Mergers & Acquisitions – Covid-19 and the Problem of Deferred Consideration
Many corporate Mergers & Acquisitions (M&A) transactions are structured with part of the purchase price being deferred. In the current climate, whether you are a seller or a buyer in this situation, it serves to check whether the expectations which were set when the deal was done remain on course to be met. Paul Hardman and Bridget Juckes from our Corporate team and Richard Gore from our Commercial Dispute Resolution team shed light on the factors to be considered.
Types of Deferred Payment
The two types of the deferred payment are a simple postponement of a fixed amount of purchase price, for instance an installment payment of the price payable after completion, and a contingent payment where part of the price is determined by reference to some measure of trading activity post completion such as turnover or net profit or linked to some other agreed measure such as the stock market quoted price of shares.
The amount payable under the simple deferral method is unchanged by the current circumstances but there may be issues around enforcement (see below).
Depending on the measure agreed, the starting point for calculation of the contingent payment method is the formula set out in the agreement. This may produce an unexpected and unanticipated result but subject to further comments below, that is not a concern of the courts who will simply enforce the contract in accordance with its terms.
Particular issues to note here are to consider whether any amount already paid can be reclaimed by the buyer. If the formula produces an unduly negative result it can mean that the aggregate purchase price is reduced below the amount that has already been paid. This is often addressed through drafting in the contract which may make specific provision against that eventuality.
It may be possible to argue that the outcome from using the agreed measure is so perverse that the parties if they had turned their mind to have it to it would have agreed some saving measures to ensure an outcome more in line with the common intention. In addition, if the measure adopted can no longer be used for instance a stock market listing is suspended it may be possible to argue that the contract is frustrated.
Looking at it from the seller’s perspective, once the amount is determined it will be a matter of enforcing the payment obligation.
The first point to check is whether the debt is owed by a company or by individuals and if owed by a company whether there are any personal guarantees of that company’s liability.
If security has been obtained it will be a matter of checking whether a deed of priority (also known as an intercreditor deed or deed of postponement) in effect obstructs the right of enforcement. For instance, typical deal structures for a management buy out involve borrowing from the bank who take first priority and without whose assistance the sellers will not be able to take enforcement action.
If security has been created over the shares in the company (the target company as was), and the sellers have a right to reacquire the shares in target company or the buyer company typically this right is outside a bank’s priority rights.
If that right is a security right then the sellers will not have an absolute right to own the company but rather a secured creditor’s right to sell the shares (again) and use the proceeds to pay off the amount that they have left outstanding owed to them with the balance going to the purchaser. In reality this may simply give the sellers a more advantageous negotiating position with the buyer when it comes to re-scheduling the payment.
Alternatively, if the right to reacquire is in the form of an option then the sellers will have the absolute right to take back control and ownership of the target company providing the rules of the option agreement are carefully observed.
The sellers may in addition or instead have the right to re-appoint to the board and so contribute to the overseeing of the running of the company and have access through the directorships to company accounts, forecasts and other records. Typically, this would not be affected by bank priority but does not come without the risk associated with director duties.
Warranty Claims and Retentions
From the buyer’s perspective, it may be tempting to look to the warranties as a means to reduce any deferred payments. Warranties speak from the date of completion however and typically acts and omissions of the buyer are specifically excluded from warranty claim.
Any deal done prior to the current Covid-19 related circumstances will not have had the benefit of foresight and therefore even warranties relating to forward forecasts may not prove fruitful to a buyer on the basis that the sellers would even now be able to say that at the time their forecast numbers were based on beliefs reasonably held.
Amounts retained from the purchase price may fare better. A retention will typically be made against final outcome of completion accounts and even though post completion trading conditions may be excluded from consideration, the impact on the business, for instance in unpaid debts, may find its way back into the balance sheet as at completion.
Warranty claims are often used strategically by buyers (irrespective of merit) where they believe they have over paid, as a means to secure a better outcome in negotiations on deferred and retained amounts.
This article does not consider the other way of bridging the value gap on an M&A deal namely using the buyers shares to pay for part of the purchase price. We will produce separate guidance on this topic.
Tax considerations should also be borne in mind in these circumstances. Sellers will have had the opportunity to either pay tax on the full amount of the purchase price including the deferred or contingent element or to defer payment until the amount is determined and actually received. There may be tax mitigation steps available where payment has been deferred but in the case of tax paid it may be a matter of making the most of the losses available. In each case specialist tax advice should be taken.
In these current circumstances, sellers and buyers should examine carefully the suite of documents executed at the time of the sale and take further advice on options and strategy. If an agreement is reached between the parries to vary the terms of the original deal, it will be important to make sure that the terms are in writing and clearly record the agreed variation to avoid dispute in the future.