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The Correct Way to Structure a Holdback

Cliff Ennico on

"I am in the process of buying a small business.

"There are some issues with this business, and I asked the seller if we could hold back ten percent (10 percent) of the purchase price for a year to see how things went.

"The seller said he was agreeable, but in reviewing the draft agreement his lawyer put together, it says the seller gets the holdback amount if he is not satisfied with the way I ran things during the one year period.

"I think we are almost certain to disagree on that next year. Do you agree, and if so, what's the best way to deal with this situation?"

This is the problem with holdbacks, and it's the reason I seldom recommend them in my merger-and-acquisition transactions.

When pricing a business, you rely upon financial statements that, by definition, only look backward at the business's past performance. There is no assurance that the business will continue to perform as it did in the past. A number of factors can cause a business to deteriorate, such as economic conditions, the loss of a key customer, a lawsuit, changes in government regulations or, simply, the buyer not knowing what he's doing and running the business into the ground.

The buyer wants protection against a decline in the business and will often ask to hold back a portion of the purchase price for a year to see what develops. A holdback can be based upon a falloff in sales, profits or some other metric, like "a 10 percent decline in gross revenue over the 12-month period immediately preceding the closing," for example. Generally, I prefer that holdbacks be based on a decline in revenue, which is more likely than not to be beyond the buyer's control; as opposed to profits, which the buyer could manipulate to his own advantage (by hiring more people or giving himself a generous year-end bonus, for example).

While holdbacks serve a useful purpose, if not carefully drafted, they may put the buyer in a position of profiting from his own incompetence, to which no rational seller would ever agree.

I agree with this reader that the holdback amount going to the seller or the buyer after one year should not depend on the seller's satisfaction with the buyer's performance, or the buyer continuing to run the business in the "ordinary course." That's way too subjective, and it's a virtual certainty that a year from now the seller (or his lawyer) will find some reason not to be satisfied with the way the business has performed. A more objective approach is called for.

Sadly, there is no perfect solution to this dilemma. Here are some of the more common solutions and why they sometimes don't work:

Requiring the Buyer to Maintain a Preset Spending Level. The seller could require the buyer to spend at least as much on marketing, advertising and promoting the business as the seller did during the year preceding the business sale. The buyer would be required to show the seller proof of marketing expenses at the end of the one-year period.

In drafting such a provision, the parties should be careful to exclude administrative and overhead expenses. If the buyer hires a full-time salesperson after he buys the business, that's a legitimate marketing expense. If he allocates one-fifth of a management employee's time to "marketing" because he sometimes calls clients, that's more questionable.

But what if no amount of additional spending will solve the problem? For example, if a major employer moves out of town and the local population declines, no amount of advertising will get that business back.

Limiting the Holdback to Material Adverse Changes in the Business. The buyer could be allowed to keep the holdback amount only if a "material adverse change that is beyond the buyer's reasonable control" occurs in the business. Of course, defining this is extremely tricky, and reasonable minds may differ about whether or not a particular event was or was not within the buyer's reasonable control.

For example, if the buyer were to move the business to a less expensive neighborhood and sales were to decline after a while, was the sales decline caused by the move? If the business were moved less than a mile away from the old location, I would think not, as long as the new location is safe and has plenty of parking...

Extending the Term of Payment If Bad Stuff Happens. However the contract language is drafted, the parties could agree that if a dispute were to arise over the disposition of the holdback amount and were not resolved within 30 days, the buyer would agree to pay the holdback amount to the seller over a period of two to three years. While not a perfect solution, this ensures that the seller will (eventually) get the entire purchase price he bargained for, while giving the buyer more time and additional cash flow to adjust to the business's decline in performance.

Cliff Ennico (crennico@gmail.com) is a syndicated columnist, author and former host of the PBS television series "Money Hunt." This column is no substitute for legal, tax or financial advice, which can be furnished only by a qualified professional licensed in your state. To find out more about Cliff Ennico and other Creators Syndicate writers and cartoonists, visit our webpage at www.creators.com.

 

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