Understanding Holdbacks: Protecting Yourself in M&A Deals

When buying a business, even the best diligence doesn’t uncover every risk. That’s where holdbacks come in. If you’re new to the term, a holdback is a common M&A tool that protects buyers (and sometimes sellers) by holding back a portion of the purchase price until certain conditions are met. It’s an essential mechanism for managing risk and ensuring a smooth transition.

Let’s break down why holdbacks matter and how they work.

What Is a Holdback?

A holdback is when a portion of the purchase price is withheld in escrow and released later based on specific milestones, conditions, or timeframes. Think of it as an insurance policy baked into the deal.

• For Buyers: It’s a way to ensure the seller delivers on promises (e.g., financial accuracy, legal compliance, or smooth handoff).

• For Sellers: It shows good faith but also ensures they don’t face unlimited liability after the deal closes.

Why Holdbacks Are Important

1. Risk Mitigation: No matter how thorough your diligence is, some risks—like undisclosed liabilities or customer churn—don’t surface until after the deal closes. A holdback gives you time to identify and address these issues.

2. Alignment: Holdbacks incentivize sellers to follow through on promises made during negotiations, like transitioning customer relationships or hitting performance milestones.

3. Flexibility in Disputes: Instead of resorting to litigation when disputes arise, the buyer can resolve them through the holdback funds, saving time and money.

Common Types of Holdbacks

1. Indemnity Holdbacks:

   • Protects buyers from unknown liabilities, such as unpaid taxes, legal disputes, or inaccuracies in financial statements.

   • Funds are typically held for 6-12 months, giving the buyer time to identify issues.

2. Performance Holdbacks:

   • Linked to specific targets or milestones, such as achieving certain revenue levels or completing customer transitions.

   • Often used in deals where the seller stays on temporarily to manage the transition.

3. Working Capital Adjustments:

   • If the final working capital at close doesn’t meet the agreed-upon target, the shortfall can be taken from the holdback.

How Holdbacks Work in Practice

Example 1: Indemnity Holdback
You’re buying a business for $5M. To protect against undisclosed liabilities, $500K is placed in escrow for 12 months. If no issues arise, the seller gets the full amount at the end of the period. But if a tax issue pops up post-close, you can claim part of the holdback to cover the cost.

Example 2: Performance Holdback
You acquire a service business with $2M in annual revenue, and part of the deal includes the seller transitioning key customer relationships. You hold back $200K, to be released after 6 months if at least 90% of the customers are retained. If retention drops below that, you adjust the payout.

Best Practices for Structuring Holdbacks

1. Be Specific: Clearly define the conditions for releasing holdback funds—whether tied to financials, milestones, or timeframes.

2. Set Fair Amounts: The holdback should be large enough to cover potential risks but not so high that it discourages the seller. Typically, holdbacks range from 5-20% of the purchase price.

3. Use Escrow Accounts: Funds should be held by a neutral third party, ensuring neither the buyer nor seller can misuse them during the holdback period.

4. Time Limits: Most holdbacks are capped at 6-18 months to balance risk mitigation with the seller’s need for financial certainty.

The Takeaway

Holdbacks are a smart way to protect yourself in M&A deals. They give buyers peace of mind and ensure sellers are incentivized to follow through on their commitments. Whether you’re buying or selling, structuring holdbacks correctly can prevent disputes, manage risk, and set both parties up for success.

Thinking about using holdbacks in your next deal? Let’s connect and strategize how to make them work for you.

-Matt 

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