Payment Terms: Holdbacks, Escrows and Earnouts

This post is Part IV of the Selling Your Small Business series. 

Check out previous parts below:

Preparing Your Small Business for a Sale

The Term Sheet – Preliminary Negotiation for a Sale

Structure of a Deal: Asset Sale vs. Sale of Equity

This Part IV of the Selling Your Small Business series of posts discusses three features relating to the payment of the purchase price for a business: holdbacks, escrows and earnouts. A holdback is the retention of a portion of the purchase price until the occurrence of some event or the expiration of a period of time; an escrow is akin to a holdback, except that the retained amount is placed in escrow with a third-party agent. An earnout refers to a deferred portion of the purchase price the payment of which is contingent upon the business meeting pre-selected financial and/or non-financial milestones.

Holdbacks and Escrows

Holdbacks and escrows generally are used to pay expenses, costs, and damages which the seller has agreed to pay in the purchase agreement, should they arise after closing (referred to as indemnification obligations) or to allow for a reduction in the purchase price if certain agreed-upon events occur (referred to as post-closing purchase price adjustments). The next post in this series (Part V) will address indemnification obligations and post-closing purchase price adjustments.

Generally, the purchaser will seek a holdback rather than an escrow. In a holdback, the purchaser can raise the necessary funds if and when they are to be paid or, if it has the amount at hand, the purchaser could invest those funds in short term, interest-bearing investments pending the obligation to pay the withheld amount. The purchaser could even use revenue from the newly-acquired business to pay the retained portion of the purchase price when necessary. Conversely, in an escrow, the purchaser must turn over to the escrow agent the relevant portion of the purchase price at closing.

A seller generally resists any form of withheld amount for obvious reasons. If the seller must agree to the withholding of the purchase price, surveys of deal terms show that the seller seeks to limit the amount to no more than 5% of the purchaser price.  Further, the seller favors the escrow option because the funds are readily available and need not be obtained or otherwise sought from the purchaser at a later time, when the purchaser’s financial situation may have declined. In addition, the determination to release the withheld amount in an escrow is in the hands of an independent party, rather than the purchaser.

Earnouts – Terms of an Earnout and Negotiating Sufficient Protections

Earnouts are often used where the owner continues to exercise some control over management of the business after the sale. It gives the parties a means to compromise on the purchase price when they cannot agree on a fixed amount. For the purchaser, it creates an incentive for the owner to show a continued commitment to the success of the business, and also provides for a transition period in which the purchaser can ease into the practical aspects of the operation of the business and relationships with customers, suppliers and others. 

          Terms of the Earnout – Five Elements to Consider

The negotiation of the specific terms of an earnout requires the parties to consider five points:

• What is the business, product or scope of services relevant to the earnout?  The purchased business may be integrated into the purchaser’s larger operations.  The parties need to consider what specific products, metrics, sales and other measurements are included for purposes of the earnout.

• What are the types of milestones that determine success, and what goal must be reached within the milestone type to satisfy the requirements of the earnout?

• Financial Measures. Some milestones used in earnouts are financial. The financial measure most commonly used for these purposes are (a) revenue, (b) net income, (c) EBITDA, and (d) earnings per share. Sellers generally prefer revenue as it is harder for the buyer to manipulate, and buyers generally prefer and buyers prefer net income as it encourages the seller to control costs and buyers often feel revenue encourages the seller to enter into otherwise unprofitable contracts.

• Non-Financial Measures. In many cases, non-financial measures are used in additional to financial milestones.  Particularly in the case of fast-growing companies in their early stages, financial measures may not be the most appropriate for measuring success and may not be practical to forecast or even expected at that stage in the company’s development. Examples of non-financial measures used in an earnout include, among others, client or customer numbers, subscribers, new users, stages of product development, stages of a prototype, number of products sold, and number of distributors.

• What measurement system is used to measure progress toward the milestones?  In many cases, sellers believe that referencing generally accepted accounting principles (GAAP) is insufficient, and that specific, more detailed principles should be adopted to govern key areas of consideration with respect to the company.  At a minimum, a seller should push to include a requirement that GAAP be applied for purposes of the earnout in the same manner as it has been historically applied in the case of the company, assuring that the application is consistent with past computations in the financial statement and the owner is familiar with the determinations.

• What is the term of the earnout and what are the intervals at which progress is determined and payments may be made?

• The total term of the earnout should be set, including any potential extensions and events triggering such extensions.  In a small business sale, an earnout is often for a short duration, often only a year; if the transaction is financed by a small business loan from the Small Business Administration (the SBA), an earnout may not last longer than one year.

• In addition, the intervals at which payments are made and calculated should be set forth, or the basis for determining the end of an interval. The parties must also determine whether partial payments will be made based on partial satisfaction of a milestone, or is the payment based on an “all-or-nothing” approach?  In addition, the parties must decide whether the earnout will also act as a form of holdback and whether a payment will be reduced by all or a portion of the then-incurred indemnification obligations or negative post-closing purchase price adjustments.

• The seller also frequently requires an acceleration provision whereby any remaining earnout will be paid in the event that the purchased business is resold or the purchaser disposes of the business’s equity such that the purchaser no longer maintains control, as that concept is defined under the securities laws.

• What procedures are in place to address disputes regarding the earnout? The financial statements by which the earnout is evaluated are generally prepared by the buyer and its accountants, but the seller should seek to negotiate the right to challenge the calculations and the conclusions reached. An independent accounting firm is at times named to arbitrate disputes and contested calculations and conclusions. In any event, although common, earnouts frequently lead to disputes and even lawsuits, so pre-negotiated dispute resolution processes are key to avoiding potentially costly and time-consuming disagreements and litigation.

Contractual Protections for Meeting the Earnout

Thus far, we have discussed negotiating the terms of the earnout. In selling the business, the owner must negotiate protections to ensure that the purchaser operates the new business in a way that satisfying the earnout is possible.  Otherwise, the new owner may intentionally or unintentionally deprioritize the new business, take on substantial debt in the new enterprise or against the newly acquired assets, shut down portions of the business or the production of certain products, or employ accounting methods or make business decisions that would make satisfying the necessary milestones impossible.

The buyer is under a non-waivable obligation to act in good faith in connection with the contract, meaning it cannot agree to requirements that it has no intention of satisfying. The seller has a number of express options in protecting its potential payment under the earnout that will be subject to the good faith obligation, including, for example:

• Expressly including a provision that the buyer will operate the business in a manner that is substantially the same as prior to the sale for the period of the earnout;

• Negotiating restrictive covenants for the term of the earnout which can only be waived with the seller’s consent (e.g., no shutting down business lines or discontinuing products, limits on reducing staff, restrictions on shifting sales and costs to the new business);

• Affirmative requirements to adequately capitalize the business, retain or increase sales force, adequate marketing and promotions; and

• Seek a covenant that the buyer will use reasonable efforts to maximize the earnout (although this will likely result in pushback from the buyer).

Even in the absence of express requirements, Delaware courts have held that the implied obligation of good faith applied to the purchase agreement means that the buyer cannot act arbitrarily or with the intent to prevent the satisfaction of the earnout milestones.

These provisions governing the payment of the purchase price are extremely important to both the buyer and seller. However, they are also a key source of post-closing disputes and litigation. Nevertheless, careful negotiation of these provisions can allow a deal to go forward even where the parties cannot settle on the purchase price and may give comfort to an otherwise reluctant buyer who fears the effect of either foreseeable or unforeseeable risks. A seller should consult counsel on these points given their complexity and importance in consummating the agreement and post-closing.