Issues with Holdbacks & Earn-outs in Business Sale Transactions

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

Holdbacks and earnouts are common mechanisms in purchase agreements, particularly in business sale transactions (mergers and acquisitions), designed to manage risk and bridge valuation gaps. While they can be useful tools, they also introduce a number of potential issues and points of contention for both buyers and sellers.

A. Issues with Holdbacks in Business Sale Transactions

A holdback (often held in escrow) is a portion of the purchase price that a buyer withholds at closing to secure against potential post-closing liabilities [more about Holdbacks].

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.

B. Issues with Earnouts in Business Sale Transactions

An earnout is a contingent payment structure where a portion of the purchase price is tied to the acquired company's future performance over a specified period [more about Earnouts].

From the Perspective of the Seller of the Business:

• Lack of Control and "Buyer's Remorse": Once the deal closes, the buyer is in control of the acquired business. The seller, even if they stay on in a management role, loses the ability to make key decisions. The buyer's business decisions (e.g., changes in strategy, integration with other businesses, or cost-cutting measures) can negatively impact the company's performance and, consequently, the earnout payment. This is a major source of disputes.

• Ambiguous Terms: Vague or poorly drafted earnout provisions are a leading cause of disputes. Issues can arise from how performance metrics are defined, calculated, and measured. For example, is "revenue" gross or net? Is "EBITDA" calculated before or after certain expenses?

• Manipulation by the Buyer: A buyer may intentionally or unintentionally take actions that minimize the earnout payment. This could include shifting revenue or expenses to or from the acquired business, overspending on R&D or marketing, or paying excessive "insider" salaries.

• Difficult to Litigate: Earnout disputes are notoriously difficult and expensive to litigate, as they often involve complex accounting issues and the implied covenant of good faith and fair dealing.

• Conflict of Interest: If the seller is also a member of the post-acquisition management team, their financial interests in maximizing the earnout can conflict with their fiduciary duties to the new company.

From the Perspective of the Buyer of the Business:

• Ongoing Relationship with the Seller: The earnout structure creates a lingering relationship with the seller, which can be a source of tension and ill will, particularly if targets are not met.

• Operational Constraints: The earnout agreement may place restrictions on the buyer's ability to fully integrate, restructure, or operate the newly acquired business. For example, the buyer may be required to maintain a certain level of investment in the acquired company, even if their broader business strategy dictates otherwise.

• Seller's Potential for Manipulation: Sellers who remain involved may engage in short-term tactics to meet earnout targets, even if those actions are detrimental to the long-term health of the business (e.g., pulling future sales into the earnout period).

• Complexity and Administration: Earnout agreements are complex and require meticulous drafting. They also necessitate a system for tracking and reporting on the performance metrics, which can be an administrative burden.

• Financial Uncertainty: The buyer's final purchase price is not known until the earnout period concludes, which can create financial unpredictability for the buyer.

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.