M&A holdbacks, earn-outs and deferred consideration

Three structures leave part of the purchase price unpaid at completion, and they are frequently discussed as though they were one thing. They secure different risks, they fail in different ways, and only one of them turns on a calculation the parties will argue about.

What each one is 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.

An earn-out makes a further payment contingent on the performance of a business the buyer already owns and controls. 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 and the one most often left unsecured.

The calculation question and the security question are separate

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 and it is where most of the negotiation goes.

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. Will it be paid? Usually yes, because most buyers pay what they owe. 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 sellers underprice it at the negotiation stage because they are focused on the calculation.

How the exposure is addressed, in ascending order of seller protection

• 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. Better, and worth exactly what the parent is worth at the time the claim is made, which is not knowable at signing.
• Funding the amount into a segregated account at completion. The strongest security of the three for the seller, and expensive for the buyer, since capital is tied up against a payment that may never fall due.

The middle position we see most often is that a proportion of the maximum is funded and the balance is unsecured, or that the amount is funded once the target is met rather than at completion. The second is weaker than it sounds, because funding at that point still depends on the buyer’s willingness.

Making the release 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, and it appears in drafts more often than it should.

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. A buyer that has funded the maximum and sees the target missed will want its money back promptly, and a seller with no entitlement occasionally becomes slow to sign a joint instruction.

A note on duration

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 is a different commercial proposition by year three, and the parties will not have modelled it.

Reporting matters over that period as well. Both parties should receive balance statements as a matter of course, because people leave and entities are reorganised, and an arrangement nobody at either party remembers the terms of is a problem waiting for the release date. 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.

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.

For sellers who have accepted deferred payment recently: was it secured in any form, and if not, was that a decision or simply the drafting you were given? Tell us the structure and we will confirm what we can hold and how release would be documented.