Tech M&A: Key Pitfalls to Anticipate and Avoid With Deferred Consideration
03 June 2024
In this article, partners Chris Grey, Jonathan Cohen and Stuart Dullard from Ashurst's global Tech M&A group provide practical guidance to help investors, companies and founders avoid pitfalls when using deferred consideration to bridge valuation gaps for deals in the technology sector. This article is the second of Ashurst's new Tech M&A series highlighting key issues, opportunities and risks for investors, companies and founders from a global perspective, starting with the UK.
Deferred consideration in the technology sector
Our previous article set out a range of alternative structures to solve for challenges unique to deal-making in the technology sector. We explained that technology companies can be particularly difficult to value and set out a list of alternative structures that we have successfully leveraged to facilitate deal-making and find common ground in a fast-moving market. This article highlights some of the key pitfalls to avoid when implementing one category of those alternative structures: deferred consideration mechanics.
Balancing complexity vs practicality
A common theme is that the more bespoke the structure and the greater its complexity, the greater the risk that there could be a post-closing dispute. In practice, any mechanism that defers the payment of consideration can also be seen as providing a buyer with de facto negotiating leverage against the seller. It is therefore critical that these provisions be expertly drafted as ambiguous provisions can become a lever to dispute calculated payments and revise the price in their favour or be used to set-off deferred consideration against accumulated rights elsewhere in the transaction documents (e.g., warranty or indemnity claims).
Key pitfalls to anticipate and avoid
Common hotspots in relation to negotiating and implementing deferred consideration mechanisms include:
- Payment Trigger Disputes. The transaction documents will need to set out a clear mechanic to determine whether or not a deferred payment has in fact been triggered. Getting this mechanic wrong can be value destructive for either party and so needs to be thoroughly tested by commercial, accounting and legal teams working together. Post-closing, if the parties are unable to agree when implementing the trigger or mechanic, there will also need to be an efficient and sensible process for the resolution of any disputes, usually by expert determination. The process should be clear and minimise either party's ability to stall to its advantage. It should appoint an independent expert that is best suited for the purpose (e.g., an accounting firm or investment bank or technical expert) with specific criteria or a pre-agreed list and should provide a solution if the independent expert refuses appointment or is otherwise unavailable (e.g., due to conflicts).
- Unsuitable Accounting Policies. Deferred payment structures will usually require the parties to agree on a set of accounting policies that will apply when determining the relevant triggers and calculating payments. Usually, the seller will want to use the accounting policies that applied to the target prior to closing because they are familiar and were the basis for its valuation of the target. The buyer will want to use its own policies that it will have imposed from closing. Both positions are defensible, however parties will often seek compromise by starting from the deal-specific policies agreed in the transaction documents to calculate the purchase price at closing, with appropriate amendments. This will be an important commercial discussion to be settled in the transaction documents.
- Unrestricted Buyer Conduct: A seller should draft protections that will ensure that wherever there is deferred consideration, the buyer is required to use appropriate efforts to ensure the triggers are satisfied. Other protections include negative covenants and undertakings to ensure that there are no material changes to the target business (i.e., asset perimeter, business activity) without seller consent during the deferred consideration period. This allows the seller to conduct a true 'like for like' comparison when measuring the target's financial or other performance against the deferred consideration metrics.
- Unforeseen Tax Treatment. The parties should obtain appropriate tax advice with respect to the treatment of any deferred consideration prior to entering into the transaction. For example, it will be important to determine whether the structure and its specific features will result in the full amount of the expected deferred consideration becoming taxable at closing or only upon actual payment, or whether the payments are taxed as income.
Looking ahead
Deferred consideration mechanisms can be an indispensable tool to bridge disagreements over valuations, however they are by definition complex. Buyers and sellers alike would be well advised to seek expert advice prior to entering into these structures. Our global team of Tech M&A experts have successfully implemented a range of bespoke structures to facilitate deal-making in the rapidly changing technology sector. We would be more than happy to discuss how these can be tailored to your transactions in the coming year.
