What Does Holdback Mean?
A holdback is a portion of the purchase price that is not paid at the closing date. This amount is usually held in a third party escrow account (usually the seller's) to secure a future obligation, or until a certain condition is achieved.
Holdbacks are very common in purchase and sale agreements. Most sellers require them to provide certainty around matters which are not fully known at the closing date. Most of the time, these holdbacks relate to achieving a specific working capital threshold or in the event there is litigation outstanding at closing.
Divestopedia Explains Holdback
Sellers should not be surprised if a buyer requires a holdback as they are common in transactions. However, holdbacks should not be more than five percent of the purchase price, and should focus on matters that can be resolved shortly after the transaction close.
There are certain matters that warrant a holdback and some that are more unusual. For example, if a seller holds back a significant component of the purchase price to motivate the seller to achieve a certain post-close EBITDA target, such a deal term would not be a holdback, but rather an earnout. Holdbacks are more commonly used with working capital thresholds.
A seller often will require a certain amount of net working capital to be delivered at the transaction close. Usually, the working capital is estimated at this point, with the final accounting completed some time after the transaction close (say 30–60 days). The buyer will use the holdback as protection against any accounting changes from the estimated working capital at close against the actual, final accounting working capital. If the working capital is below the threshold at this point, the holdback protects the buyer as any difference would be subtracted from the repayment of the holdback.
Another common situation where a holdback is used is if the target company has a pending litigation at the closing date. The buyer will require an estimate of the potential loss from this litigation, and either may reduce the purchase price or simply leave the estimated loss amount as a holdback until the litigation is resolved.