What is a “holdback” and how can it help
We’ve all bought something that didn’t live up to our expectations. When it’s something small, we may grumble about it for a moment or two, and move on with our lives. When you’re buying a business, your financial life may hang in the balance. Understanding your rights if you don’t get the business you were promised, or better yet, having an effective remedy, is critically important.
In my experience advising buyers and sellers of businesses, the “holdback” is far and away the most powerful tool to ensure a buyer they get what they’ve bargained for. Fundamentally, a “holdback” provision allows a buyer to retain part of the purchase price after closing. It will specify that remaining funds are due after certain conditions are met.
The beauty of a “holdback” from the buyer’s perspective is it’s a self-help remedy. You don’t need to sue the seller, wait years for a judgment, and hope the seller will pay. You simply refuse to pay the balance of the purchase price. Your remedy is instant, and you force the buyer to endure the hardship of litigation if they disagree with your decision.
A thoughtful holdback provision will be tailored to the specific transaction and concerns unique to the deal. Sometimes the concern is over the truth of representations and warranties made by the seller. In other deals, the concern may be over the true profitability of the business because the seller kept incomplete records. You may be concerned about whether the seller will abide by the non-compete agreement they agreed to sign, or on the flip-side, whether they will show up and do their job if you’ve agreed they will stay on as an employee for some period of time. As a buyer, there is only so much comfort that promises, even contractually binding promises, should give you. Having a significant amount of the seller’s cash is much better.
Imagine this scenario: you agree to purchase a business after the seller shows you his books, which boast strong profits. You’ve visited his offices several times, and noticed that his top employees are fantastic, and he’s got first-rate equipment. Based on all those factors, you are comfortable with a purchase price of $10 Million.
Immediately after the deal closes, you realize things aren’t at all what they seemed. Those top employees? Sure, they’re motivated, because the former owner verbally promised them equity in the company, and he didn’t disclose this to you. That equipment? It is all leased, on unfavorable terms, which were also not disclosed, and the payments are 90 days past due. And that fantastic balance sheet wasn’t just misleading, it was a work of fiction. Still, the business has promise, it just wasn’t worth nearly what you agreed to pay.
How Large Should the Holdback Be?
Now is the time to exercise that holdback provision. If it’s large enough, you may even be able to self-discount the business to its actual value. If it isn’t quite that large, retaining it will still get the seller’s attention, and hopefully bring him to the table to renegotiate, rather than litigate.
Customary holdback provisions range between 10% and 20% of the purchase price. I have seen them reach 60% in high-risk sales. Like any other form of security, however, holdbacks generally cost you something. Be prepared to bargain on other deal points if the seller recognizes the value of the holdback, and balance this against your other interests early in negotiations.