M&A holdbacks, earn-outs and deferred consideration

Three structures leave part of the purchase price unpaid at completion. They secure different risks, and earn-outs characteristically depend on a post-completion performance calculation.

What is each structure for?

A holdback retains part of the price against a risk that is already identifiable at signing: a warranty exposure, a known tax position, a receivable that may not collect, a consent not yet obtained. It secures the buyer against something the seller has said or promised. Where the buyer also holds warranty and indemnity cover, the exposures a policy leaves with the parties are the ones that reach a holdback.

An earn-out makes a further payment contingent on the performance of the business, typically during a period in which the buyer controls it. It bridges a disagreement about value.

Deferred consideration is simply part of the price paid later, on a date rather than on a condition. It is the simplest of the three.

The calculation and the security are different questions

On an earn-out in particular, the two get conflated. Whether the target has been hit is determined by the accounts, the definitions, and the protective covenants restricting how the buyer may run the business during the earn-out period. That is a drafting exercise for counsel.

It is also outside what an escrow agent can assist with. The agent does not compute the earn-out, does not review the accounts, and does not decide whether a covenant was breached.

Assume the calculation produces a number. Whether it is paid then depends on the buyer’s covenant and its financial position at that date. But by then the seller has lost every point of bargaining power. It has transferred the shares, it has no ongoing role in most cases, and its remedy is a claim against a buyer that may be a special purpose vehicle in another jurisdiction. On a deferred payment of any size that is a real exposure, and it is a separate question from the calculation mechanics.

How the exposure is addressed

• Nothing. The buyer’s covenant to pay, unsecured. Common, and adequate where the buyer is a substantial trade party with a name to protect.
• An undertaking from the buyer’s parent. Its value depends on the parent’s financial position when the claim is made.
• Funding the amount into a segregated account at completion. This gives the seller the strongest position of the three, and ties up the buyer’s capital against a payment that may never fall due.

A middle position is to fund a proportion of the maximum amount and leave the balance unsecured, or to fund once the relevant target is met. The second is weaker than it sounds, because funding at that point still depends on the buyer’s willingness.

How is the release made mechanical?

Whatever is held, the release condition has to be applicable by a party that knows nothing about the business.

The formulations that work are release against a certificate of the amount signed by both parties, release against a determination by a named expert in a defined form, or release on a longstop date absent a notified dispute. “Release when the earn-out is determined in accordance with clause 8” is not a condition an agent can apply.

The reciprocal point matters as much. If the target is not met, or the warranty claim is never made, the held funds return to the buyer, and the agreement should say against what. The return leg should specify the evidence or the date on which the funds revert to the buyer, so that return does not depend on a joint instruction being signed.

Arrangements that run for years

Holdback periods running to the end of a warranty limitation period, and earn-out periods of two to three years, are ordinary. That is a long fundholding period, and it should be priced once, at the outset, for the full term including extensions. An arrangement quoted annually will have cost more by year three than the initial quote suggests.

Reporting matters over that period as well. Both parties should receive balance statements as a matter of course, because personnel and entities change over a period of that length. Where the release produces payments to a large seller register rather than to one account, that is a paying agency exercise and it has its own timetable.

What the agent has to verify

The drafting question is not only when the money becomes payable, but what the escrow agent is required to verify before releasing it.

A joint instruction signed by the authorised signatories, a specified document issued by a named third party, an expert’s determination in a defined form, and a longstop date absent a notified dispute are all mechanics an agent can operate on their face. Each carries a different failure mode, and the one worth testing at drafting is what happens if a party simply goes quiet.

What the agent cannot do is form a view on whether the target was met, whether a covenant was observed, or whether a claim is well-founded. Where the condition turns on that view, the release has been left to a judgement no fundholder is in a position to make, and the parties will discover it at the point they least want to.

Outside the role

Titanium does not compute an earn-out, review accounts, determine whether a warranty or indemnity claim is well-founded, or decide whether a milestone has been achieved. It holds the amount and releases it on the mechanism written into the escrow agreement, and it provides no legal, tax or investment advice.

Common questions

Can Titanium calculate an earn-out?

No. Titanium applies the release mechanism recorded in the agreement and forms no view on the underlying calculation.

How long can funds be held?

Our standard terms do not prescribe a fixed maximum holding period. Where an arrangement runs for years, the agreement should record a longstop date, a defined destination, and how fees are met.

Are statements provided during the term?

Yes. Account statements are issued to both parties throughout the mandate.