06 May 2018

Issues for sellers to consider when adopting deferred consideration structures in a Share Purchase Agreement

Authored by: Hadef & Partners, Sector Groups

In a market where valuation risk is a concern for buyers, some sellers are more likely to have to accept that part of the purchase price in a share purchase sale is likely to be settled through deferred consideration in some form, if they want a sale to complete.

In this article, we breakdown in detail several of the main issues which sellers may face when trying to protect themselves against adverse consequences that might arise under a deferred consideration structure.

  1. Security from a buyer against a payment obligation of that buyer

A seller will always be primarily concerned about being paid in full for any deferred consideration. The type of protection that would ordinarily be sought by a seller will vary depending on whether the payment obligations are fixed or varied (such as in an earn-out structure). The extent of protection that a seller might seek will depend on a number of factors such as the length of the period during which deferred consideration will be paid, any conditions attaching to the deferred consideration, its method of payment and the creditworthiness of the buyer.

  1. Bank guarantees, letters of credit and post-dated cheques

The most common methods of protection in this market are likely to consist of bank guarantees, letters of credit and post-dated cheques (given their draconian criminal sanction). As with all deferred consideration, the complexity of the release mechanisms will vary depending on whether the deferred consideration is fixed or variable. If variable, then we often find that a certain amount of input from the relevant parties to specify the commercial mechanics before suitable drafting can be inserted into the SPA.

  1. Joint deposit account / escrow arrangement

A seller could also consider seeking to have a substantial part of the deferred consideration, if not the whole, placed into a joint deposit account (with signatory release mechanisms structured in a way that would mean this money is effectively “tied up” or held in de facto “escrow”). Buyers normally try to resist this point fairly forcefully, so its likelihood of success will largely be linked to some of the reasons for having deferred consideration in the first place.

  1. Corporate guarantee / promissory note

Another alternative would be for a seller to obtain a robust corporate guarantee from a financially robust shareholder of the buyer or other related party (including a parent company guarantee if the buyer is a subsidiary of a larger corporate group), or the target itself if this is appropriate. We tend to also use forms of promissory notes to the same effect if we are working in a UAE context, given the advantages conferred upon these under applicable law.

  1. Security over assets or pledge over shares

Under certain circumstances, a seller may try to obtain security over the assets of the buyer or a pledge over the shares held in the buyer (or the target if appropriate). However, this may not be meaningful if there are senior lenders and in the case of a pledge of shares, the seller is unlikely to want to have to assume an “investment” in the buyer, or the target, if it needs to enforce this pledge. The DIFC has a clear legal framework and procedure in place for registering a pledge over shares in a company established in the DIFC in favour of a person, company or financial institution. Article 79 of the Federal Law No. (2) of 2015 Concerning Commercial Companies and a large proportion of the different free zone rules and regulations recognise the concept of a share pledge and there are processes and procedures for notarisation and registration of a share pledge. However, in practice, save for in the DIFC, a share pledge is likely to only be notarised and registered in “on-shore” Dubai or in a free zone if the pledge is in favour of a financial institution (such as a bank) rather than a private limited company or individual and therefore, as it stands, these forms of security are only practically implemented in the DIFC, or a suitable offshore jurisdiction.

  1. Control over retained earnings

Although more relevant generally to protections under an earn-out structure, a seller may wish to prohibit a buyer from carrying out certain material actions in respect of the target to obtain some form of control over the use of retained earnings in the target, if it is agreed that this will have a secondary obligation to pay the deferred consideration, if the buyer fails to do this in its primary obligation. A seller may feel more comfortable having the target entity that it has sold, as providing a guarantee for payment given the seller’s understanding of that entity’s ability to pay deferred consideration.

  1. Restrictions over assignment of assets

Finally, a seller may require a buyer to agree that it can not assign the target’s assets (or any benefit in these) to any person without the consent of the seller.  In particular, the seller may want the assignee to also accept the burden to pay the deferred consideration as well, subject to the seller being satisfied as to the creditworthiness of that assignee.

  1. Right of set-off by a buyer
  1. General right to set-off

In general, a seller would tend to resist any general right of a buyer to set-off claims against deferred consideration. A fairly aggressive buyer will try to include a general right of set-off to try to reduce any payment of deferred consideration owed to a seller if the buyer has a claim, namely a warranty or indemnity claim, against the seller.

This general right can be a real concern for a seller as it gives a buyer a contractual right to unilaterally withhold payment of any deferred consideration, leaving the seller having to resort to the dispute procedure set out under the SPA to reclaim such payment. This general right can be set out in a specific clause or as is often the case, arguably quite mischievously as it is a major term for a seller to amend, may be buried in the detail of a SPA. 

  1. Claim to be determined and agreed under an arbitral award/expert

If a right of set-off is accepted in principle, then the better position for a seller is for the claim to have been determined and agreed under an arbitral award (or whichever other dispute resolution process is applicable); the main alternative and slightly weaker position for a seller is for the matter to be decided by a relevant expert (depending on the nature of the claim).

  1. Earn-outs

If the form of deferred consideration is that of an earn-out, a buyer would naturally want to be able to set-off against any amount payable to a seller but this should be refined and adapted for each specific deal.  One purpose of a particular earn-out may be to incentivise a seller to help a buyer achieve certain performance criteria for a target. Therefore, any indemnity claim from a buyer may require the buyer to invoke its set-off right quite early during an earn-out period, which would then of course defeat the original incentivising purpose. However, if the seller will not be involved post-completion in a target, then a buyer would naturally want to have a right of set-off against an earn-out payment.

  1. Protection for a seller during an earn-out period

Sellers will naturally need to ensure that the earnings of the target company on which their earn-out is based are protected from any adverse events that could occur as a result of actions of the buyer following completion, to the maximum extent possible.

The typical issues that a seller would want to address during the earn-out period would include the following:

  • ensuring that funding of the target business is maintained at a healthy level in order to remove working capital pressure;
  • the buyer undertaking that it will operate the target in the ordinary course of business in a manner which is consistent with historic practice;
  • the seller having control or consultation rights over key material decisions that might affect the target’s business;
  • defining parameters for pricing certain products/services or business plan changes;
  • payment of the earn-out in full upon the earlier of the occurrence of certain “liquidity events” such as:
  1. sale of the whole or a substantial part of the target or a sale of material assets of the target;
  1. any exit by the buyer of the either the whole or a substantial part of any interest in the target; or
  1. refinancing of facilities in a manner that may affect ability of buyer to make an earn-out payment.
  • monitoring rights for the seller in being able to access the target’s financial records to carry out its own calculations regarding the progress of its earn-out;
  • ensuring that clear and realistically measureable performance criteria using only key variables are set out in sufficient detail with an objective process for their determination (which is an issue that tends to result in significant detail being negotiated); and
  • ensuring that the earn-out period is sufficiently short enough to ensure that actions by the buyer have less chance of affecting the ability for the earn-out to be achieved, whilst also providing the seller with a certain level of comfort given its knowledge of the activities of the target at that time.

Summary

In summary, there are a number of reasons to adopt deferred consideration for both parties, especially given current market conditions and the fact that valuations based on the past three years of financial accounts may not provide a sufficient basis for confidence in future earnings.

It is clear that sellers will always naturally be very reluctant to accept deferred consideration structures and it is often this reluctance that can prevent a transaction from proceeding. We believe that protections that are well designed for a seller should be able to address the reasons that underpin this reluctance whilst, if balanced and reasonably fair, should also be acceptable to certain buyers.

Adopting a pragmatic approach to understanding underlying concerns in this situation and drafting appropriate protections that address these for both parties in a manner that tailors the SPA specifically to the priority attached to these concerns can be of great assistance in ensuring that certain deals can be progressed and completed.

For more information, please contact us on sectors@hadefpartners.com