Understanding deal structure: cash, deferred consideration and earnouts

In short: Headline value is the start of the analysis. What matters is how much is paid at completion, how much is fixed but deferred and how it is secured, how much depends on future performance and who controls the measure, what equity you keep and on what terms, and how the price mechanism adjusts the figure. Compare offers on fixed consideration first, with a view on its credit risk, then on what the contingent elements would pay under downside, base and upside cases built from stated assumptions. Every figure in this guide is an illustration and none is a benchmark.

From enterprise value to what you receive

Four numbers get confused in negotiations, and the gaps between them are where value moves.

• Enterprise value is the price for the business as a whole, usually expressed as a multiple of normalised EBITDA or sometimes of fee income. It is the headline.
• Equity value is what the shareholders receive for their shares: enterprise value plus cash, less debt and debt-like items, adjusted for the difference between actual working capital and an agreed normal level. Agency deals are commonly agreed on a cash-free, debt-free basis, and the definitions of cash, debt and working capital are negotiated. Deferred income, client deposits, accrued bonuses, unpaid tax and dilapidations are examples of items that get argued over.
• Cash received at completion is the part of the consideration paid on the day, after the completion adjustments and after any escrow or retention is held back.
• Total seller receipts is everything a shareholder is paid in connection with the sale, across all dates and all components, before fees and tax. An undiscounted total that includes an earnout or shares is a maximum that may or may not be reached, and should never be described as cash proceeds.

Three things are easy to count twice. A loan the company owes to a shareholder, options to be settled on completion and transaction bonuses are all debt-like items that reduce equity value; the people owed them are then paid from the company or at completion. They are deducted once, in the bridge, and paid once, in the funds flow. They are not deducted again from what the shareholders receive.

Cash received at completion

Cash received at completion is the component with the fewest conditions attached, which is why sellers prefer it. It is still not unconditional. Before completion, conditions may have to be satisfied: client or regulatory consents, financing, a reorganisation. At completion, the figure is reduced by the adjustments to equity value, part of it may sit in escrow or be held as a retention against warranty claims, and under completion accounts the final figure is not known until some months later. After completion, warranty and indemnity claims can still be made against the seller, within the agreed caps and time limits.

Rick’s experience in Motion’s part of the agency market is that buyers frequently resist paying more than half of the total consideration on completion, because they want the seller to carry some of the risk of the business they are buying and to stay engaged through handover. That is an observation from our own work. It is no market benchmark and no rule. The proportion paid on the day depends on the buyer’s type and funding, the seller’s negotiating position, the quality of the evidence and the length and importance of the handover. Offers with a higher proportion of cash do not necessarily carry a lower total; the relationship depends on the specific buyer and process.

Fixed deferred consideration

Fixed deferred consideration is a defined sum payable on defined dates, independent of performance. It is money the buyer owes and the seller has yet to receive: in substance a loan from the seller to the buyer, so the questions are those a lender would ask. It is sometimes described as certain, or as a floor. It is neither; it is a fixed obligation carrying credit risk.

• Credit and security. Who exactly owes the money: a holding company with assets, or an acquisition vehicle with none? Is the payment secured on assets, held in escrow, or simply a promise? A parent company guarantee is only as good as its terms (what it covers, for how long, and whether it can be withdrawn) and the guarantor’s financial strength, which you should assess from its accounts.
• Set-off. Can the buyer deduct warranty or indemnity claims from the deferred payment? Set-off rights turn a fixed payment into one that is paid in full only if no claim is asserted, and they shift the burden of disputing a claim onto the seller.
• Subordination. Does the buyer’s bank require the seller’s deferred consideration to rank behind its own lending, or to be paid only if the bank’s covenants are met? Subordinated deferred consideration can be deferred again without the seller’s consent.
• Interest and acceleration. Is interest paid on the outstanding amount, and does the whole sum fall due if the buyer sells the business, defaults or is itself acquired?
• Enforcement and insolvency. How would you recover an unpaid instalment, at what cost and in which jurisdiction? If the buyer fails, where does the seller rank among creditors?

None of this means fixed deferred consideration is bad. It means it should be valued as what it is: a loan to a specific borrower on specific terms.

Earnouts: mechanics and behaviour

An earnout pays the seller according to the business’s performance after completion. It bridges a gap between what the seller believes the business is worth and what the buyer is prepared to underwrite. It is most often discussed where the seller stays on and can influence the result, but it can also be used where the seller is leaving, provided the measure is one the seller has shaped and the buyer commits to how the business will be run; the less influence the seller has, the more the protections matter. The mechanics decide its value.

• Measure. Revenue or gross profit measures are less exposed to allocated costs than EBITDA, but they are not simple and not immune from buyer influence: pricing decisions, which clients are served by which group company, how referred work is attributed, and the accounting policy for recognising revenue all sit with the buyer after completion. EBITDA rewards profit but adds exposure to costs the buyer controls, such as central charges, recharged salaries and integration costs. Whichever measure is used needs a definition that runs to pages, covering attribution, cost allocation and accounting policy.
• Targets and shape. A cliff pays all or nothing; a sliding scale pays in proportion between a floor and a cap; a cumulative target over the period smooths timing but delays payment. Annual targets pay sooner but punish a single weak year.
• Period. Longer periods increase total potential but tie the seller in and expose the measure to more change under the buyer’s ownership.
• Control and protections. Who sets prices, approves hires, allocates shared clients and decides what the acquired business is charged for. Sellers negotiate covenants on how the business will be run, ring-fencing of the measured business, treatment of referred work and acceleration if the buyer breaches them or sells the business.
• Leaving early. What happens to the earnout if the seller is dismissed, resigns, is ill or dies. Good and bad leaver definitions matter as much here as in equity documents.
• Disputes. Who prepares the earnout accounts, how the seller challenges them and who decides, usually an independent accountant acting as expert.

Earnouts change behaviour on both sides. A seller measured on gross profit may resist investment in people the buyer wants to make. A seller measured on EBITDA may argue about every allocated cost. A buyer who wants the business integrated quickly finds the ring-fence that protects the earnout gets in the way. These tensions are predictable, and the time to address them is in the definitions, before completion.

Rollover equity

Rollover equity means taking part of the price as shares in the buyer or a new holding company. Its value depends on the class of share and its rights, how the investor’s own instruments rank ahead of it, how much debt the group carries, the leaver provisions, drag and tag rights, and when and how the shares can be sold. Rollover aligns the seller with the buyer’s plan, which is the point. It also means the seller’s outcome depends on that plan succeeding, on the group’s other acquisitions and on a future exit the seller does not control. Value it as equity in a business that usually carries debt. It is no form of delayed cash. Rollover equity: what could your stake return? works through an example capital structure and three exit outcomes. If the question is instead whether to take an investor into your own business and keep control, see minority investment.

Locked box or completion accounts

The price mechanism decides how the equity value is fixed when the balance sheet on completion day is not yet known.

Under a locked box, the price is fixed by reference to a historic balance sheet, often the last audited or management accounts. Economic ownership passes to the buyer from that date, the seller gives covenants that no value has leaked out since (dividends, management fees, related party payments), and the buyer may pay a ticking fee or interest for the period to completion. Sellers like the certainty; buyers like it when they trust the accounts.

Under completion accounts, the price is adjusted after completion for the actual cash, debt and working capital on the day. The seller receives an estimated amount at completion and the balance is settled, up or down, once the accounts are agreed. Buyers like the protection; sellers carry uncertainty for several months and bear the cost of a second negotiation.

Under either mechanism, the classification of balance sheet items is negotiated. Deferred income is the classic agency example: a buyer may argue that cash received for work not yet done is debt-like, a seller that it is ordinary working capital. The outcome can move equity value by more than the arguments about the multiple. Whatever is agreed, each item should be counted once: a balance treated as debt cannot also depress the working capital adjustment.

Employment terms and tax

Where the seller stays on, the employment or consultancy terms are part of the deal: salary, bonus, notice, duties and the link between leaving and the earnout or equity. Payments that are in substance for continued employment may be taxed as income and not as proceeds of sale, which affects net proceeds and sometimes the design of the structure itself. The treatment varies by jurisdiction and by the detail of the documents. Take tax advice before heads of terms are signed.

A worked comparison

Two indicative offers for the same agency, which last year made normalised EBITDA of £900,000 on gross profit of £2.2 million. The figures are hypothetical and simplified, and they are chosen to show how structure changes value. They say nothing about what any buyer would offer.

Before any scenario analysis, four points stand out. Buyer A pays more at completion. Buyer A’s fixed deferred consideration is larger and supported by a parent guarantee, whose value depends on its terms and the parent’s balance sheet; Buyer B’s is unsecured and can be reduced by claims the buyer itself asserts. Buyer B’s higher maximum depends on a longer earnout measured on a figure the buyer can influence through central charges. The £0.55 million gap in fixed consideration is a difference in amounts owed, each carrying its own credit risk; the £0.60 million gap in maximum consideration is a difference in what might be earned.

Buyer B’s rationale. In this illustration, Buyer B is a group with an established client base in a complementary discipline whose clients, it says, regularly ask for the kind of work this agency does. It proposes to introduce the agency to those clients, and its larger earnout reflects its belief that the agency’s profit could grow faster inside the group than on its own. That is a legitimate proposition, and the right response is to test it. The seller would want to see: which clients, named, and evidence of their demand; what happened when Buyer B made the same promise to the founders of businesses it bought before, ideally from those founders directly; what resources Buyer B will commit to the introductions and who is accountable for them; how referred work would be attributed to the earnout measure, priced and costed; and the central charges policy in writing, with history.

What would improve Buyer B’s proposal. Central charges fixed or capped for the earnout period; a defined method for attributing referred revenue and its costs; covenants on how the business will be run, including hiring, pricing and client allocation; ring-fencing of the measured business; acceleration or a floor payment if the buyer breaches the covenants or sells the business; a dispute mechanism with an independent expert; and security or a parent guarantee for the fixed deferred consideration, with the set-off right removed or capped. With those in place, the larger earnout is a proposition worth weighing. Without them, it is a hope.

The comparison also depends on points the table does not show: the adjustments to equity value under each buyer’s price mechanism, the warranty caps and escrow each asks for, the seller’s role and remuneration in each case, the tax treatment of each component and whether each buyer has its funding in place.

Scenario analysis: downside, base and upside

To compare the earnouts, build cases from stated assumptions and apply each buyer’s formula. The inputs below are invented for the illustration.

Buyer A’s earnout. Up to £0.60 million for each of two years, paid annually once each year’s earnout accounts are agreed. Each year pays in proportion to gross profit between a floor of £2.0 million (nil) and a cap of £2.4 million (full). Formula per year: £0.60m × (gross profit − £2.0m) ÷ £0.4m, bounded between nil and £0.60m. Gross profit is defined in the agreement, including how referred work is attributed and which direct costs are deducted.

Buyer B’s earnout. Up to £2.35 million on cumulative EBITDA over three years, after central charges, paid once at the end of year 3 when the cumulative accounts are agreed. Pays in proportion between a floor of £2.7 million cumulative (nil) and a cap of £3.3 million (full). Formula: £2.35m × (cumulative EBITDA − £2.7m) ÷ £0.6m, bounded between nil and £2.35m. Central charges are assumed at £100,000 a year in the base and upside cases and £150,000 a year in the downside case. The higher downside charge is a scenario assumption chosen to show the sensitivity to a cost the buyer controls; it is not a claim about how buyers behave. In every case, revenue attribution, cost allocation and accounting policy are assumed to follow the definitions in the agreement.

Buyer A pays more in the downside and base cases; Buyer B pays more only if the upside case is achieved and the central charges stay as assumed. The sensitivity to control is the point: in the base case, if Buyer B’s central charges were £200,000 a year instead of £100,000, cumulative EBITDA after charges would be £2.7 million and the earnout would pay nothing. A single cost allocation decision, made by the buyer, moves £1.175 million. The same sensitivity exists, in smaller form, in how referred work is attributed and in the revenue recognition policy applied to the measured business.

The totals are nominal: pounds received on different dates, added together as if they were received today. They also ignore the credit risk on each fixed deferred payment, the set-off right on Buyer B’s, the equity value adjustments and tax. They are a way of thinking and no substitute for a valuation. The next section shows how timing changes them.

Timing and present value

Money received later is worth less than money received now, and money that is uncertain is worth less than money that is fixed. Nominal totals hide both. A present value framework makes them visible: for each payment, divide the amount by (1 + r) raised to the power of the number of years until it is received, where r is a discount rate chosen to reflect time and the risk of that specific payment. Well secured fixed payments justify a lower rate; unsecured or contingent payments a higher one.

As an illustration only, Buyer A’s fixed deferred consideration of £1.20 million, paid as £0.60 million after one year and £0.60 million after two, has a present value at an 8 per cent rate of £0.60m ÷ 1.08 + £0.60m ÷ 1.08², which is £0.556m + £0.514m, or about £1.07 million. Applying the same 8 per cent rate to every component, purely to show the effect of timing, the base case nominal totals of £4.80 million (A) and £4.225 million (B) become present values of about £4.54 million for Buyer A (£2.40m now, £1.07m of deferred consideration and £1.07m of earnout paid at years 1 and 2) and about £3.92 million for Buyer B (£2.25m now, £0.80m paid at year 1 worth £0.74m, and £1.175m paid at year 3 worth £0.93m). In practice the rate would differ by component and by buyer, or the cash flows themselves would be adjusted for risk; what should not happen is both at once, because that counts the same risk twice.

Scenario analysis, probability weighted receipts and discounting can support a decision where the assumptions are transparent and can be defended, and they are better than comparing headlines. Their limits need stating. Probabilities attached to the downside, base and upside cases are judgements and should be shown as judgements; the point of weighting them is to see how much of each offer sits in outcomes you do not control. A single number does not settle the choice. Show the downside exposure separately, because an average conceals it. Then read the result alongside the things no calculation captures: the liquidity the shareholders need at completion, how much control the founder keeps over the measured business, the contractual protections secured, and the shareholders’ tolerance for the chance of receiving less.

What to do next

If you have an offer, rebuild it under the headings above and ask the questions in each section before responding. If you are earlier, the buyer guide explains how structure varies by buyer type and how to decide between proposals. We negotiate structure for founders as part of a sale, and we are happy to look at a proposal in confidence.

Written by Rick Palmer and Rob Reid, founding partners of Motion Advisory Partners. General guidance, not advice on any specific business or transaction. Legal and tax points vary by jurisdiction and should be checked with appropriate advisors.