Watch Out! Your Deferred Consideration Clause May In Fact Be A Penalty

When structuring the acquisition of a company the buyer often looks to pay the consideration over a period of time. Such deferred consideration can be dependent on performance targets of the company being met as well as key individuals remaining in the business and protecting the goodwill. This gives the buyer comfort that it is making the right investment and that the company is as valuable as the seller said it would be.

If the seller is in breach of his promises relating to performance, protection of goodwill or otherwise then a buyer will not want to rely on the court's assessment of damages for breach as these can often be restrictive and do not reflect the true value of the loss suffered by the company or the buyer. In order to increase the losses that can be recoverable various provisions are negotiated into the acquisition agreement to provide better protection. In the context of a share purchase agreement (SPA), buyers often include provisions that defer the payment of a part of the consideration to the key seller shareholder which is reduced or falls away entirely in the event of a breach of contract or failure to meet certain targets. Restrictive covenants in the SPA and in the director's service contract can set out what will be deemed to constitute a breach of contract, for example, if the shareholder/director competes with the target company and undermines the value of the company's goodwill.

However, great care needs to be taken when drafting and negotiating such deferred consideration provisions and restrictive covenants. Will they be seen to be a "liquidated damages" clause (enforceable) or a "penalty" (unenforceable)?

Liquidated damages and penalties

Penalty clauses are clauses which have the effect of compensating the innocent party for a loss which is greater than that which it has suffered and are characterised by wording which deters the party from breaching a contract by penalising them with a large financial or other loss. What is permissible is for a party to make a genuine assessment of the loss that it would suffer should a breach occur and include provisions for recovery of such loss. This loss can be greater than the loss which a court would award under a usual measure of damages provided that some thought has gone into the assessment and this can be seen as a genuine pre-estimate of the loss that would be suffered.

Penalties are usually drafted in the context of a payment of a sum of money on breach. However...