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In a simple asset purchase agreement (an “APA”), a seller makes warranties about assets, a buyer purchases them, and if the warranties turn out to be inaccurate, the buyer’s main recourse is to collect damages from the seller. However, in the sale of an existing dealership business, where the selling entity often exits the business and may even dissolve shortly after a sale, a buyer may worry that the entity and its owners have less incentive to stand behind their representations regarding the assets and operations of the business. The risks of purchasing the operating assets of an existing dealership are numerous and difficult to estimate: the fixtures, equipment, inventory, and any real estate purchased may have unknown and costly problems, the prior dealer’s employment policies and practices could be non-compliant, and there may be unknown claims resulting from questionable prior customer dealings that have not yet come to light.
Joint and several liability
To address a buyer’s demand for protection against pre-closing liabilities, the parties can negotiate an APA, jointly signed by the selling entity and its principal owner(s), purportedly making the owner(s) jointly and severally liable for all obligations of the selling entity under the APA. This joint and several liability provision makes all signatories responsible, individually, for the entire amount of all liabilities under the APA, allowing buyer to go after any signatory for the full amount of any claim.
However, buyers may find it difficult and time-consuming to litigate (or if provided in the APA, arbitrate) indemnity disputes against a seller and/or its principals, that have already been paid in full. In addition, many principals will object to post-closing personal liability since they were not personally liable for the selling entity’s actions while they actually owned and controlled that business. Additionally, the law of suretyship and guaranty can limit the reach of the joint and several liability provision.
Personal and corporate guaranties
Another approach that protects buyers against pre-closing liabilities is a personal guaranty the individual owners of the selling entity, or from a corporate parent entity where the seller is one unit of a dealer group. A well drafted form of guaranty can avoid many of the suretyship and guaranty legal issues noted under joint and several liability, above, but the protection afforded by the guaranty is only as strong as the finances of the guarantor, which even if strong today could be less than adequate to satisfy a claim made in the future.
In recent years, we have seen purchasers fight harder for holdback escrows in conjunction with APAs, to varying degrees of success. A holdback escrow (or “holdback”) involves setting aside some portion of the purchase price in an escrow after the closing for a set period. The purchaser may make claims against the holdback funds until the term has ended, at which time all remaining funds are distributed to the seller, unless any outstanding funds remain in dispute, which are typically held in escrow pending a resolution.
A study was conducted of over 925 private-target acquisitions that closed from 2014 through 2017 found that for 2017, the average holdback escrow was 8.3% of the transaction’s value (SRS Acquiom 2018 Deal Terms Study). Studies of general “M&A” deals like this do not generally track well with automobile dealership buy-sell agreements. However, as dealer group and investor ownership has increased in the industry, M&A concepts, like holdbacks, have gained wider acceptance in dealership purchase agreements.
Preliminary considerations in considering a holdback escrow
In negotiating a buy-sell, dealers on both sides should carefully consider the terms of a holdback proposal, which can affect a significant portion of the purchase price. Many of the terms of the holdback are addressed in the context of the APA’s indemnity clause. For example, buyer’s claims against the holdback may be limited to the claims for which seller is indemnifying the buyer. Here are some primary questions to consider:
Should you have a holdback escrow at all?
Holdbacks tend to be more common with larger deals that include a substantial multiple for the seller’s goodwill. Like a luxury car purchaser, a buyer of a high-value dealership business may demand a more solid “warranty” for their money. Holdbacks tend to be less common where the transaction value is smaller or goodwill is a less significant fraction of the purchase price. Regardless of the transaction size, a buyer has a better argument for a holdback when it can identify specific risks or operating issues that a holdback can address, such as a “free oil for life” program or existing employment issues that may need to be rectified. If a holdback escrow is in place, the parties need to agree on specific types of claims that can be made against the holdback funds.
What amount of the purchase price should be held back?
For a holdback to be effective, it should be substantial enough to motivate the seller to seriously consider its outstanding liabilities and address or at least disclose them prior to the closing. For example, some sellers may view a $25,000 holdback on a multi-million dollar deal as more of an annoyance or cost of doing business than a reason to wrap up any loose ends. On the other hand, sellers will likely view an excessively large holdback as a substantial risk to the stated purchase price, which could motivate them to seek a new buyer or to only accept a higher purchase price.
Who will hold the funds and how are claims made and disputed?
Typically, an escrow company, such as the one that handled the closing, handles the holdback funds. This offers some neutrality since the escrow officer is a third party that will have to follow the parties’ mutual instructions before disbursing funds. But the parties can also designate a specific account or a different third party to hold funds and can agree on mutual restrictions as to how they can be taken out.
With a typical escrow company holdback, the parties choose a claim submission process, such as buyer notifying seller with written details and evidence of an alleged claim. The parties also typically include a claim resolution process, such as providing the seller with a limited amount of time to object to claims and/or mediation, arbitration or another neutral dispute resolution process if objections are timely made. The overall indemnity obligations of an APA may be subject to complicated dispute provisions and many parties choose a more simple resolution process for disputing holdbacks, like informal mediation.
Will the size of claims be limited?
Sellers can limit their exposure by negotiating the size of holdback claims. A floor, which is a minimum amount for holdback claims, can help to prevent buyers from proposing a large number of small, nuisance disputes. A ceiling, which is a maximum amount that a buyer can claim against the holdback amount, can help the seller direct such serious matters to litigation and can prevent large amounts from being tied up in escrow pending involved disputes.
How long should funds be held back?
Buyers will seek longer holdback periods. Sellers will want their funds as soon as possible since after all, all of the value of the dealership and all control over it is now in the buyer’s hands. This term is discretionary but we rarely see holdbacks that last more than a number of months. One practical approach is to look at the issues covered by the holdback and to estimate when claims will arise. For example, if a holdback mainly addresses 90-day dealer warranties provided before the closing, most claims on that front should come to light within 90 days.
We wrote this article to provide some primary considerations in holdback escrows. Of course, we cannot address all of the business and legal considerations present for this topic. Any dealership seriously considering an asset sale should consult with legal counsel experienced in the automotive industry to advise them on this topic as well as the other terms of an APA. Counsel is best sought well before the transaction is underway and ideally, before a letter of intent is signed.