David Beveridge, managing director of Macdonald Henderson
Recently, business commentators have spent a lot of time scratching their heads to identify common trends in the Scottish deal market aside from (with a few exceptions) a massive senior-lender-shaped hole in the funding market.
Other than a trend of global players swallowing up well kent Scottish companies and ownership and control leaving these shores as a result, it’s difficult to identify a pattern or make a forecast.
However, one trend we have identified in the course of the last few years is the increasing prevalence of deferred consideration in the acquisition and disposal of businesses, whether they be small, medium or large enterprises.
Deferred consideration: What does it look like?
Invariably there will be a payment up front with the back end taking the form of either equity in the acquiring company (quite common if a PLC is the purchaser) but more often than not (and certainly in the SME market) a promise to pay cash dependent upon:
** The passing of time (i.e. a fixed payment schedule)
** The finalisation of completion accounts
** The achievement of profit targets
** The achievement of turnover target or some other performance based measure such as the winning of particular sales contracts.
Of course this allows the purchaser to defer the acquisition cost (and usually make savings when compared with the cost of traditional forms of borrowing).
Benefits for all parties
The benefits to all parties are clear. In a period of poor liquidity, deferred consideration mechanisms can let the deal be done, allow sellers to retreat from the business whether to retirement or to a new business challenge, and of course give management teams and/or third party purchaser the opportunity to take the target business to new levels of profitability and into new markets. It allows the parties to sign legal documents, effect the transaction and achieve a form of closure, whilst allowing the consideration to drip through in a manner customised to the specific sensitivities of the parties and the business.
So far, so good.
For the seller however, the deferred consideration route is fraught with danger and needs to be approached very carefully indeed.
The risks and mechanisms to alleviate these risks can be summarised as follows:
The purchaser’s covenant
If the purchaser is broke or unable to pay the consideration, then the seller has lost its right to payment. There is no third party insurer or governmental authority to which appeal can be made. If the purchaser ends up going through an insolvency event, then the (unsecured) seller will be exposed (as an ordinary creditor) and will in all likelihood end up with nothing.
And the advisors could then find themselves asked to explain why the seller was left so exposed under the deal structure adopted.
How can this be avoided?
Funds on Joint Deposit
Ideally, in an acquisition scenario, the Purchaser is a cash-rich predator on the acquisition trail and has the funds to meet the deferred consideration (in which case, the seller should be fighting tooth and nail to have the funds placed on a joint deposit account (perhaps between the parties’ solicitors) where all parties have visibility on the same. Note that this does not (as some sellers sometimes assume) allow them free reign to take the funds as the conditions are met. Rather, signature by the solicitors will be required to effect any release of funds. But the security of seeing the funds held between reputable and regulated advisors can help ease a seller’s concerns and give all parties the comfort that matters are at least under some control.
Bank and other guarantees and securities
In the absence of a joint cash deposit, we would always recommend that a seller seeks either a bank guarantee or alternatively (and more likely in the current climate) a guarantee from either the owner managers of the purchaser ie. a personal guarantee or corporate guarantee from a related group company which has a proven covenant and balance sheet. This can be backed up by security over a property or other assets whether personal or that of the business, though the existence of a senior lender on the purchaser side will usually mean that such security is postponed, and therefore of at least questionable value.
Assignation and alienation of assets
The well negotiated terms of deferred consideration will be worthless if the purchasing company has no assets, or is allowed to divest itself of its worth following the acquisition. The latter issue can arise in a situation where a purchaser seeks to get rid of its liabilities by assigning the same to an associated company. The seller can tackle this by providing in the sale agreement that no assignation can take place without its consent, and/or unless the assignee meets certain criteria such as having commensurate financial strength, reputational strength or be resident in the same location or jurisdiction as the assignor. Another provision is to provide that the burden as well as the benefit under the agreement must be assigned together so that the purchasing vehicle is not left behind with the liability to pay, but none of the original assets.
In short, a blanket veto over any assignation is the seller’s preference.
Accepting paper money: Shares in the purchaser
A quick word should be said about accepting paper money ie. shares in the purchaser, whether it be a private or public company. Clearly the seller is tying up their right to payment for their shares in the business with the fortunes of a company in which the seller has little or no command or control. The risk of the old warning – “shares can go down as well as up” is well worth repeating at this juncture. Often sellers can be dazzled by a plc’s interest, in the shiny offices, shiny advisors and shiny large figures, particularly round share prices and market capitalisation.
The recent stock market activity should provide a timely reminder of the volatility of markets and the risk of selling one’s life’s work and business – for paper.
Avoid or mitigate a right of set off
“Set off” - this fairly innocuous phrase can often appear in heads of agreement, and be allowed to pass without comment.
But it hides a serious risk to the seller’s wealth.
The seller should be made well aware of any set off rights which are very often well disguised in the context of a large purchase document and which can give the purchaser carte blanche to hold back cash if it claims that a warranty or indemnity in the purchase document has been breached following completion of the deal.
There are sensible compromises we can suggest to allow the seller to exercise some control on the purchaser’s right of set off. One of the most prevalent is to agree that the purchaser should have a right of set off, but only once the claim underpinning the set off claim has been adjudicated to be “reasonable” and have some basis in reality. The simplest route to achieve this is to set up a process where by one or both parties can refer the matter to a third party expert – for legal issues, perhaps counsel, for financial issues, perhaps an independent accountant.
Once the opinion has been generated, the sum can be set off, or released to the seller or locked up in an account (such as the joint solicitors’ deposit suggested above) just as determined by the expert.
The overarching issue arising out of post-deal seller concerns (where there is money still due and owing), is the loss of control.
But this need not be the case. A canny seller will provide in the sale agreement a list of matters which the target and or the purchaser may do and not do without the seller’s consent.
These can vary from case to case, but will usually cover strategic matters such as branching into a new market or area of business, making an acquisition, selling a part of the business, lending money to an associated company or commencing a significant capital expenditure programme, to taking on new senior employees, commencing large litigations or opening new offices.
If the deferred consideration is based on profitability, the seller will want to know that the profit generating entity is left intact, and not interfered with, stripped of resource or sales diverted from its coffers to other divisions of the business. There may be key people who the seller may wish to see remain in place and not redeployed until the profit earning period has expired.
The seller at the very least should be insisting that it sees regular and frequent management accounts information for the relevant business and in a form which satisfies the vendor’s requirement for visibility and more importantly, accountability.
Bring the lawyers in early
Or at least when the parties are sitting down to agree outline heads of terms.
Many of the issues detailed above – guarantees, joint deposits, rights of set off, management controls – are so fundamental to the parties and their understanding of the deal that to omit these, or to accept principles without exploring the ramifications can have serious consequences later in the transaction process.
It is often very difficult for either party to introduce qualifications on rights to payment or set off near to the completion date without putting the underlying agreement under stress and risk upsetting the trust and confidence between the parties and perhaps even the deal itself.
For the seller the aim must be to secure as much money as possible up front in the initial deal negotiations - sometimes even at the cost of accepting a reduced price for the business. We have seen many occasions, particularly in the current climate, where purchasers have sought to claw back what has turned out to be a bad commercial deal (due to market and other forces) by welching on payment of consideration which was otherwise payable to the seller.
By the same token, we can attest to a fair number of purchasers who have been extremely grateful for the inclusion of set off mechanisms which, though at the time seemed complex and over detailed, gave them the golden ticket to hold back consideration as a vendor’s skeletons come marching out of the wardrobe.
Whether you are a seller or a purchaser, or advising on either side, deferred consideration is a fact of like in the corporate deal market, and the tensions and balance of getting this right can determine whether the deal is “worth the paper”.