When you sell your business, the buyer is worried about things that may have happened before the closing that cost the buyer money. For example, you didn’t pay all of your taxes and the government seeks to collect against the buyer. This is especially worrisome in a stock deal. But even in an asset deal, pre-closing liabilities can end up costing the buyer money after the sale.
The tool used to protect the buyer is “indemnification.” Indemnification means that one person agrees to pay for any losses that another person incurs. In the sale of the business, the seller indemnifies the buyer, promising to pay for any losses the buyer incurs that result from something the seller did wrong.
It’s a simple concept, but there is a problem. The buyer just sold the company and has a lot of money. But where is that money going? What guaranty does the buyer have that the seller will still have cash available to actually pay for the indemnification provided? Indemnification is great… unless the person protecting you is broke. And the four hundred thousand dollars you just paid them may not be there when it comes time to pay up. What to do?
The buyer is going to ask for an “escrow holdback”. People call them different things, but the idea is that a portion of the purchase price is set aside into an account and held for a while until the buyer can be more comfortable that the likelihood of incurring a loss is diminished. The money is held by a third party called an “escrow agent”. Sometimes that is one of the attorneys for buyer or seller. Other times it is a totally unrelated party like a title company. A document is prepared for the rules on how the money is accessed if the buyer has a claim. And at the end of the escrow period, the escrow agent cuts a check to the seller for whatever is left in the account.
The main points of negotiation are how much to hold back, and now long to hold it. The seller does her best to hold back as little cash as possible, and for as little time as possible. The buyer of course tries for exactly the opposite. There is really not a good rule of thumb as to how much or how long, because every deal is so different. But you can expect a buyer to be looking for about ten percent of the purchase price, to be held for at least a year. But I’ve see numbers much higher and lower, and times much longer and shorter. There really is no “typical” in this situation.
One good tool to consider for a seller is “tail insurance”. One of the things the buyer is looking for protection from accidents that may have happened, like a slip and fall or some other issue that would have been covered by insurance if the business had never been sold. For these types of losses, the seller can pay a one-time insurance premium to buy “tail insurance” that will keep insurance in place for these types of issues for a period of time after the closing. A year or two is typical. Essentially the buyer decides that would rather pay a little out of pocket today on an insurance premium rather than take the risk of fighting over escrow funds with the buyer for two years. Tail insurance doesn’t cover all types of losses that an escrow fund might cover, so the buyer will still be looking for some amount to be held back. But it can be used to negotiate down the amount held back from the purchase price.
This is one of those topics that proves the point that purchase price isn’t the only issue that is negotiated during the sale of a company. Escrow hold-back is just one of the other issues that may tip a seller to choose one buyer over another.
Have a great day,