In this article we will discuss the earnest money deposit, down payment, cash at close, and the escrow process when buying a business.
What is an Earnest Money Deposit When Buying a Business?
An earnest money deposit is a sum of money a buyer puts into escrow within a short time period after an accepted offer. The time period is typically 1-3 days. The purpose of the deposit is to help both the buyer and seller step forward together in the transaction in small steps. An earnest money deposit indicates the buyer is serious and provides the seller some confidence in selecting the buyer and taking the listing off the market.
How Much is an Earnest Money Deposit When Buying a Business?
A common earnest money deposit amount is 10% of the purchase price. Business brokers will typically not ask for more unless there is some unusual circumstance or justification. The earnest money deposit can certainly be less than ten percent. It is often called a “good faith deposit.” At a certain point, if the earnest money amount is quite low, the buyer is giving very little good faith to the seller. Naturally it requires both seller and buyer to agree to the terms, including the amount of the deposit.
Do Most Buyers Provide an Earnest Money Deposit?
Earnest money deposits are common in main street business sales although they are not as ubiquitous as in real estate sales. A seller may accept an offer with no earnest money deposit. The market for buying and selling businesses is less active than real estate, so the seller of a business may decide to accept an offer with no earnest money deposit. In fact, most financial buyers of larger businesses do not provide earnest money deposits. Earnest money deposits are common in main street business brokering and not common in M&A transactions.
What is Escrow’s Role in the Sale of a Business with Real Estate?
Most escrow companies are geared for real estate transactions where they deal with multiple parties including buyers, sellers, lenders, title companies, attorneys, agents, intermediaries and even contractors or service providers who will be paid out of escrowed funds. They require the parties to the transaction sign an escrow agreement that protects the escrow company and defines their duties and limitations. They act as a neutral third party managing the flow of documents and funds as set forth and agreed by the parties to the contract.
What is Escrow’s Role in the Sale of a Business without Real Estate?
Many escrow companies do not handle business transactions without real estate involved. Escrow companies that handle the sale of businesses without real estate are specialized and more prevalent in mergers and acquisitions. In some regions, business brokers have very few choices for escrow companies willing to assist with business acquisitions that do not involve real estate.
How Safe is the Business Buyer’s Earnest Money Deposit?
While the purchase agreement outlines how the earnest money is to be treated with timeframes, triggers, conditions etc., disputes can happen with the interpretation of the contract or its intent. Certain events such as sickness or death can also leave money stranded in escrow. And worst of all scenarios, certain parties may willingly choose not to honor the contract or its intent citing grievances with the other party. Earnest money deposits and any other escrowed monies do not flow from escrow to one of the parties automatically.
Escrowee is authorized and directed to release the Earnest Money Deposit in accordance with any written instructions signed by all parties below, it being understood and agreed that such written instruction shall clearly indicate the payee, method of delivery and amount.
Note the requirement for signatures from all parties
What Does Escrow Do With the Earnest Money Deposit In the Event of a Dispute?
Just as in a real estate transaction, the escrow company is a neutral third party. They hold money for a fee. As long as everything is going smoothly between the buyer and seller, escrow’s job is straightforward. In the event of a disagreement, escrow does not get involved. Some buyers and sellers are under the false impression that escrow companies have clear directions enabling them to move money in a dispute. This is not the case. Regardless of how clear the terms of the escrow between buyer and seller and how clear one party or the other is entitled to escrow funds, the escrow company’s only action in the event of a dispute is to bow out and let the parties resolve the matter by coming to an agreement or engaging legal representation.
The money they are holding is now “in jail” and it will require a resolution between the parties to move that money in one direction or the other. Escrow agreements contain language releasing them from liability, giving them the ability to file interpleader actions in the event of a dispute or if the funds have been with the escrow company with no resolution past a certain time frame. This places the funds with a court and requires the parties to litigate. Here is a passage from an escrow agreement:
In the event of a dispute as to the disposition of the Deposit, Escrowee may refuse to deliver funds. Escrowee is also authorized and may file an interpleader action as provided by law. Upon depositing the Deposit with the court, Escrowee shall be released from any further liability under this Agreement. It is understood and agreed that should Escrowee file an interpleader action Escrowee may charge the Deposit money for attorney’s fees and court costs. Escrowee may file an interpleader action and deposit the Deposit with the court any time after what is specified in the separate escrow instructions to be provided at closing.
This clearly notifies the parties of the escrow companY’s (ESCROWEE’S) limited actions and permitted actions in the event of a dispute
What is a Down Payment When Buying a Business?
A down payment is the sum of money provided by the buyer to the seller at closing, often through an escrow company. The down payment is a portion of the purchase price. An additional portion of the purchase price can be paid to the seller at closing by a third party lender. Any other types of balances are typically paid in the future in the form of seller financing or earnouts. Seller financing is when the seller acts as the lender and receives consistent periodic (typically monthly) payments at a certain interest rate. Earnouts are future payments contingent upon certain triggers, such as achievement of financial targets or retention of customers or key employees.
How Much is the Down Payment When Buying a Business?
The down payment can be as low as 10% with an SBA loan. However, based on the qualifications of the buyer and the financials of the business to be acquired, the required down payment may be higher. If there is no SBA or third party loan and the seller has agreed to finance a portion of the purchase price or accept earnouts, then the seller will typically require a significantly larger down payment from the buyer. Sellers are unlikely to finance or accept earnouts on over 50% of the purchase price and most would prefer to limit payments after closing to 25% or less.
Do Most Buyers Buy a Business with a Down Payment?
Most buyers purchase businesses with a down payment versus all cash. This is also true of real estate. However, all cash is more common in real estate. One likely justification for this is that a buyer of a business would prefer the seller to have some skin in the game after closing to ensure a smooth transition into a business with a lot of moving parts and unknowns. Real estate on the other hand, is a more well understood asset that has more standard due diligence and often has more competition, all factors making it easier for a buyer to justify an all cash offer for real estate than a buyer for a business.
How Safe is the Business Buyer’s Down Payment?
Similar to real estate, the down payment represents the buyer’s equity investment in the business. The safety of that investment depends on how well the asset performs. Most main street businesses are purchased at a small multiple of earnings. A down payment means the buyer is leveraging a loan from a bank or the seller and thus shortening the buyer’s return of their investment. This limits the buyer’s exposure which makes sense given the higher risk in investing in a business than in real estate in general. Note that the larger the business profits, the higher the multiple. This indicates that buyers feel there is less risk in buying larger businesses. Also, buyers of larger businesses are more capable of risking larger sums.
How Does Escrow Handle the Down Payment for a Business?
As in real estate, escrow will require the down payment and any other fees from the buyer in order to close the sale. Funds can be delivered as a check or wired, and escrow will disburse the down payment less any seller fees to the seller. If a buyer does not perform at this stage, any earnest money will be forfeited and can be claimed typically by both the intermediary and the seller depending on the terms of the purchase agreement.
What is an Escrow Holdback in the Sale of a Business?
In the event that there are post-closing conditions that the seller needs to meet, part of the seller’s proceeds can be held back until those conditions are met. For example, a tax clearance is often required by a lender, but requested at the end of the escrow process. Meanwhile some states can take months to deliver a tax clearance. In this case, escrow will hold funds and release them to the seller once the tax clearance is provided to the lender or borrower. This can be weeks or months after the closing.
Can a Business Be Purchased Without an Escrow Company?
Business acquisitions do not require a third party escrow company. Attorneys or intermediaries can handle funds and documents acting as escrow agents. However, most business brokerages will not take on or allow agents to take on escrow functions due to the liability. Many attorneys also will not take on this function. Intermediaries and attorneys are often not neutral and will prefer or require the use of third party escrow companies.
How Does Going Under Contract Differ Between Main Street vs. M&A Acquisitions?
Here is a rough guide as to when certain deposits are used in the industry or not. Sometimes they correspond to the type of offer/interest documents used. For example, in deals where a letter of intent is used, there is typically no deposit. However, a letter of intent, which could be used for a $3M acquisition, does not correspond to break up fees which typically occur at roughly a $10M or higher purchase price. These are rough guidelines and you may see hybrid models between the main street business broker process and the lower middle market M&A process where the two types of intermediaries may overlap. This overlap is common in deal sizes from $2M – $20M.
| Main Street | M&A | |
| Indication of Interest (IOI) | No | Yes |
| Letter of Intent (LOI) | No | Yes |
| Purchase Agreement (PA) | Yes | Yes |
| Earnest Money Deposit (EMD) | Yes | No |
| Breakup Fee | No | Typical Over $10M purchase price |