- What Is a Seller Holdback?
- Why Is a Seller Holdback Important?
- Examples of Seller Holdback
- How Seller Holdback Works
- Seller Holdback vs Earnout
In acquisitions, a seller holdback is where a buyer “holds back” a portion of the purchase price to offset any potential liabilities post-closing. Once the seller or business meets pre-agreed upon conditions post-closing, the buyer then instructs escrow to release the funds to the seller.
If you’ve ever bought something privately, a car, for example, you’ll remember the anxiety of handing money to someone you barely know. Will you get what you pay for? Has the seller been honest? Will it perform as described or fail days after closing?
It’s the same with company acquisitions, and the higher the price tag, the greater the need for reducing risk post-closing. As a result, you typically add a seller holdback towards the end of due diligence after discovering any potential issues that could arise post-closing, and you add the holdback to the asset purchase agreement.
Below, we explain what a seller holdback is, how it works, and why (within reason) it can allay fears on both sides of the negotiating table to ensure you close your deal swiftly and happily.
What Is a Seller Holdback?
A seller holdback is where you hold a portion of the purchase price back – usually in escrow – until the business you’re acquiring meets a certain condition or a time period elapses without a specified event occurring.
Unlike an earnout, which makes purchase price payments conditional on performance milestones, seller holdback helps to mitigate your financial risk should a business you acquire not live up to the seller’s promises.
Why Is a Seller Holdback Important?
With the best of intentions, sellers don’t always get everything right nor can buyers expect to mitigate every conceivable risk during due diligence. Whether you’re buying or selling a business, seller holdback can help calm anxiety over what happens post-closing and incentivize peaceful resolution of any post-closing problems.
Holdback is mostly an informal insurance policy that protects your interests when acquiring a company, but it can benefit sellers too. You might perceive a seller offering or agreeing to holdback more positively, for example. Why? A seller who offers holdback likely has nothing to hide and is confident in their business and how they presented it. Perhaps that’s all you need to justify paying a higher asking price (along with holdback).
You can think of a holdback as a separate bucket of money to recover from in the event something goes wrong post-closing, or some agreed-upon event does not occur. Typically, you would have to initiate litigation against the seller to try and recover the damages you claim you incurred as a result of a breach of the purchase agreement.
With a seller holdback, however, you have money that is already set aside to draw from should something goes awry. And if a seller disagrees with your position on the matter, it will efficiently bring both of your back to the negotiating table instead of pitting you against one another in a protracted legal battle.
Even if a seller refuses to work with you to resolve post-closing issues, you minimize your potential losses by not paying the holdback amount. Once the holdback period expires, the money returns to you from escrow to offset any losses. A holdback can’t guarantee to cover any loss completely, however, so ensure you negotiate a sufficient amount to draw from in the event something does go awry post-closing.
Examples of Seller Holdback
You can use seller holdback for just about any risk or future change that might impact a business you’ve acquired or your ability to earn a return on the acquisition. Below are a few examples where you might consider including a seller holdback clause in your offer.
The most common seller holdback is an “indemnity holdback,” in which a specified amount of money is held in escrow post-closing to pay for buyer indemnity claims. Such indemnity holdbacks come in all shapes and sizes, but the general mechanism is that a seller agrees to indemnify (or make whole) the buyer post-closing if certain things occur, most often if it turns out that the seller breached a representation or warranty or a covenant in the purchase agreement. The buyer and seller negotiate a reasonable amount of funds to hold back for a specified period of time should such an event occur, and if it does, the buyer can make an efficient indemnity claim to that bucket of money rather than try to extract the funds from the seller directly.
Say you’re feeling antsy about the outcome of pending litigation, for example, and as a deal point you have agreed to assume the corresponding liabilities of such litigation in an asset deal. Seller counsel expects a judgment in twelve months and has advised the company might have to pay damages of around $1 million. If you value the company at $10 million, you might hold back 10 percent of the purchase price in escrow ($1 million) until the court rules on the case.
Incomplete Financial Records
If the seller’s accounting software glitched or physical records were lost (in a fire, flood, or through simple human error), you might include a holdback to account for the missing data. Perhaps it obscures seasonality or some other pattern that would’ve impacted your valuation before closing. Again, a holdback can offset any losses should the missing data cause a loss.
Non Competes and Transition Services
If you’re worried about the seller competing with you or abandoning you after the deal closes, consider holdback to incentivize their agreement to non-compete clauses and transition services. You might add a 10 percent seller holdback condition and only release the funds when the seller fulfills their transition obligations or after 12 months, whichever is soonest.
How Seller Holdback Works
Like all closing conditions, use seller holdback with caution. Just because you want to de-risk the acquisition, it doesn’t mean the seller has to agree. It’s much better if you agree to a reasonable seller holdback percentage rather than use it to beat down the asking price.
Agree to a Reasonable Percentage
Seller holdback is a negotiation point. Most sellers won’t want anything higher than five percent holdback. That seems reasonable for simple matters like working capital adjustments, but for things like incomplete data, pending litigation, and so on, you might argue for a higher amount.
Decide on a Reasonable Duration
Seller holdback applies for a specific period only. Decide during what time span the post-closing risk is greatest and then negotiate a duration that matches. It might be six months or two years. Expect sellers to push back on any seller holdback period greater than one year.
Set Reasonable Conditions
Whatever the reason for seller holdback, codify the point at which seller holdback no longer applies. It might simply be the expiration of time. But for anything else, such as the outcome of litigation, specify the condition (damages of no less than X, for example) so that as soon as the condition is met, escrow can release the holdback amount to the seller immediately.
Put Seller Holdback in Escrow
Regardless of the seller holdback percentage, you must agree to hold the funds in escrow for the duration of the condition. Without escrow, you force the seller to trust your integrity and creditworthiness. They’re more likely to agree to holdback if it’s held in a neutral third-party account, such as Escrow.com, that automatically releases the funds once conditions are met.
Seller Holdback vs Earnout
Seller holdbacks and earnouts might look the same but are very different. While seller holdback can apply to anything post-acquisition, an earnout applies only to financial performance. An earnout is almost like a reward for hitting certain growth milestones – the business earns its post-closing payments.
Seller holdbacks are more like insurance policies. They offset the risk of something unexpected that reduces the value of the business post-sale. The business can fail financially, for example, but as long as the conditions of seller holdback were met, you’d still need to release the holdback amount to the seller.
What Is the Purpose of a Holdback?
In mergers and acquisitions (M&A) transactions, a seller holdback protects the buyer of a company from unforeseen losses or liabilities after the deal closes. Rather than pay the purchase price in full, the buyer escrows a portion until certain conditions are met. In this way, it acts like an insurance policy that indemnifies the buyer in the event of a qualifying loss, such as a dishonest seller, pending litigation, or incomplete financials.
What Is a Holdback in a Transaction?
A holdback in a mergers and acquisitions (M&A) transaction is when the buyer of a business keeps a portion of the seller’s purchase price in escrow after the deal closes. This protects the buyer against unforeseen losses or liabilities once the business changes hands. The seller only receives this escrowed portion when the business meets certain conditions, or after a certain amount of time has passed, as outlined in the holdback clause in an asset purchase agreement.
What Is a Typical Holdback in M&A?
A typical holdback in M&A is usually between five and 10 percent of the purchase price, but can go higher. It varies from deal to deal. Sellers will push for as low a figure and as short a duration as possible, where buyers will push for higher. It’s a negotiation.
How Do You Calculate Holdback?
To calculate holdback, first measure your anticipated loss should the conditions of the holdback not be met and then calculate that as a percentage of the purchase price.
For example, if a business worth $1 million is involved in pending litigation that could require it to pay damages of $100,000, the buyer might hold 10 percent of the purchase price in escrow. If the company then wins the litigation case, the buyer can release the funds to the seller.
If the company loses the case, the buyer would retain the holdback amount to cover legal costs and damages. Even if the damages are higher, the seller doesn’t pay or receive anything, and the buyer would have to cover the loss themselves.
As you can see, seller holdback helps mitigate risk but doesn’t eliminate it completely.
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