Trust But Verify – Escrow Holdbacks

On the heels of many seemingly smooth business deals, a buyer may have doubts. Sometimes they question whether specific details of the business meet regulatory standards. They may also be concerned with potential misrepresentation. To quell their apprehensions, many buyers request a holdback.

In a holdback, a portion of the purchase price, normally 10% to 20%, is held in escrow for a period of time after the closing, normally 18 to 24 months, and is used to satisfy any indemnification claims in the purchase agreement. If there are no claims, the money is released to the seller once the time period expires. The majority of mid-sized transactions include some form of holdback, also called an escrow. 

Escrows give the buyer assurance that money will be available to reimburse them if any of the seller’s representations or warranties later prove to be untrue or for other breaches in the purchase agreement. 

For example, let’s examine the sale of a manufacturing plant that includes expensive machinery. The seller may have represented that the machinery is operable and in good repair. If a piece of machinery breaks after the closing, and the seller determines that there was deferred maintenance on the machine and the problem was concealed by the seller, the buyer will file a claim to seek reimbursement from the seller to repair the machinery.

The money is held in an escrow account with a neutral third-party escrow agent. This offers protection and a guarantee that the funds are there if the buyer is not willing or unable to make payments later on. The funds are governed according to an escrow agreement. In most cases, the funds may only be released upon the mutual consent of the buyer and seller. If there are no claims, the money is released to the seller once the escrow period expires.

If a buyer isn’t comfortable with taking a seller at their word over certain aspects of the transaction, they may request a holdback.

Situations That Can Prompt a Holdback

If a buyer isn’t comfortable with taking a seller at their word over certain aspects of the transaction, they may request a holdback. Buyers find all manner of things with which to concern themselves. Most of the time, they are simply being prudent. But there are situations that have merited previous buyer holdbacks. 

Here are some examples of typical situations that might prompt a buyer to request a holdback:

  • A buyer purchasing a manufacturing company may be concerned about the environmental condition of the property. Any type of business that has industrial activity is at risk for contamination. Assessment and cleanup of the property can be expensive, time-consuming, and risky.
  • A buyer may be apprehensive that hazardous materials have leaked onto the property or that they have been stored improperly. This could cause concern for the buyer about future liability to employees working on the property or nearby dwellings and their inhabitants.
  • Buyers may be worried about fraud within the business. We are facing a time when fraudulent activities are at their height. 

In each of these examples, a prudent buyer might request a holdback in order to assure that they are protected from the threats of purchasing a business. Most M&A transactions include some form of deferred payment, and nearly any deferred payment can also function as a form of escrow if it contains a right of offset. 

Here are several alternatives to escrow:

  • Promissory Note: The promissory note can include language that affords the buyer the right to withhold future payments in the event of a breach. This may also be called an “offset” or “setoffs.”
  • Earnout: Earnouts can also include a right of offset, but the likelihood of the seller receiving any earnout payments should be considered.
  • Consulting or Employment Agreement: Consulting and employment agreements can also include a right of offset. However, this may not be allowed in certain states that prohibit setoffs against employment agreements. 

Sellers are likely to resist a right of offset against guaranteed, deferred payments, such as a promissory note and consulting or employment agreements, because such an arrangement affords the buyer a significant amount of leverage since the buyer “controls” the money. Allowing the buyer to simply withhold payments may afford the buyer too much power, and sellers may justifiably prefer an escrow.

Major Terms of the Escrow Agreement

The parties should consider the following terms of the escrow agreement:

  • Amount of Money: Most transactions include an escrow that ranges from 10% to 20% of the purchase price. The size of the escrow should correlate to the likelihood and magnitude of the potential risks and whether other forms of deferred payments also contain an explicit right of setoff. 
  • Time Period: The time period for most transactions ranges from 18 to 24 months, but I have seen time periods as short as 12 months and as long as 36 months. Most buyers prefer to prepare a full year’s P&L statement and close the books so they can examine an entire accounting period, which is why time periods tend to be at least 18 months. In most cases, two years is more than sufficient to uncover potential risks.
  • Conditions: The escrow agreement should prescribe the conditions of the escrow, who controls its release – normally mutual, and how disputes are handled. 
  • Interest: Who should receive interest on the amount held in escrow?

Successor Liability

Regardless of the transaction structure, there is a possibility of successor liability. This can be mitigated to a certain extent with thorough reps and warranties, an escrow, or other protective measures, but the risk can never be completely eliminated. In certain matters, such as for tax or environmental issues, successor liability can never be eliminated. 

In other matters, such as employee issues, successor liability can be mitigated by reducing the possibility of being labeled a “continuation” if the sale is an asset sale. The business is considered a successor, or continuation, if the product lines, employees, and other aspects of the business are substantially similar both before and after the closing. In other words, if the business is essentially the same, the courts may characterize the business as a “mere continuation” and impose successor liability. This happens in most M&A transactions, meaning that successor liability exists in most M&A transactions. As a result, many of the reps and warranties are designed to address these potential areas of liability.