M&A Vocabulary – Expert insights: “Retention Amount”

Ultimately, a liability claim is only worth something if it can actually be enforced. This insight underpins the policy of agreeing a “Retention Amount” (also known as a “holdback”) in a business acquisition—i.e., retaining part of the purchase price for a limited period to secure the buyer’s potential warranty and indemnity claims against the seller. Various structuring tools are available to secure such claims. In addition to purchase price retention, third-party guarantees in various forms (e.g., sureties or bank guarantees) may be used. Increasingly popular—especially for large-volume transactions—are W&I insurances (Warranty & Indemnity insurances), which insure liability claims arising from breaches of warranties and indemnity obligations.

Unlike an Earn-Out, the entitlement to the relevant portion of the purchase price is generally not conditional on future events occurring (e.g., achieving certain KPIs). As a rule, the entitlement arises at the time the contract is signed, while the actual payment only becomes due at a future date fixed by calendar or contingent upon the occurrence of an event. This allows the buyer to set off claims it has accrued against the seller up to that point, e.g., from breach of warranty or indemnities. Drafting the exact conditions under which the retained amount is (still) not to be paid out (e.g., where court proceedings are still pending), as well as the requirements for such set-off and the consequences of a subsequent purchase price adjustment, are key challenges for the transaction lawyer (often in coordination with tax advisers) when structuring the retention arrangement.

Occasionally, multiple retentions are agreed, with different conditions for different risks and/or liability claims.

A retention is a very important element of the purchase price structure. At the same time, it is generally the easiest form of security to implement for all parties, since no third parties need to be involved. For the buyer, it is the strongest—and correspondingly, for the seller, the most burdensome—security instrument. Therefore, the buyer will generally only be successful in demanding a flat retention for abstract potential liability claims from a very strong negotiating position.

A mere reference to the information asymmetry that usually exists in an acquisition is typically not sufficient. Rather, the buyer can only expect the seller to take its demand seriously if it can substantiate the potential claim itself and the risk to its enforcement, and even quantify its amount. When negotiating whether to include a retention and at what level, two aspects are therefore generally important and should be presented by the buyer side—usually as cumulative arguments—for such a structure:

1. Specific findings regarding the basis of the Business Valuation and purchase price determination, and the related risks, in particular from the due diligence;
2. Indications that the seller may have insufficient assets available to satisfy liabilities in the future, or other foreseeable obstacles to successful enforcement in the event of liability.

Potential liability claims

Examples of identified liability risks include, for instance, claims by public authorities for repayment of subsidies, emerging product liability claims by customers, potential antitrust fines, tax matters still to be clarified that could result in additional tax assessments.

With knowledge of such risks, where amounts are material and the likelihood of occurrence is relevant, the buyer will have to consider adjusting the purchase price or even walking away from the acquisition. With a more moderate risk assessment, or to avoid risking a breakdown in negotiations at an advanced stage, the buyer may instead demand that an indemnity obligation be included in the contract and require a purchase price retention in an appropriate amount as security. The retention would then remain in place, for example, until the limitation period for tax claims expires or until a final, binding decision is issued in proceedings.

Predictably, the seller will make a different assessment of the risk, so at this stage of negotiations it is not uncommon for relevant legal and tax opinions to be exchanged. The relevant issues should therefore be identified as early as possible as part of the due diligence and the line of argument anticipated.

Critical seller characteristics

Indicators of insufficient and/or inaccessible assets available to satisfy liabilities at the seller include, for example, a seller holding structure using low-liability vehicles, offshore residence, an opaque ownership structure, or a weak financial and asset position.

Negotiation options

In deadlocks, proposing mitigation measures and compromise structures can lead the seller to agree to a purchase price retention after all. Conceivable options here include, for example, an attractive interest arrangement and/or placing the retained purchase price in an escrow account, meaning the buyer no longer has immediate access to the retained amount.

At the latest at this point, W&I insurance can also be introduced into the negotiations as an option. In this case, it is advisable to clarify in advance—at least on a preliminary basis—whether the risk is insurable.

Caution with sellers at risk of insolvency

When acquiring from a seller in financial distress, retentions can create an often overlooked risk.

If insolvency proceedings are opened over the seller’s assets, the insolvency administrator can decide whether to continue to perform the business purchase agreement if, at the time the proceedings are opened, not at least one party has already fully performed the contract. This depends not only on the primary obligations but also on ancillary obligations. In this context, purchase price retention arrangements—just like purchase price adjustment or Earn-Out clauses—can become a gateway.

Conclusion

Especially for the “strong” buyer and for small to mid-sized transaction volumes with a “risky” seller, a partial purchase price retention is an instrument that is usually easy and inexpensive to implement and at the same time effective in securing liability claims.

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