Not every business is sold for cash on the day. In many South African transactions, part of the price is paid later: as a fixed deferred amount, as vendor finance repaid over time, or as an earn-out linked to the business’s future performance.
These mechanisms help close deals that would otherwise fail. The buyer may lack the funding for the full price, or the parties may disagree about what the business is worth. But they also leave the seller exposed after it has given up control, and they are a frequent source of disputes. This article explains how to structure them properly.
Three ways to defer the price
- Fixed deferred consideration. A set amount is payable on a future date, regardless of performance. It is effectively a debt owed by the buyer.
- Vendor finance. The seller lends part of the price to the buyer, usually repayable in instalments, with or without interest. It is common in management buy-outs and sales to employees.
- Earn-out. An additional amount is payable only if the business meets agreed targets after completion, for example revenue, gross profit or EBITDA over one or more years.
Many deals combine all three.
Why parties use earn-outs
An earn-out bridges a valuation gap. A seller may believe the business will grow strongly. The buyer may doubt it. Instead of arguing about forecasts, the parties agree that the seller will be paid more if the growth actually materialises.
Earn-outs also keep sellers involved. Where the founder stays on to run the business, an earn-out aligns their interests with the buyer’s during the transition.
Drafting the earn-out
Most earn-out disputes come from vague drafting. A sound earn-out clause deals with the following.
The metric
- Revenue is simple to measure and hard to manipulate, but ignores profitability.
- Gross profit or EBITDA better reflects value but is more open to dispute about costs, allocations and accounting judgements.
- Net profit is the most exposed to buyer-controlled items such as financing costs and group charges, and is rarely appropriate.
How it is calculated
- Which accounting policies apply (usually those used in the last pre-sale financial statements, applied consistently).
- Which adjustments are made, such as excluding acquisition costs, extraordinary items, management fees charged by the buyer’s group and the effect of new financing.
- Whether the target’s results are measured on a stand-alone basis if the business is integrated with the buyer’s.
- A worked example in a schedule, which removes much of the ambiguity.
The formula
- Whether the payment is all-or-nothing on reaching a target, or scales between a floor and a ceiling.
- Whether there is a cap on the total earn-out.
- Whether shortfalls in one year can be made up in the next (“catch-up”).
Buyer conduct during the earn-out period
The seller’s biggest risk is that the buyer, now in control, runs the business in a way that reduces the earn-out. The seller should seek:
- an obligation to run the business in the ordinary course and consistently with past practice;
- restrictions on diverting customers, revenue or opportunities to other group companies;
- limits on charging group costs to the business;
- a prohibition on deliberately reducing the earn-out; and
- information rights: access to management accounts and the right to have the calculation reviewed.
Buyers will resist restrictions that limit their ability to manage and integrate the business. A balance is usually struck by protecting against bad-faith conduct and specific actions, rather than freezing the business.
Acceleration events
The seller may negotiate for the earn-out (or a fixed amount) to become payable immediately if:
- the buyer sells the business or the target company during the earn-out period;
- the buyer materially breaches its conduct obligations; or
- the seller-manager is dismissed without cause.
Dispute resolution
Earn-out calculations should be referred to an independent expert, usually a chartered accountant, rather than to court. The agreement should state that the expert acts as an expert and not as an arbitrator, that its decision is final and binding except in the case of manifest error, and how its costs are borne. Legal disputes, such as whether the buyer breached its conduct obligations, are better suited to arbitration or court.
Earn-outs tied to employment
Where sellers remain as employees, earn-outs are often linked to continued employment, with “good leaver” and “bad leaver” outcomes. Be careful. If payment depends on the seller continuing to work, SARS may argue that it is remuneration for services, taxable as income through payroll, rather than part of the capital price for the shares. Separating the purchase price from employment incentives, and documenting the commercial rationale, reduces this risk.
Vendor finance and security
A seller who accepts deferred payment is an unsecured creditor of the buyer unless it negotiates security. Options include:
- Pledge and cession of the sold shares back to the seller as security.
- Suretyships or guarantees from the buyer’s shareholders or group companies.
- Security over the target’s assets, which requires compliance with the financial assistance rules in section 44 of the Companies Act 71 of 2008 (special resolution, solvency and liquidity, and terms that are fair and reasonable to the company).
- Restrictive covenants limiting dividends, new debt and disposals while amounts remain outstanding.
Pledges and the pactum commissorium
South African law prohibits a pactum commissorium: an agreement that the creditor may simply keep the pledged property if the debtor defaults. Such a clause is void. A pledge agreement may, however, allow the creditor to sell the pledged property privately on default (parate executie), subject to the debtor’s right to approach a court if the sale prejudices it. It can also provide for the creditor to take over the property at a fair value determined at the time.
A different mechanism is a right to cancel the sale on non-payment and have the shares returned, with appropriate treatment of payments already made. This is a contractual remedy rather than a pledge and must be drafted accordingly. Legal advice is essential here, because a poorly drafted “reversion” clause may be unenforceable.
Subordination to banks
If the buyer also raises bank finance, the bank will usually require the seller’s claim to be subordinated, with no payments to the seller while the bank debt is in default. Sellers should negotiate permitted payments and what happens if the bank enforces.
National Credit Act
The National Credit Act 34 of 2005 generally does not apply to credit extended to juristic persons above a threshold, or to large agreements with smaller juristic persons. Where the buyer is an individual and the price is payable in instalments with interest or fees, consider whether the agreement is a credit agreement under the Act.
Tax timing
As a general rule, a seller is taxed when the proceeds accrue, which happens when it becomes unconditionally entitled to them (CIR v People’s Stores (Walvis Bay) (Pty) Ltd 1990 (2) SA 353 (A)). This affects deferred consideration and earn-outs differently:
- Fixed deferred amounts generally accrue on the date of sale, even if payable later, so the seller may pay capital gains tax before receiving the cash.
- Earn-outs that depend on uncertain future performance are conditional. They should not accrue until the condition is met and the amount is determined.
- Section 24N of the Income Tax Act can defer the accrual of a deferred price for shares where more than 25% of the price is payable after the year of sale and is based on the future profits of the company, the parties are not connected persons after the sale, and other requirements are met. Its requirements are strict and should be checked at the drafting stage.
Later adjustments to the price, such as an earn-out that is lower than expected or a warranty claim that reduces the price, are dealt with under the capital gains tax rules for re-determination of proceeds.
Practical tips
For sellers:
- Treat the deferred portion as at risk, and price it accordingly.
- Insist on security, information rights and buyer conduct obligations.
- Keep the earn-out short (one to three years) and the metric simple.
For buyers:
- Preserve freedom to run and integrate the business, and resist open-ended conduct restrictions.
- Build in set-off against deferred amounts for warranty and indemnity claims.
- Make sure the calculation mechanics are workable for your finance team.
For both:
- Include a worked example and an expert determination clause.
- Take tax advice on accrual, section 24N and the risk of employment-linked earn-outs.
How O’Reilly Law can help
We structure and negotiate deferred consideration, vendor finance and earn-out arrangements for sellers, buyers and management teams, including the security and subordination documents. Speak to our business structuring team. For earn-out disputes, our litigation and dispute resolution team can assist.
Contact us to discuss your transaction in confidence.
This article is general information and not legal or tax advice. Every transaction turns on its own facts and drafting. Correct as at October 2026.