This post is Part IV of the Selling Your Small Business series.
Check out previous parts below:
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:
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:
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.
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There is 1 comment left for Payment Terms: Holdbacks, Escrows and EarnoutsAlan said: Wednesday, May 18, 2022
Thank you for sharing this. Easy to understand and I have everything in one place now.HBS Staff replied: Wednesday, May 18, 2022
Alan, Thank you for reading our blog and we're glad you found it helpful to you.