Definition of deferred consideration: An element of a purchase price which is only settled in cash at much later date than the transaction.
What does deferred consideration mean
In the simplest of terms, deferred consideration is whatever part of a large purchase which doesn’t need to be paid upfront.
The term is used for one-off transactions where the period of deferment is much longer than a month. You’ll most commonly see the phrase used in the context of mergers and acquisitions or large pieces of capital expenditure.
The standard trade credit terms which see businesses pay for invoices after 30, 45 or 60 days are not examples of deferred consideration.
Deferred consideration shouldn’t be confused with deferred compensation, which refers to the element of an employee’s remuneration package which is not paid during the service period.
How is the phrase ‘deferred consideration’ used in a sentence?
Here’s an example of the phrase ‘deferred consideration’ being used in a realistic manner:
“The deal was structured in a way that saw company A pay $4m on the transaction date, with a further $4m of deferred consideration which is due on the second anniversary.
Beyond the definition of deferred consideration
Now we know what deferred consideration is, let’s reflect on why do companies write sale & purchase agreements which include it.
1) First of all, deferred consideration reduces the need to finance an acquisition. Companies rarely have cash reserves on hand in large enough quantities to be able to make an acquisition in cash. Loans or rights issues are common ways to raise the funds needed.
However, if a company is given permission to pay a significant amount of the purchase price at a later date, then this gives an extended amount of time to find the cash. The company may even be able to use the operating cash flows of the business to make the payment.
2) Deferred consideration is also interest-free and isn’t as restrictive as bank borrowings such as an overdraft. It’s, therefore, a slightly softer debt element to include within a companies capital structure.
3) Deferred consideration also provides a useful ‘commercial advantage’ to the buyer in case of any dispute that arises soon after the acquisition. For example, if the companies assets turn out to have been overstated, or it begins to substantially underperform against its budget.
If the buyer believes that the seller had misrepresented the business for sale, they may decide to try and recover costs from the seller in the form of a warranty claim, partial refund or other damages.
The fact that the buyer is holding onto a large proportion of the consideration on a deferred basis, means that the buyer does not actually need to ask the seller for cash payment. They can deduct what they believe is owing to the remaining deferred consideration and only pay over the surplus (if any).
This doesn’t make the deduction lawful, but in the case where the dispute is settled or the court does agree that the seller should compensate the buyer, the cash is already in the buyer’s hands. This is a big practical win for the buyer.
They needn’t worry about the buyer declaring bankruptcy, fleeing the country or squandering the cash before it can be retrieved through a court order.
How does the definition of deferred consideration relate to investing?
Deferred consideration may be mentioned in the financial press when any business makes an acquisition to expand their empire.
Buying shares in companies which have recently made an acquisition can be riskier than normal. This is because the share price of companies involved in such announcements can often overreact to the new information as shareholders reset their forward-looking expectations.