Deferred consideration: Meaning, Criticisms & Real-World Uses

What Is Deferred Consideration?

Deferred consideration, in the realm of corporate finance and mergers & acquisitions, refers to a portion of the purchase price for an acquired business or asset that is not paid at the time of the initial transaction closing but is instead paid out at a later date. This financial arrangement falls under the broader financial category of acquisition accounting. It is distinct from the upfront payment and is often contingent on certain future events or performance targets being met. Deferred consideration can take various forms, including cash, shares, or other assets, and its value is typically determined at the acquisition date.

History and Origin

The concept of deferred consideration has evolved alongside the increasing complexity of mergers and acquisitions. As businesses sought to mitigate risks and align the interests of buyers and sellers, mechanisms for structuring payments beyond an immediate lump sum became more prevalent. The formal accounting treatment of deferred consideration gained significant clarity with the development of international and national accounting standards. For instance, the International Financial Reporting Standard (IFRS) 3, titled "Business Combinations," outlines how contingent consideration (a common form of deferred consideration) should be recognized and measured in financial statements. IFRS 3 emphasizes that contingent consideration should be measured at its fair value at the acquisition date.⁷, ⁸, ⁹, ¹⁰

Key Takeaways

Deferred consideration is a part of the acquisition price paid at a later date, not at closing.
It is often contingent on future performance or specific events.
This mechanism helps align the interests of both the acquirer and the seller.
Deferred consideration can be paid in various forms, such as cash or equity.
Its accounting treatment is crucial for accurate financial reporting.

Formula and Calculation

While there isn't a single universal formula for "deferred consideration" itself, as it represents a payment structure rather than a calculated value, the present value of deferred consideration, especially when contingent, is a critical calculation in acquisition valuation.

For a simple deferred payment not subject to contingencies, its present value would be:

$PV = \frac{FV}{(1 + r)^n}$

Where:

( PV ) = Present Value of Deferred Consideration
( FV ) = Future Value of Deferred Consideration (the amount to be paid later)
( r ) = Discount Rate (reflecting the time value of money and risk)
( n ) = Number of periods until payment

For contingent deferred consideration (often called an "earnout"), the calculation becomes more complex, involving probability-weighted scenarios for various outcomes. Financial modeling is typically used to estimate the fair value of such arrangements.

Interpreting the Deferred Consideration

Interpreting deferred consideration involves understanding its implications for both the buyer and the seller. For the buyer, it represents a liability—a future obligation to transfer economic resources. The size and conditions of the deferred consideration indicate the level of risk sharing between the parties and the buyer's confidence in the acquired entity's future performance. A higher proportion of deferred consideration tied to specific performance metrics might suggest that the buyer seeks to ensure the acquired business delivers on its promises. For the seller, deferred consideration represents a future cash inflow, often providing an incentive to remain involved or ensure a smooth transition and continued success of the divested operations. The terms of the deferred consideration can significantly impact the overall return on investment for both parties.

Hypothetical Example

Consider "Acme Corp" acquiring "Innovate Solutions" for a total consideration of $100 million. The agreement specifies $70 million paid upfront and $30 million as deferred consideration. This $30 million is structured as an earnout, payable over three years, contingent on Innovate Solutions achieving specific revenue targets.

Year 1: If Innovate Solutions generates $10 million in new recurring revenue, Acme Corp pays an additional $10 million.
Year 2: If Innovate Solutions increases its customer base by 20%, Acme Corp pays another $10 million.
Year 3: If Innovate Solutions launches a new product that captures 5% market share, Acme Corp pays the final $10 million.

This structure allows Acme Corp to pay a significant portion of the purchase price only if Innovate Solutions meets predefined growth and operational milestones, thereby aligning the seller's post-acquisition incentives with the buyer's financial objectives. The purchase price here is effectively split into an immediate payment and a performance-based future payment.

Practical Applications

Deferred consideration is widely applied in various business transactions, particularly in mergers and acquisitions (M&A). It is commonly used in scenarios where there is uncertainty about the future performance of the acquired business, or where the seller's continued involvement and motivation are crucial.

Technology and Biotech Acquisitions: In these sectors, where the value of a target company often relies on future product development, regulatory approvals, or market adoption, deferred consideration (often in the form of "earnout" clauses or contingent value rights) is prevalent. For example, Eli Lilly and Company's acquisition of Prevail Therapeutics included a contingent value right (CVR) as part of the total consideration, payable upon the first regulatory approval of a Prevail product. T⁴, ⁵, ⁶his illustrates how payments can be tied to the achievement of significant milestones.
Small Business Sales: When a small business owner sells their company, part of the payment might be deferred to ensure a smooth transition of clients, employees, and operations.
Private Equity Transactions: Private equity firms often use deferred consideration to incentivize management teams of acquired companies to meet specific operational or financial targets post-acquisition. This helps align the interests of the existing management with the private equity firm's goals.
Seller Financing: While not exclusively deferred consideration, seller financing arrangements can incorporate deferred payment terms, allowing the buyer to pay over time, often with interest.

The use of deferred consideration impacts enterprise value and the overall deal structure.

Limitations and Criticisms

While deferred consideration offers benefits in M&A transactions, it also comes with limitations and potential criticisms. One major challenge lies in the complexity of valuing and accounting for these arrangements, especially contingent payments. Estimating the fair value of contingent consideration at the acquisition date can be subjective and require sophisticated valuation techniques, which may lead to discrepancies or future adjustments.

³Another criticism centers on potential disputes between the buyer and seller regarding the achievement of performance targets. The metrics used for earnouts can be influenced by post-acquisition decisions made by the acquirer, potentially creating a conflict of interest. For example, if the buyer integrates the acquired business in a way that negatively impacts the earnout metrics, the seller may feel unfairly treated. This can lead to legal battles or strained relationships.

Furthermore, deferred consideration, particularly if substantial, can create uncertainty for the seller. The full value of the deal is not guaranteed, and the seller's liquidity is impacted by the waiting period. From an acquirer's perspective, while it defers some payment, it also keeps a liability on the books and requires ongoing monitoring and potential adjustments to the financial statements. The intricacies of these arrangements necessitate careful legal and financial due diligence.

Deferred Consideration vs. Contingent Consideration

While often used interchangeably, "deferred consideration" and "contingent consideration" have distinct nuances in corporate finance.

Feature	Deferred Consideration	Contingent Consideration
Payment Certainty	Payment is certain to occur at a future date, though the exact amount might vary.	Payment is uncertain and depends on specific future events or conditions being met (e.g., performance targets).
Primary Driver	Time-based payment, often for cash flow management or administrative convenience.	Performance-based payment, primarily used to align incentives and mitigate risk.
Examples	Fixed installments paid over a period; a retention amount held back for a set time.	Earn-outs based on revenue or profit milestones; payments tied to regulatory approvals or successful product launches.
Accounting Impact	Generally a fixed liability, discounted to present value.	A liability that needs to be measured at fair value at the acquisition date and subsequently re-measured. ¹, ²

In essence, all contingent consideration is deferred consideration, as it is paid later, but not all deferred consideration is contingent. Deferred consideration encompasses any payment made after the closing date, while contingent consideration specifically refers to deferred payments whose release is subject to predefined conditions. The accounting for deferred revenue or deferred tax accounts, while involving deferral, is a different accounting concept.

FAQs

What is the main purpose of deferred consideration?

The main purpose of deferred consideration is to bridge valuation gaps between buyers and sellers, align the interests of both parties after an acquisition, and mitigate risk for the buyer by making a portion of the payment contingent on the acquired business's future performance or other specific events. It can also assist with the buyer's cash flow management.

How is deferred consideration typically paid?

Deferred consideration can be paid in various forms, including cash, shares (equity), or other assets. The specific form of payment is outlined in the acquisition agreement. The choice often depends on the buyer's financial position, tax implications, and the preferences of the seller.

Is deferred consideration a liability on the balance sheet?

Yes, deferred consideration is typically recognized as a liability on the acquirer's balance sheet at its fair value on the acquisition date. For contingent consideration, this fair value may be re-measured in subsequent periods, with changes recognized in profit or loss. This ensures proper financial reporting.

What happens if performance targets for contingent deferred consideration are not met?

If the specified performance targets or conditions for contingent deferred consideration are not met, the buyer is generally not obligated to pay that portion of the consideration. This is precisely why such arrangements are used: to protect the buyer from overpaying for future performance that does not materialize. This can affect the ultimate valuation of the deal for the seller.

Can deferred consideration be negotiable?

Yes, the terms of deferred consideration are highly negotiable during the due diligence and negotiation phases of an acquisition. This includes the amount, the payment schedule, the specific triggers for contingent payments, and the form of consideration. Both parties typically engage in extensive discussions to arrive at mutually agreeable terms that reflect the deal's overall risk and reward profile.