When selling a business, it is common for the buyer and seller to utilize the services of a third-party escrow agent. This agent acts as a neutral stakeholder who oversees the delivery of documents, funds, communication, and the eventual closing of the deal. They make sure each party complies and fulfills their end of the contract. The seller has assurance from the buyer that they’ll follow through on the deal because the escrow is funded with the agreed amount of money before the closing. The buyer has the assurance that they’ll receive a refund if the seller doesn’t follow through on their end. Therefore, it is a safe and secure transaction for both parties.
An escrow holdback is another type of escrow that is sometimes used for the sale of a business. This is a special account which holds a percentage of the sale proceeds after the closing date. The purpose of an escrow holdback is to guarantee that certain items, debts, work, or services will be paid for and/or completed by the seller within a short time after the closing takes place. These contingencies are listed in the Purchase & Sales Agreement. The seller does not receive the held funds until they have successfully performed these actions. If the seller fails to do this, the buyer receives a refund on their money that is being held in the escrow holdback account.
Here are some examples of how escrow holdback funds are spent:
- The buyer may want an escrow holdback to pay for any business losses which are the result of the seller’s false misrepresentation on certain aspects of the business. This may include promises or warranties which are not honored. When an escrow holdback is made, it doesn’t mean the seller is guilty of these things. It just gives the buyer some peace of mind to know that they’ll be covered in case the seller does not deliver what they promised.
- If you’re selling a business and still owe certain business taxes to the state government, such as Sales & Use Tax or Unemployment Insurance Tax, then your buyer will want a guarantee that they won’t be left with these tax bills after they take ownership of the company. To get this guarantee, the buyer will require that a portion of the sales price goes into an escrow holdback to cover the taxes owed. In some states, it is mandatory for a seller to obtain a state tax certificate which shows that no taxes are owed before ownership of their company is transferred to the buyer. Check with your state taxing authorities for more information.
- If your business has litigation pending against it (e.g. lawsuit against your company), then your buyer certainly won’t want to inherit that after they purchase your company. The only thing you can do is assure them that they’ll be protected in case the litigation causes your company to lose money. To do this, you can set aside funds in an escrow holdback which covers the potential amount of money that the company could lose from the litigation. That way, the buyer can feel safe about purchasing your company in case the lawsuit doesn’t go your way.
The buyer is usually the one who’ll want an escrow holdback. As a seller, you should be willing to agree to an escrow holdback if you think it’s in your best interests. For instance, if one of the above examples applies to your situation, such as pending litigation against your company, then you cannot expect buyers to be too excited about purchasing your business. You’ll need to give them an incentive of financial protection and security if you want to make a deal with them. Otherwise, they will be too scared that the litigation will devalue your company and cause them to lose out on their investment. If you use an escrow holdback for contingency purposes to cover any potential losses like these that may arise, then your buyer will feel confident that they have nothing to lose by going through with the deal.
Sellers may not like the idea of an escrow holdback, but it does give them one big advantage. Many buyers won’t agree to purchase a business unless the seller provides an escrow holdback. So, if you’re serious about selling your business and you’re anxious to find a buyer, then agreeing to an escrow holdback is a great way to attract more interested buyers. It gives them peace of mind that you’ll pay your business debts and take care of other responsibilities before transferring ownership to them. Not only that, but it also gives you a way to fulfill your financial obligations with creditors and lenders. Then you aren’t stuck in a business with so much debt that you can’t get rid of.
The biggest drawback of an escrow holdback is that you cannot get all your funds right away after the closing. The funds that you do receive at the closing is called your working capital. This is supposed to be the money that you use to fulfill your contractual obligations. There are very strict limits placed on the working capital which dictate what you can spend the money on. If you end up spending under the threshold amount of the working capital, the buyer is refunded the difference of the holdback and the amount under the threshold.
If the buyer needs to apply for a loan to purchase your business, their lender may not like seeing contingencies and an escrow holdback as part of the sales agreement. Lenders get very nervous about escrow holdbacks because they’re afraid the seller won’t follow through with their obligations. Because of this, lenders likely won’t approve the buyer’s loan if there is an escrow holdback. This leaves you with two choices; you can either provide seller financing or you can accept cash buyers only. The former is very risky while the latter will attract fewer buyers.
How Much Does It Cost?
Between 5% and 15% of the sales price is the average percentage held beyond the closing date. The exact percentage depends on the type of acquisition taking place, the valuation of the business, and the findings of the due diligence. The percentage is often negotiated by multiple parties, including the buyer, seller, and their attorneys. If the buyer wants a higher percentage of the sales price to go into the escrow holdback account, then it may not be worth it for you as the seller.
An escrow holdback can be risky for a seller. It all depends on the buyer’s method of payment and the number of contingencies attached to the Purchase & Sales Agreement. In most cases, you will have between 30 to 60 days from the date of the closing to satisfy your obligations. If you are unsuccessful in doing this, then you could lose some or all the funds being held in the escrow holdback account. It doesn’t even matter if you end up satisfying these obligations after 60 days. You could still lose out on the funds if you go over the set time limit. This will put a lot of pressure on you, especially if you have any pending litigation to deal with. There is no telling when that will be resolved.
Therefore, you must be very careful before signing a Purchase & Sales Agreement which has contingencies listed. If you think that you’ll need more time to pay certain debts or get through your litigation issues, then don’t sign the agreement. Of course, you could ask the buyer to give you more time on the escrow holdback, but they probably won’t be too thrilled about that. The longer you want them to wait, the more likely they’ll want to walk away. But if litigation is not an issue and you only have some business debts to clear up, then an escrow holdback could be the best way to sell your business and get rid of these obligations forever.