Holdbacks and escrow in a business sale: the warranties they secure
Part of the price usually stays behind after closing to cover the promises you make about the business. A worked $3 million sale shows how the limits on those promises decide what comes back to you.
A holdback is part of the sale price the buyer keeps back after closing, for a set period, to pay claims that your representations and warranties were untrue. An escrow does the same with a third party holding the money. The cap and the basket limit what you can owe, and what is left comes back to you.
What a holdback in a business sale is for
A holdback in a business sale is part of the price the buyer keeps back at closing, for a set period, to pay any claim that the business was other than you described. When the period ends, you receive what is left. Offers for owner operated companies commonly include one, and the letter of intent is where its size and length should first appear.
The holdback secures the promises you make in the purchase agreement, called representations and warranties. A representation is a statement of fact about the business, such as that the financial statements are accurate or that every tax return has been filed. A warranty is your promise that the statement is true. Canadian agreements use the two words together, and the rest of this piece calls them representations.
Representations, and the indemnity behind them
A purchase agreement for a small company carries a long list of representations, reaching from the books to any lawsuit in progress. The buyer relies on them in place of checking everything itself. Behind them sits the indemnity, which is your promise to repay the buyer’s loss if a representation proves false. A buyer of a software company that claims SR&ED credits may ask for one covering a refund that is later reversed, as selling a software or IT company explains.
Your protection is the disclosure schedule, a list attached to the agreement of every exception you know about. If the company faces one lawsuit and the schedule names it, the representation about litigation is accurate. The schedule draws on the same file the buyer reviews in due diligence, so anything you disclose there belongs in it.
Two further phrases narrow what you promise. To the seller’s knowledge limits a statement to what you actually knew, which matters for questions such as a customer’s plans. In all material respects sets aside trivial errors. Buyers accept these on some representations and resist them on others, and the line between the two is a large part of the negotiation.
How long the promises last
Each representation has a survival period, the time after closing in which the buyer can bring a claim. General representations about the operation of the business usually share one period, and the holdback is often set to last the same length of time, so the money is there while claims can still arrive.
Two groups usually last longer. Fundamental representations, which cover your ownership of the shares and your authority to sell them, often survive for years, sometimes until the statutory limitation period runs out. Tax representations are often tied to the period in which the Canada Revenue Agency can still reassess the company’s returns. In a share sale the buyer inherits the company’s history, so a buyer asked to take shares commonly asks for a larger holdback. Share sale or asset sale covers that trade.
Caps and baskets: the limits on what you owe
A cap is the most you can owe for breaches of the general representations. Sellers usually ask for the cap to equal the holdback, so the money kept back is the end of their exposure. Fundamental and tax representations are commonly capped higher, up to the full price.
A basket is the amount of claims the buyer absorbs before it can recover anything. It comes in two forms. With a deductible basket, the buyer recovers only the amount above the threshold. With a tipping basket, once claims pass the threshold the buyer recovers from the first dollar. Many agreements also set a floor for a single claim, so small items are left alone.
A $3 million sale with a holdback and a claim
Take, as an illustration, a share sale at $3,000,000. The buyer keeps back $300,000, ten percent of the price, for 18 months. The cap for general representations equals the holdback, and the basket is $15,000. Nine months after closing, a former employee’s claim for unpaid overtime from before the sale settles for $42,000, and the buyer claims it under your employment representation.
| Step | Deductible basket | Tipping basket |
|---|---|---|
| Paid to you at closing | $2,700,000 | $2,700,000 |
| Held back for 18 months | $300,000 | $300,000 |
| Claim found in month 9 | $42,000 | $42,000 |
| Paid to the buyer from the holdback | $27,000, the amount above $15,000 | $42,000, since the claim passed $15,000 |
| Released to you in month 18 | $273,000 | $258,000 |
| Total you receive | $2,973,000 | $2,958,000 |
The type of basket moved $15,000 on one claim. Had the overtime claim been listed in the disclosure schedule, it would have been an exception to the representation, and the whole $300,000 would have come back to you. The net proceeds tool shows the holdback as its own line, apart from what lands in your account at closing.
A working capital adjustment is a separate calculation made a few months after closing, and some agreements keep a smaller, separate holdback for it. Working capital in a business sale explains how that figure is set. Read the claims clause for set off as well, since a buyer who can deduct claims from a vendor note or an earnout has a second source of money to draw on.
Holdback or escrow, and where insurance fits
With a holdback, the buyer keeps the money until the release date. With an escrow, a third party holds it, usually a lawyer in trust or an escrow agent, under a short agreement that says when to pay it out. Escrow is the stronger position for a seller, because release follows the agreement and both sides’ signed instructions, and the funds sit apart from the buyer’s own accounts.
Some buyers propose representations and warranties insurance, a policy that pays the buyer for losses from a breach. The policy has its own premium and deductible, and a seller should ask whether it comes with a smaller holdback or a lower cap. On tax, where part of the price arrives in a later year, the capital gains reserve can spread the gain over the years you receive it. Whether a holdback qualifies is a question for your accountant.
Ask for the holdback’s size and length in the letter of intent, while other buyers are still interested. Net proceeds when selling a business sets the holdback beside the other deductions from the headline price, and the Quick AI valuation gives a range to measure an offer against.
The terms used in this piece are defined in the glossary of M&A terms.
Questions owners ask
- How much of the price is held back when you sell a business?
- The amount is negotiated in each sale and depends on the risks a buyer finds in diligence. This piece uses ten percent of a $3 million price, held for 18 months, as an illustration. A share sale tends to carry a larger holdback than an asset sale, because the buyer inherits the company’s history.
- What is the difference between a holdback and an escrow?
- With a holdback the buyer keeps the money until the release date. With an escrow a third party, usually a lawyer in trust or an escrow agent, holds it under an agreement that sets out when it is paid. Escrow keeps the funds apart from the buyer’s own accounts.
- What is a basket in a purchase agreement?
- A basket is the amount of claims the buyer absorbs before recovering anything from the seller. With a deductible basket the buyer recovers the amount above the threshold. With a tipping basket the buyer recovers from the first dollar once claims pass it.
- How can a seller reduce exposure under the representations?
- The disclosure schedule is the main tool. Every exception you list there makes the matching representation accurate, so a known issue you disclose is priced before closing and stays out of the claims that follow it.