Closing Might Not Be the End
It might seem logical to think that the deal is done when the closing docs are signed and the check for the sale of your business clears. This indeed is when you may realize most of the money from the sale, but there may be clauses in the Purchase Agreement that hold back some of the funds for the
protection of the buyer. Here are some examples.
A holdback for indemnification. Usually, a seller makes several Representations and Warranties in the Purchase Agreement; one example is that there are no pending lawsuits or other threatened legal action against the company. However, issues can arise months later. A product or component might fail, for example, even causing injury or other harm. An employee might bring a suit against the company months after being fired. A product may be recalled due to safety concerns.
What if these scenarios originated during the seller’s ownership, and are not covered by insurance? In that case, the buyer will want to ensure the Seller is responsible for these costs without having to chase the Seller for the funds. Often, holdbacks of this nature are held in escrow by a third party. If a warranty or legal issue arises, the buyer can make a claim against the funds. Typical holdbacks range from 10 to 15% of the sale price; they’re negotiated between the parties and provide an incentive for sellers to be completely transparent about any issues the company might face in the future.
A holdback for working capital adjustment. In a small company sale, it’s easier to verify the amount of working capital included in the deal, whether it’s accounts receivable, accounts payable, or inventory. Some buyers conduct physical verification of inventory during the diligence process.
But in a larger company, estimating the amount of inventory the buyer is acquiring can be more difficult. It’s not always practical to count items in a 40,000 square foot warehouse upon Closing. The buyer may find, after the sale, that some of the inventory is damaged, obsolete, or unsaleable. The buyer may discover that the inventory was miscounted and is much smaller than estimated during the sale negotiation.
That’s how one seller came to realize that he had an employee who had been stealing inventory (building supplies) for years. When the buyer took possession of the storage facility, the amount of product was significantly less than the owner’s records showed.
It’s possible that some of the Accounts Receivables turn out to be uncollectible after the sale. There are ways for both parties to prevent these issues. One is for the owner to keep detailed records and do regular inventories and audits. Counting inventory and making sure that receivables and payables are meticulously monitored will prevent unpleasant surprises during diligence and after closing. Buyers can develop a method for spot checking elements of inventory and working capital to gain confidence that the numbers are accurately represented. Both parties will also have to agree on how customer deposits should be divided based on when the work will be completed and paid for.
This is why many deals include a holdback for a Working Capital Adjustment, which is usually released approximately 90 days after Closing, once the Buyer has had a chance to verify that they have received the Working Capital that was supposed to be included in the deal.
Seller financing. If a seller agrees to finance some of the sale, they may not receive the full payment amount for a few years. These kinds of agreements, although common, present risk for sellers, who are no longer in control of the business. It requires trust and due diligence on the part of the seller to make sure they are prepared to put some of their funds at risk in this way. Buyers like to have some Seller financing as a way to ensure the seller has some skin in the game and would cooperate with the transition to ensure the buyer’s success.
Earnout agreements for future sales or performance goals. Buyers may want a seller to defer some of the payment for the sale, paying it out over time based on specific performance milestones. Again, this is a way to ensure that the seller is incentivized to help maximize company performance after the sale. Earnouts are used when there is a gap between the value that the buyer is willing to pay and what the seller is willing to accept. This often happens when the projected revenue or profits in the near future is higher than current company performance. The buyer is essentially saying: I’ll pay you based on next year’s projections if we hit those numbers.
Earn-outs can also be written to benefit the seller. A recent example we encountered was a seller who had invested several hundred thousand dollars in the development and marketing of a new product. At the time of the sale, the investment was simply listed as expenses on the P&Ls. But if the product took off over the next year or so, the company could achieve substantial growth. It was only fair to write an earn-out clause that allowed the seller to benefit from their initial investment after the sale.
All this complexity means that the seller could easily agree to something that’s not in their best interest down the road. That’s why I always recommend that sellers surround themselves with a team of experienced advisors to avoid costly pitfalls and help the seller understand the implications of every clause in the sales contract before closing.
