M&A Vocabulary – Understanding Experts: Retention Amount

In this ongoing series, a number of different M&A experts from the global offices of Rödl & Partner present an important term from the specialist language of the mergers and acquisitions world, combined with some comments on how it is used. We are not attempting to provide expert legal precision, review linguistic nuances or present an exhaustive definition, but rather to give or refresh a basic understanding of a term and provide some useful tips from our consultancy practice.

A claim for damages is in the end only worth something, if you can enforce it. Based on this insight, the concept of agreeing on a retention amount (or a holdback) is used in business acquisitions – that is, part of the purchase price is withheld for a certain period of time as collateral for the buyer’s possible warranty and indemnification claims against the seller. Various structuring instruments can be used for securing such claims. Apart from purchase price retention this may include various forms of third-party guarantees (e.g. suretyships or bank guarantees). W&I insurances are becoming more and more popular, in particular in large-volume transactions; they insure claims for liability arising from breach of warranty and indemnification obligations.

As opposed to earn-out structures, the claim for payment of the relevant part of the purchase price basically is not tied to the condition of fulfilling future covenants (e.g. achieving certain KPIs). Generally, the claim already arises when the contract is signed but the actual payment does not become due until a specific calendar date or a point in time that depends on an event occurring in the future. This enables the buyer to offset his claims against the seller arisen to that date, e.g. from breach of warranty and indemnification obligations. Formulating the exact conditions subject to which a retained amount may not (yet) be paid out (e.g. in the case of pending court proceedings) and the requirements the meeting of which will allow such a set-off and also the consequence of a subsequent purchase price adjustment (often in consultation with tax experts) are the most challenging tasks for a transaction lawyer when drafting a retention agreement.

Sometimes, the parties agree on several retention amounts and define different conditions for different risks and/or liability claims.

Retaining part of the purchase price as security is a very important element of the purchase price structure. At the same time, it is generally the easiest instrument to be used as collateral by all parties involved, since no third parties need to be involved. It is the most favourable form of collateral to the buyer – and thus the most burdensome to the seller. Therefore, as a rule, the buyer will only be able to successfully enforce a lump-sum amount retained as collateral for abstract, potential liability claims if he has a very strong negotiating position.

Invoking the information asymmetry in the purchase transaction alone, a fact that is true anyway in most cases, will not be sufficient to this end. The buyer can only expect to be heard by the seller if he substantiates his claim as such and the fact that its enforcement is jeopardised and, on top of this, if he is able to put a figure on such a claim. Therefore, when negotiating whether the retention of part of the purchase price will be agreed on and in what amount, two aspects are important, on principle, and the buy-side should refer to them in most cases cumulatively as arguments towards appropriate structuring:

specific findings on principles used for business valuation and purchase price determination and the related risks, obtained in particular from a due diligence review;
indications suggesting that the seller’s assets for satisfying any claims of the buyer (“liable assets”) will not be sufficient in the future or any other foreseeable obstacles hindering successful enforcement of a substantiated claim.

Potential Claims For Liability

Examples of identified liability risks are claims of authorities for the repayment of state subsidies, looming product liability claims from customers, possible fines to be imposed on the basis of antitrust law, tax issues yet to be clarified that could result in additional tax claims.

In a situation where such risks are known to the buyer, the involved amounts are significant and risk materialization is probable, the buyer will have to consider a purchase price adjustment or even refraining from the acquisition at all. Instead, where risk is assessed to be moderate or in order to avoid the risk that negotiations will be cancelled at an advanced stage of negotiations, the buyer could demand that an indemnification obligation be included in the contract and that an appropriate amount of the purchase price be retained as collateral. The retention would then be valid e.g. until tax claims become time-barred or a final decision is passed in relevant proceedings.

It is foreseeable that the seller’s risk assessment will be different, so it is not uncommon that at this stage of negotiations the parties exchange respective legal and tax opinions. The relevant issues should therefore be identified as part of a due diligence review as early as possible and an appropriate line of argumentation should be anticipated.

Critical Sell-Side Hallmarks

Indications suggesting that the seller does not have sufficient liable assets or access to them is hindered are e.g. a holding structure where the seller's vehicle bears little liability, offshore residency, a non-transparent ownership structure or weak financial position and net assets.

Negotiation Options

In deadlock situations, proposing a compromise or structures that mitigate the effect of a retention agreement on the part of the seller may have the effect that the seller will finally agree to the buyer retaining part of the purchase price. Such structures might include e.g. an attractive interest rate arrangement and/or depositing the retained purchase price into an escrow account, which means that the buyer would no longer be able to directly access the retention amount.

At this stage at the latest, the option of W & I insurance can also be introduced into negotiations. In this case, it is recommended to at least initially clarify in advance if the risk is insurable.

Watch Out For Sellers On The Brink Of Bankruptcy

In the case of sellers who are in financial difficulties, retaining part of the purchase price as collateral may create a risk that is often overseen.

If insolvency proceedings are initiated against the assets of the seller, the insolvency administrator has the discretion to decide whether the company acquisition agreement is continued – unless at least one party has completely fulfilled the contract at the time when insolvency proceedings are instituted. In this context, not only the main contractual obligations but also supplementary duties are of relevance. Here, agreements on the retention of part of the purchase price – just like purchase price adjustment or earn-out clauses – may open the door to such decision.

Conclusion

Especially for buyers that have a “strong” position and where small and medium transaction volumes are involved and the sell-side seems "risky”, the retention of part of the purchase price is often a simple and affordable but also efficient means to secure liability claims.