Legal Viewpoint: Understanding and Mitigating the Holdback in an M&A Transaction, a Sell-Side Perspective

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By Mike Stanczyk, Mergers & Acquisitions Attorney

So you’ve decided to sell your business. You’ve grown the business’s revenues over the last couple of years through blood, sweat and possibly some tears.  You want to get full market value for it, as you should.  So you work with an expert to determine a reasonable valuation for the company and enter into negotiations with an acquirer, or hopefully, multiple acquirers.

Then the first Letter of Intent comes in from an acquirer.  While the overall purchase price looks fine, they want to only pay you a portion of the amount at the closing and keep or “hold back” the rest for six months.  Then another Letter of Intent comes in, which has a higher purchase price but the second potential acquirer wants to hold back more of the purchase price for a period of twelve months from the closing.  What gives?

Well, if you are in a certain industry, the pest control industry being one of them, holdbacks have become commonplace.  Holdbacks serve a necessary purpose for acquirers.  They can also (but not always) serve a purpose for sellers.

You will be negotiating the purchase price and holdback amounts and timeframes which will be dependent on your company’s revenues or other factors.  If you believe the acquirer has a dim view of what your company is worth, and you continue to press them on it, the holdback will make you put your money where your mouth is.  If you accurately forecast your company’s revenue you can be relatively sure (notwithstanding other contingencies that may arise) that your company’s revenue will be what you believe and you’ll get your entire holdback.   But if you are greatly overselling your company’s actual revenues, you might get a higher purchase price initially, but when the holdback timeframe is up, you likely won’t get your full holdback.

As an acquirer works through the diligence period to check your accounts, revenues, customer agreements, retention rates, etc. their financial people come up with what they believe is your average portfolio revenue.  That’s what they think they are acquiring at closing, and the holdback is a way for them to hedge their bets if the agreed upon purchase price does not accurately match your company’s revenue number.  So for example, you negotiate a purchase price for your company of $3,000,000, and your company has say $1,800,000 in annual revenue, then the holdback will be dependent on the acquirer receiving a certain minimum percentage of your annual revenue after closing (say for example 80%), and anything below that is retained by the acquirer on a dollar for dollar basis.  So if the acquirer receives anything less than $1,440,000 (being 80% of $1,800,000) in the 12 month period after closing, you won’t receive all of the holdback amount (typically the reduction to the holdback is a dollar for dollar reduction based on the delta between the target, here being $1,440,00 and what the business made in the 12 month period).  So using the example, if $600,000 were held back out of the $3,000,000 purchase price, and the business was $200,000 below the target of $1,440,000, then you would receive only $400,000 of the holdback amount.

Another reason for holdbacks, which largely benefits the acquirers, are that they allow the acquirer to allocate risk to the seller, as there are many items which the seller knows about the company but the purchaser does not.  The Seller will represent in the asset purchase agreement as to the status of the business (most notably financial statement representations), including tax items, working capital adjustment, and others.  If any of the foregoing turn out to not be as the seller stated, or any unforeseen contingencies arise, then the acquirer has suffered, or may suffer, damages.  The seller will have to indemnify the purchaser for such damages and such indemnification amounts will usually be retained by the purchaser from the holdback amount.  For example, if you state that the company has no liens on any of its equipment, but it turns out there was a UCC filing on something that had a small loan with a balance still outstanding, the acquirer would pay the loan, get the lien removed and deduct the amount it had to pay from your holdback.  The same process would work for tax items and other issues that arise prior to the time the holdback payment is due.  Note that if indemnification was required after the holdback was paid, or the amount of indemnification is higher than the holdback amount, legally the seller has to come out of pocket to make up the difference.

As to the time frame of the holdback, typically if the holdback is related to revenue verification, the purchaser will want it to be a twelve (12) month period.  If the holdback (occasionally there are multiple holdbacks in the same transaction) is related to something such as accounts receivable which the purchaser is buying, the time frame will be shorter, such as four (4) months.

If you understand why the acquirer is requiring a holdback and how it works prior to negotiating the Letter of Intent you can set yourself up for success.

Things you can do:

  1. Request to have a smaller portion of the purchase price held back (even if this would slightly decrease the overall purchase price you would benefit in the long run by getting the money earlier)
  2. Request that the holdback amount to serve as the sole amount which the acquirer can look to if something should go wrong (or not turn out as the acquirer thought).
  3. Ensure that the revenue amounts upon which payment of your holdback amount are realistic and attainable.  State your case to the acquirer.  If there are reasons why customers may leave or revenue may slow down, then bring that up and push for a lower revenue amount to peg it on or a more lenient percentage of what is needed (say 75% of the total revenue instead of 85% or 80%).
  4. Negotiate the ability to stay on as an employee or consultant to ensure things run smoothly for the time period until you are entitled to the holdback amount. If customers are lost in that interim, put on your sales hat to bring in new revenue to make up for it.

Mike Stanczyk is a mergers and acquisition lawyer from Upstate New York who represents individuals selling their companies in multiple industries throughout the United States.  He assists in the negotiation and implementation of strategies to help them maximize value while limiting potential liability. Over the years Mike has worked closely with Potomac on pest control M&A transactions of all sizes across the United States and we recommend him without hesitation.

Mike can be reached on the telephone at 315.476.1010 or email at mike@centolellalaw.com

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