In business purchase and sale transactions, the purchase price leads to some of the most contentious push and pull in negotiations. A majority of disagreements arise from each party’s valuation of the target company as well as how to determine which party will assume more risk. To alleviate those contentions and come to a mutually beneficial agreement, alternative payment structures can be useful to provide flexibility when negotiating a deal. The three types of structures we review in this article are earnouts, escrows, and holdbacks.
A. Earnouts
An earnout is a structure where the seller must “earn” part of the purchase price in a deal. This is done through negotiated financial milestones, usually revenue-based, that the target company must achieve after the closing for the additional payments to be released to the seller. This structure is often used with private, closely held companies or start-ups to help bridge the gap between the buyer and seller’s expectations on valuation and to help mitigate risk for the buyer.
Mitigating risk is very important for buyers when acquiring a new or closely held company because they inherently carry substantial risk. There is a risk for the seller that the company might not meet the earnout requirements, and that extra purchase price consideration might never be realized, but an earnout could also allow the seller to profit from the full, unrealized potential of the company they are selling.
One thing to note is that inclusion of an earnout makes the deal more complex. It is important to set clear measurement criteria for earnout milestones before execution to avoid disputes later on. When utilizing an earnout, it’s also important for the seller to ensure that the buyer is subject to certain covenants. For example, the seller should retain the right to inspect the company books after the buyer assumes control, to ensure these the books accurately depict whether an earnout milestone has been met. Lastly, in most closely held companies, the seller will remain involved in the day-to-day operations of the business after the closing, usually for 3 – 12 months. It’s generally in the buyer’s best interest to keep the seller on board as an employee or a consultant to ensure a smooth transition, and in the seller’s best interest to remain involved to help maximize their earnout payments. Using an earnout based on the success of the business is a useful tool to incentivize the seller to continue working at a high level for the business they just sold and ensure those earnout benchmarks are met.
SIMPLE EXAMPLE: The buyer agrees to pay the seller $10,000,000 in cash at closing, and if the company achieves aggregate net revenue of $4,000,000 within 2 years from the closing, the the buyer will pay the seller an additional $400,000 in purchase price consideration within 30 days of the second anniversary of the closing.
B. Escrows and Holdbacks
Escrows and holdbacks are other risk mitigation mechanisms often employed in business acquisition transactions. An escrow is where part of the purchase price is held by a third party (usually a bank or a law firm) until certain contractual obligations are met, or as security for the seller’s representations and warranties. A holdback has essentially the same purpose as an escrow, except that there is no third party escrow agent holding the funds. Instead, with a holdback, the buyer simply retains part of the purchase price in their own bank account. A benefit of using a holdback as opposed to an escrow is reducing the costs associated with setting up the escrow account and paying the escrow agent’s fees. A disadvantage is the credit risk to the seller, in that the buyer may not be able to make the holdback payment when it’s due because they don’t have the money. Escrow ensures that the money will be available when payment is due and puts a neutral third party in charge of distributing the escrowed funds according to the terms of the escrow agreement.
Neither method is favorable for the seller because it ties up some of their purchase price. Typically, around 10-25 percent of the total purchase price will be held back or placed in escrow. If there is any form of deferred purchase price (like a promissory note or an earnout), an escrow or holdback is not quite as important to the buyer because the note balance can always be reduced. However, if a significant cost arises as a result of an indemnifiable loss, setting off against a note is not as helpful to the buyer as cash. Escrowed funds and holdbacks are used to cover losses incurred by the buyer as a result of the seller’s breach of representations, warranties or covenants in the purchase agreement, without the parties having to go through a formal legal process. The period of time the payments are to be held in escrow or held back by the buyer is typically 1 – 2 years. It may be beneficial for a seller to negotiate a graduated release schedule, where a percentage of the escrow or holdback will be released to the seller at multiple intervals throughout the escrow or holdback period.
SIMPLE EXAMPLE: Seller represented in the purchase agreement that their company had no pending or threatened litigation. Three months after closing, a disgruntled former employee sues the company for wrongful termination that occurred prior to the closing of the sale and it is clear that the former employee had sent multiple demand letters to the seller prior to the closing. The buyer can use the escrowed or held back funds to pay their legal fees and and damages payable by the company to the former employee as a result of the lawsuit.
When structuring a purchase and sale transaction, consider using an earnout, escrow, or holdback to help bridge any gaps in valuation expectations, move negotiations along, mitigate risk to the buyer, and close the deal.
[View source.]
