Purchase Price Escrows vs. Holdbacks, An Overview

Recently, I’ve worked on several business sale transactions where the parties expressed varying preferences as to the use of an escrow account versus a holdback mechanism in the transaction structure, so I thought a brief overview of those two concepts might be something that readers of entreVIEW might find interesting.

In a business sale transaction, the parties typically (but not always) opt to incorporate either an escrow account or holdback mechanism, both of which generally serve the same role in any transaction—the parties agree to set aside a portion of the purchase price that a Buyer can recover against, as needed, after the closing. This could be for purchase price adjustment, often related to

working capital or indemnity obligations of the Seller.  The idea being that it’s much simpler and cleaner for the Buyer to be able to recover these amounts from money already set aside for that purpose, rather than having to try to claw back a portion of the purchase price that has already been disbursed to the Seller or its shareholders, which, as I’m sure you can imagine, can get complicated fairly quickly.  Absent the implementation of an escrow account or holdback mechanism, there is really no way to ensure that the Seller will have remaining sale proceeds available after the closing to fulfill these obligations.

If the parties opt to use an escrow account for these purposes, the agreed-upon amount(s) are held out of the purchase price and transferred to an escrow account with a mutually agreed-upon independent third-party escrow agent in lieu of the seller at closing.  The terms of the escrow account (e.g. whether the account will be interest bearing, the allocation and disbursement of interest earned (if any) from the deposited amount(s), whether the escrow agent can invest the deposited amount(s), the allocation and disbursement of income earned (if any) from the investment of the deposited amount(s), the escrow agent’s fees and expenses (if any), and the timing and mechanics of the ultimate disbursement or release of the deposited amount(s), are usually set forth in a separate escrow agreement that is negotiated by the parties and the escrow agent and entered into at the closing.  

In addition to the escrow agreement, the parties will need to negotiate and agree upon the allocation of any fees and expenses associated with having the escrow account as part of the provisions in the purchase agreement.  Any remaining amounts are frequently released by the escrow agent to the Seller in a lump sum at the end of an agreed-upon period, often tied to the expiration of the applicable indemnity survival period in the purchase agreement.

Alternatively, if the parties prefer not to incur the additional costs and expend the additional time and resources necessary to establish an escrow account, they can agree to allow the Buyer to simply hold back the agreed-upon amounts from the purchase price at closing instead. All the terms associated with the holdback will be negotiated by the parties and included as part of the purchase agreement. Unlike with the deposited amounts in an escrow account, the Buyer is not normally required to set aside the holdback amounts in a separate account or invest the holdback amounts, and the management of the holdback amounts is wholly within the Buyer’s control until the disbursement or release of the holdback amounts at the end of the agreed-upon period.  For those reasons, as well as the lack of assurances that the Buyer will have the holdback amounts the Seller is entitled to on hand or otherwise readily available and will promptly transfer such amounts to the seller following the end of the agreed-upon period, Sellers tend to favor having an escrow account over utilizing a holdback mechanism.  Buyers, on the other hand, tend to favor a holdback mechanism because it simplifies the transaction documentation, avoids the additional costs and expenses of an escrow agent, and eliminates the delay between when the Buyer becomes entitled to a payment and receipt of the funds.

With respect to quantifying the appropriate amount of the purchase price the parties agree should be set aside in an escrow account or held back by the Buyer, there is no foolproof way of predicting as of the closing date the amount for which the Seller may ultimately be responsible. As a result, the parties often (but not always) rely on the prevailing market trends for purchase price escrows/holdbacks, which are analyzed and published publicly by a number of independent third-party organizations (e.g., the M&A Deal Terms Study published by SRS Acquiom annually and the Private Target M&A Deal Points Study published by the American Bar Association’s Business Law Section biennially). The current market trend is to reserve roughly 1% of the total transaction value for working capital adjustments and approximately 10% of the total transaction value for indemnity claims.

From a tax perspective, and without getting too much into the weeds, for U.S. federal income tax purposes only, (1) the deposited/holdback amounts will be treated as owned by the Buyer until disbursed or released; (2) all interest and other taxable income earned, if any, from the investment of the deposited/holdback amounts will be treated as earned by the Buyer; (3) the Seller’s right to receive the deposited/holdback amounts will be treated as deferred contingent purchase price for the sale of the business; and (4) if and only to the extent any portion of the deposited/holdback amounts are actually dispersed or released to the Seller, interest can be imputed on the deposited/holdback amounts under the tax code.