HOLDBACK in a Business Sale Transaction

Contact Neufeld Legal PC for corporate transactional and legal matters at 403-400-4092 / 905-616-8864 or Chris@NeufeldLegal.com

A holdback is a portion of the purchase price in a business sale that the buyer withholds at closing, usually placing the funds in an escrow account managed by a third party. This mechanism protects the buyer against potential post-closing liabilities that may arise from a breach of the seller's representations and warranties, such as undisclosed debts, pending litigation, or inaccurate financial statements.

The primary purpose of a holdback is to mitigate the buyer's risk. Instead of relying on the seller's promise to pay for any future issues, the buyer has a dedicated fund to draw from. This also incentivizes the seller to be transparent during due diligence and to cooperate with the buyer in resolving any issues after the deal closes, as the seller's final payment is contingent on a clean exit.

The terms of a holdback are negotiated and included in the purchase agreement. Key elements include:

• Amount: The size of the holdback is typically a percentage of the total purchase price, often ranging from 5% to 15%, depending on the perceived risks of the transaction.

• Duration: The funds are held for a specific period, such as 12 to 24 months, which aligns with the time frame for which the seller's representations and warranties are legally enforceable.

• Escrow Agreement: The holdback funds are usually placed in an escrow account with a neutral third party (like a law firm or a bank). This ensures that neither the buyer nor the seller can access the funds unilaterally.

• Release Conditions: The agreement specifies the conditions under which the funds will be released to the seller. If no claims are made by the buyer, the full amount is released at the end of the period. If claims are made, the disputed amount is retained until the issue is resolved.

Risks and Considerations with Holdbacks in Business Sale Transactions

From the Perspective of the Seller of the Business:

• Deferred Payment and Cash Flow Uncertainty: The most obvious issue is that the seller does not receive the full purchase price at closing. The money is held for a specified period, which can be a few months to a couple of years, creating cash flow uncertainty.

• Loss of Control: The seller has no control over the held-back funds during the escrow period. This can be problematic if they need the capital for other purposes.

• Disputes Over Claims: Disputes can arise if the buyer makes claims against the holdback funds for breaches of representations, warranties, or other post-closing obligations. The seller may believe the claims are without merit, leading to costly and time-consuming negotiations or litigation.

• Negotiating a "Sufficient" Amount: The seller wants the holdback to be as small as possible, while the buyer wants it to be large enough to cover all potential claims. This becomes a significant point of negotiation.

From the Perspective of the Buyer of the Business:

• Incomplete Protection: While a holdback provides a source of funds for claims, it may not be enough to cover all potential damages. For example, a major undisclosed liability could exceed the holdback amount.

• Negotiating a "Reasonable" Duration: The buyer wants the holdback period to be long enough to discover and address any issues, while the seller wants a quick release of funds.

• Administrative Burden: Managing the holdback and any claims against it can be an administrative burden, especially if a third-party escrow agent is involved.

• Buyer's Obligation to Pay: The buyer still has a contractual obligation to release the funds if no claims are made, which can be a point of friction if they are reluctant to do so.

When it comes to the legal component of corporate mergers & acquisitions, that is when the law firm of Neufeld Legal P.C. comes into play. Such that when your company is seeking knowledgeable and experienced legal representation in orchestrating and completing business mergers, acquisitions and divestitures, contact us at strong>403-400-4092 [Alberta], 905-616-8864 [Ontario] or Chris@NeufeldLegal.com.