:  

Date

Deal Description

Payment on Completion (% of total deal value)

Deferred Payment (% of total deal value)

Interest

Feb 2021

Founder selling to management team and retiring to do other things

0%

16 monthly payments using Loan Notes

5% pa fixed

Mar 2021

Founders who had already left the business selling to management who had been in place for some time.

100%

0%

NA

July 2021

Founders selling to young management team willing to take on the business

50%

50% over 2 years

Only in the event of default (5% pa)

Feb 2022

Founders selling to young entrepreneur willing to take on the business

36%

76% up to 4 years

Rate rising over 4 years from 4% pa to 9% pa

This is a small sample but even from this it can be seen that there is a huge variation.  In my experience the factors at play include:

  • Owner’s needs – specifically the owner’s financial needs;
  • Cash flow – the effect of the extra financial burden on the company;
  • Legacy – the extent to which the owner wishes to see his or her business continue to the next generation
  • Tax – and specifically whether there will be enough to pay the tax liability that arises on sale when it becomes due.

In most cases deferred consideration is paid within 4 to 5 years and some payment is made on completion: the longest period I have ever heard of is 15 years, but I do not know whether that deal completed successfully.  The reasons for keeping it to a relatively short period is that as time moves on so the business that the owner will have created and developed changes and it ceases to be the business that the parties were relying on to pay the deferred consideration when they agreed the deal. 

It helps the deal process move along to completion if the management team have put up some of the funding or personally guaranteed a bank loan as that process creates deadlines.  It also helps if there is some payment on completion as otherwise there is little incentive on the owner to change from simply continuing to take the profits from the business whilst the management team work for him or her. It also helps to fund the professional costs that will be incurred on both sides.

Typically, the owner accepts instalments of deferred consideration as delayed payment rather than a loan and does not charge interest, although as bank interest rises with inflation, we may see that changing.

Accelerated Payment

When considering these questions, it should be borne in mind that the final terms will include events which accelerate payment of deferred consideration.  These include typical ‘events of default’ such as insolvency related circumstances but also can include:

  • A failure to pay an instalment on time
  • A change of control, in other words if the management team decide to take on a new investor
  • A sale of the company or the business by the management team
  • A re-financing of the company – in other words if the company is able to fill the funding gap using bottom slice bank funding.

These will need careful consideration in each case.  The effect of any one of them happening will be that the deferred consideration is immediately due and payable thereby bringing forward any agreed deferral period. 

Specialist legal advice

Our expert team of corporate lawyers are on hand to offer advice and support every step of the way. If you would like to discuss your situation, please call 0117 906 9400 or email hello@gl.law 

The contents of this article are intended for general information purposes only and shall not be deemed to be, or constitute legal advice. We cannot accept responsibility for any loss as a result of acts or omissions taken in respect of this article.

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