Earnest Money Deposit | M&A Basics

Jacob Orosz Portrait
by Jacob Orosz (President of Morgan & Westfield)

Executive Summary

Earnest money deposits are common in small-business sales and less common in middle-market transactions. They demonstrate good faith by the buyer to show that they are serious about purchasing your business.

Private equity groups and sophisticated corporate buyers almost never provide an earnest money deposit. They view the time and effort they spend conducting due diligence as an equal substitute for an earnest money deposit.

If the buyer of your business is an individual, we feel it is important to push for an earnest money deposit, especially if they have never owned a business. The buyer will request a lot of information on your business, and you won’t want to divulge sensitive information to anyone unless you have received an earnest money deposit.

Why shouldn’t you expect an earnest money deposit from a sophisticated corporate buyer or private equity firm?

Private equity firms are professionals who buy and sell companies for a living. Their reputation is critical to their success.

Still, you should carefully screen any company claiming to be an investment or private equity firm — such groups regularly approach us, and quite a few are nothing more than someone working in their basement. It’s important to screen the firm and ensure they have committed funds before accepting a letter of intent (LOI) from such a group.

When it comes to corporate buyers, such as competitors, we sometimes request an earnest money deposit from smaller companies that have never acquired a business. If the company has made acquisitions in the past, it’s customary not to request an earnest money deposit as they have already evidenced their ability to complete an acquisition.

What is the typical amount for an earnest money deposit? What should you do if a potential buyer refuses to pony up? We address these and other earned-money issues in the article that follows.

Summary of the Process

If the seller accepts the LOI or offer of purchase, the buyer will place the earnest deposit with a third party, normally an escrow company. The earnest money deposit is typically 5% of the purchase price, although the amount is negotiable.

This earnest money is applied toward the purchase price at closing. A higher earnest money deposit carries more weight and leads to a more cooperative seller. The lack of an earnest money deposit may lead to an uncooperative seller.

Do You Recommend Obtaining Earnest Money?

We always recommend asking for an earnest money deposit when dealing with an individual unless the buyer has completed multiple acquisitions in the past. Earnest money deposits serve two purposes:

  1. They offer demonstrable proof that the buyer is serious about buying your business.
  2. If the buyer defaults on the purchase agreement after due diligence and other contingencies have been removed, the earnest money deposit typically serves as liquidated damages to the seller.

Always ask for an earnest money deposit. This demonstrates good faith on behalf of the buyer and lets you know that the buyer is serious. This also psychologically commits the buyer to a greater degree. You share a lot of private and financial information with the buyer, so obtaining an earnest money deposit is a reasonable request to make.

Typical Earnest Money Deposit Amounts

Would you, as a business owner, take an offer for your $1,000,000 business seriously when it was accompanied by a good faith deposit of only $5,000? Would you allow someone to tie up your business for 30, 45, 60 days, or more with only $5,000 in escrow?

A typical earnest money deposit is 5% of the purchase price of the business. The amount of the earnest money deposit, however, is negotiable. An offer with a higher earnest money deposit carries more weight. Many buyers know this and are willing to put down a larger deposit. The earnest money deposit is usually held by a third party, such as an escrow company or attorney.

Do I Keep the Deposit if the Buyer Backs Out?

Some sellers erroneously believe that if a buyer defaults, they automatically receive the earnest deposit. This is not true. Before a third party will release the deposit, both the seller and the buyer must agree to do so. If there is no agreement, you may have to go to court to get them to release it to you.

The Buyer is Refusing to Provide an Earnest Money Deposit. Is this Common?

Why is the buyer refusing? Shouldn’t I always demand an earnest money deposit?

There are two general reasons why a buyer may refuse to put down an earnest money deposit. One is valid. One is not. Let’s explore each.

Reason #1: The buyer is a private equity group, competitor, or larger company.

Let’s collectively call this group “companies.” Now, this does not refer to small businesses, such as a small retail business, which may be seeking to purchase another location unless they have made multiple acquisitions before. If the company is a small business and has never made an acquisition, it should be treated as an individual. (See #2 below)

Why do “companies” refuse to put down an earnest money deposit? It’s simple — they view their financial investment in due diligence as an equal substitute to an earnest money deposit. And they are right.

In other words, they believe that the investment they make in performing due diligence demonstrates their earnest intent. These fees can easily run into tens of thousands of dollars on smaller transactions and even hundreds of thousands of dollars on larger transactions. Fees are often paid to outside advisors such as accountants, attorneys, and consultants, as well as to internal staff.

Individuals, on the other hand, usually conduct due diligence themselves and do not normally retain outsiders, with the exception of an accountant, to conduct due diligence. As a result, the fees they incur in conducting due diligence are significantly less than what a corporate buyer may incur.

There are rare occasions when a competitor’s primary objective is to obtain competitive information, but there are mechanisms you can use to protect yourself in these scenarios. In circumstances such as these, you should carefully observe the buyer’s actions.

Are they spending money on professional advisors, or are they going straight from the heart and asking you for your customer list or other competitive information?

You can also release information to buyers in phases, such as releasing highly sensitive information to the buyer later during due diligence.

Earnest money deposits are rare in mid-sized transactions, though they may occur if the seller is in a very strong bargaining position or if multiple parties are in negotiations with the seller. Otherwise, consider that an earnest money deposit is not the norm if you are selling a larger business.

Reason #2: An individual is not serious or is overcome by fear.

The second reason is not a valid one. Yes, a buyer can become fearful. However, acquiescing to the buyer will only set up false expectations with them and make it nearly impossible to manage their expectations for the remainder of the transaction. If an individual refuses to put down an earnest money deposit, we tread cautiously or sometimes not at all.

The circumstances will dictate if we decide to work with a particular buyer. If the individual is a serial entrepreneur who has owned many businesses and if they do not own a competitive business, we will likely choose to work with this buyer. But we will carefully consider if we grant this buyer exclusivity.

If the buyer owns a competitive business and competitive information will have to be shared with them, we will press hard for an earnest money deposit. We will also spend significant time drafting and negotiating the letter of intent and include other protective measures in the LOI, such as milestones and a clause addressing attempts at retrading.

If, on the other hand, the buyer is a corporate escapee who has never owned a business, we will tactfully demand an earnest money deposit. We may attempt to reassure the buyer, but we will be careful not to provide too much reassurance when doing so. If the buyer is not willing to place a refundable earnest money deposit, then we won’t consider this buyer to be serious, and we will move on.

Put the buyer’s motivation and other actions in perspective. Does the buyer seem serious to you? Do they own a competitive business? Are they financially qualified? How much liquid cash are they offering to put down? How many other businesses have they looked at? How long have they been looking for a business? Have they made any offers? Are their expectations realistic?

Evaluating the buyer’s motives can be difficult unless you have significant experience selling businesses. If you are unsure, consider obtaining advice from an experienced professional to ensure you are protected.