A benefit of being the oldest business brokerage firm in the Pacific Northwest and successfully facilitating the most transactions in the region since 1975 is that IBA’s experienced, knowledgeable, highly skilled intermediaries have identified and utilized many best practices in terms of sale process and deal structure. One transaction component that is prudent for inclusion in most deals is an escrow holdback. A seller promissory note with a right of offset can also address the same issues.

I tell most sellers and buyers I work with on transactions that the purchase and sale of a business involves a process at time of transfer similar to an exchange of locomotive engineers where the existing driver relinquishes control jumping off and the new one assumes control climbing aboard a moving train. The situation is going to create chaos, and some responsibilities have the possibility of being overlooked.

An effective legal, transactional tool to address issues associated with this transfer is an escrow holdback.  An escrow holdback is a percentage of the purchase price payment that rather than being disbursed to the seller at closing is held in a neutral, third party controlled account.  The size of the holdback depends on the business model being sold and the details of a specific transaction. The general principle behind holding the money is that it provides the business buyer with leverage to ensure the seller addresses trailing liabilities that are their responsibility and works in good faith to smoothly transition ownership.

The following are the most common situations addressed through an escrow holdback.

1. Bill Reconciliation – It is common in business purchase & sale transactions for the parties to sit down 30 – 60 days after the sale and reconcile who owes who money for expenses that could not be cleanly cut off at the date of the transfer of ownership.  A straight forward example is utility bills.  If a business transferred on the 15^th of the month, 50% of the expense for utilities for that month would be due from the seller and the other half from the buyer.  If the account was transferred without interruption, utility invoices for the subject month would be delivered to the buyer.  An escrow holdback gives the buyer a tool to get reimbursed for the seller’s portion, if they do not assume responsibility on their own.
2. Net Working Capital – In many M&A transactions, an amount of net working capital is included in the acquisition price to help facilitate a smooth transfer of ownership and proper acquisition financing. It is standard for parties to agree on a target amount of working capital for determining the sale price for a company in the legal documentation because it is nearly impossible to have an exact number on the date of closing when inventory movement, accrued payroll, and work in process have the ability to change up until the moment of business ownership transfer.  An escrow holdback provides a tool for the buyer to be reimbursed for overpayment.
3. Taxes – There are multiple tax implications to the sale and purchase of a business. In a stock sale, the buyer is assuming responsibility that the correct amount of taxes were paid of every type in every period in the past.  If a government agency audits a period, the tax liability could change.  An escrow holdback provides the buyer with some protection if an audit results in a previously unidentified tax liability.  In addition, some taxes have successor liability, even in an asset sale.  An example where that is true is sales and business & occupational taxes in Washington.  Sales and B&O taxes in Washington are paid mostly monthly by businesses at the end of the next month after completion of a period.  Let’s use the scenario of a January 1 transfer of ownership of a jewelry store in Bellevue, Washington.  If the business sold $500,000 worth of jewelry in December, the seller would owe the state & city over $50,000 in sales and use taxes after the sale of their business was completed.  If this liability was not paid, the buyer would be responsible for paying it as they continued operation of the business under the same name at the same location as the previous owner.  An escrow holdback provides the buyer with a resource to pay these tax liabilities if they are not satisfactorily addressed by the seller.
4. Warranties – IBA is known as a market leading business brokerage firm in Washington & Oregon to facilitate the sale of construction and manufacturing companies. It is not uncommon in these two industry sectors to have situations arise where previous work needs to be revisited to remedy a defect.  If the seller of a business was paid for these projects and the buyer needs to address a situation to maintain a happy customer, they should not be financially damaged by taking that action.  An escrow holdback can be used to address any out of pocket expense accrued by the business buyer to honor warranties behind products or work performed.
5. Trailing Liabilities – Taxes & honoring warranties are two of the most common trailing liabilities occurring in a business sale, however many other can exist which can be addressed with an escrow holdback.
6. Transition Training – In most business sales the seller will stay with the company for a period of time post transfer of ownership. An escrow holdback can provide the seller with incentive to deliver a quality period of transition training/consulting/employment.
7. Non-Competition Agreement – Most transactions will include a non-competition agreement where the seller promises to provide the buyer with a safe harbor for operation of the business model without a threat of competition from the party who just sold the business.  An escrow holdback can provide the buyer with leverage to ensure the seller does not violate the terms of the non-competition agreement they signed.

Banks and investors supporting acquisitions also like escrow holdbacks as they mitigate risk for the capital they deployed.  On the seller side, an escrow holdback is often preferred to an offset clause in a promissory note because disbursement of the funds often occurs sooner than with seller financing.  In today’s lending environment, it is common for banks to require that seller financing promissory notes match the term of their debt instruments to avoid a seller note getting preferential treatment for repayment.

As with many legal documents, the devil is in the details with escrow holdbacks.  Properly drafted legal documentation associated with escrow holdbacks should have a clearly defined process for determining if a claim by the buyer is valid and worthy of payment out of the escrow fund.  The time frame the money is held should be based on the period of risk exposure for the buyer on specific issues.

The negotiation of a “win-win” business purchase and sale transaction requires knowledge, experience, and a strong professional skill set.  No two deals are the same.  Sellers are encouraged to strongly vet potential business brokerage representation prior to signing any agreements.  Buyers are encouraged to work with business brokerage firms with a track record for integrity, best practices, and experience doing deals in the relevant industry.   If you have questions about this article or the process associated with selling or buying a privately held company or family business, IBA would welcome the opportunity to talk with you.  All conversations with IBA are held in strict confidence.

IBA, the Pacific Northwest’s premier business brokerage firm since 1975, is available as an information resource to the media, business brokerage, mergers & acquisitions, real estate, legal, accounting, banking, and wealth management communities on subjects relevant to the purchase & sale of privately held companies and family businesses.  IBA is recognized as one of the best business brokerage firms in the nation based on its long track record of successfully negotiating “win-win” business sale transactions in environments of full disclosure employing “best practices”.