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Escrows and AR Holdbacks

In most of the acquisition offers we see for our clients, the letters of intent, mainly drafted by the buyer, contain provisions for bad debt, a.k.a. dated accounts receivable that have not been written off the seller’s books.

In a process a little like the game hot potato, the buyers don’t want to assume dated accounts receivable, yet the seller wants to pass it off under the assumption that the buyer can collect it when the company is under new ownership.

However, no buyer wants to take on the onus of these collections. So, here is how buyers typically address the matter:

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In the vast majority of deals, at the closing, the accounts receivable become the property of the buyer. However, the value of the accounts receivable reflects collectible sales amounts. Typically, any accounts receivable that is not collected within 180 days post-closing reverts to the seller to collect. The bad news for the seller is that the value of the uncollected bad debt becomes a dollar-for-dollar reduction in purchase price.

For example, let’s say you, the seller, have an account that stuck you for $10,000 and the account holder mysteriously stops answering their phone or responding to emails. As much as this leaves you with a sinking feeling, it’s rare that an LBM dealer has not had this happen; bad debt is par for the course.

When the seller closes the acquisition, and the business comes under new ownership, that $10,000 is hanging out there. But who assumes it? The buyer might briefly assume the risk of collecting it, but if it goes out more than 180 days post-close, the buyer no longer considers that an asset of the deal, and the seller takes ownership of it, a.k.a. debt repurchase. At that point, the buyer gets to reduce the purchase price by $10,000, because the seller owes the buyer that sum.

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How does the buyer collect on the $10,000 if the deal has closed? After all, funds have wired at the closing, and buyer and seller have already celebrated a successful closing. Well, that’s where one of two deal elements comes into play. The first is an escrow arrangement. The vast majority of deals have escrow, which is between 5% and 10% of the total enterprise value. The escrow is held by a third party (usually a bank, designated by the buyer) for between 12 and 18 months, post-close. If the seller owes the buyer $10,000 for the uncollectable accounts receivable, and the seller hasn’t voluntarily written a check for that amount after the 180-day period, that $10,000 would get settled out of the escrow.

The second deal to address this potential liability is an accounts receivable hold back. In that situation, as much as 25% of the accounts receivable value at closing would be withheld from funds paid to the seller at the closing. After an agreed-upon period, the seller would repurchase uncollectable accounts receivable, and the holdback would be reduced by that amount. The math is quite simple: If the accounts receivable is valued at $200,000 at closing, the accounts receivable hold back would be 25% of that, or $50,000. If the $10,000 gets repurchased by the seller, then the net yield to the seller would be $50,000 minus the $10,000, or $40,000.

It is not unusual for an accounts receivable holdback and an escrow to co-exist in the deal terms. The accounts receivable holdback would be exclusively used to address bad debt, and the escrow—a much larger dollar amount—would be to used to address other matters that may arise post-close, like an unexpected seller’s liability.

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Deal terms announced in the LOI, and spelled out in the purchase and sales agreement, don’t leave much to chance. They should be welcomed, because it keeps both sides of the deal honest, and avoids potentially messy legal issues later down the road.

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