Earnest Money Deposit | M&A Basics

Introduction

Earnest money deposits are a common feature in small-business sales but tend to be less prevalent in middle-market transactions. They serve as a tangible sign of a buyer’s commitment, showcasing their genuine interest in acquiring your business.

However, when dealing with private equity groups and seasoned corporate buyers, earnest money deposits are almost never on the table. These entities consider the time and effort they invest in due diligence as an equivalent demonstration of their seriousness.

In the case of an individual buyer, especially one who’s new to business ownership, advocating for an earnest-money deposit becomes paramount. Given that the buyer will likely request extensive information about your business, safeguarding sensitive data is crucial, and an earnest money deposit offers that protection.

So, why shouldn’t you anticipate earnest money from experienced corporate or private equity buyers?

Private equity firms are experts in the art of buying and selling companies, and their reputation is a linchpin of their success.

Nevertheless, it’s imperative to exercise due diligence when dealing with firms claiming to be investment or private equity entities. We frequently encounter such claims, and not all of them hold water. It’s essential to scrutinize these entities and confirm their financial commitment before accepting a letter of intent (LOI) from them.

As for corporate buyers, particularly competitors, we may request an earnest money deposit from smaller companies unfamiliar with business acquisitions. If a company has a history of successful acquisitions, the norm is to forgo the earnest-money deposit requirement, as they’ve already proven their capability to complete such transactions.

Wondering about the typical amount for an earnest-money deposit or how to navigate situations where a potential buyer resists providing one? We delve into these and other earnest-money matters in the upcoming article.

Summary of the Process

Upon the seller’s acceptance of the LOI or purchase offer, the buyer will typically secure the earnest deposit through a trusted third party, often an escrow company. While the standard earnest money deposit hovers around 5% of the purchase price, it’s important to note that this amount is open to negotiation.

It’s crucial to recognize that a heftier earnest money deposit holds significant sway and tends to foster a more collaborative atmosphere with the seller. Conversely, the absence of an earnest money deposit can potentially hinder cooperation from the seller.

Do you Recommend Obtaining Earnest Money?

We consistently advocate for requesting an earnest money deposit, particularly when dealing with an individual buyer, unless they have a track record of multiple successful acquisitions. The rationale behind earnest money deposits is twofold:

• They provide tangible evidence that the buyer is genuinely committed to purchasing your business.
• In the event of a buyer defaulting on the purchase agreement after the removal of due diligence and other contingencies, the earnest money deposit often serves as compensation to the seller.

It’s a prudent practice to always seek an earnest money deposit. Doing so not only underscores the buyer’s good faith but also signifies their heightened commitment on a psychological level. Considering the substantial amount of confidential and financial information exchanged during the process, requesting an earnest money deposit is entirely justified.

Typical Earnest Money Deposit Amounts

Would you, as a business owner, seriously consider an offer for your $1,000,000 business if it came with a mere $5,000 in good faith deposit? Would you be willing to tie up your business for 30, 45, 60 days, or even longer, with just $5,000 held in escrow?

Typically, an earnest money deposit amounts to 5% of the business’s purchase price, but it’s important to note that this figure is open to negotiation. Offers that come with a more substantial earnest money deposit carry more weight and are often favored by sellers. Many buyers understand this and are prepared to offer a larger deposit. Usually, a third party, such as an escrow company or attorney, holds the earnest money deposit.

Do I Keep the Deposit if the Buyer Backs Out?

There’s a common misconception among sellers that in the event of a buyer’s default, they will automatically receive the earnest deposit. However, this assumption is not accurate. Releasing the deposit from a third party requires mutual agreement from both the seller and the buyer. In cases where consensus is lacking, you may need to pursue legal action to secure its release.

The Buyer is Refusing to Provide an Earnest Money Deposit. Is this Common?

What’s behind the buyer’s refusal? Shouldn’t I insist on an earnest money deposit in all cases?

There are two fundamental reasons why a buyer might decline to provide an earnest money deposit. One is legitimate, while the other is not. Let’s delve into both.

Reason #1: The buyer is a private equity group, competitor, or larger company.

Let’s collectively categorize this group as “companies.” However, it’s important to clarify that we’re not referring to small businesses, like a local retail shop looking to expand, unless they have a track record of multiple acquisitions. In the case of small businesses with no prior acquisition experience, they should be treated as individuals (see #2 below).

So, why do these “companies” often resist putting down an earnest money deposit? The answer is quite straightforward — they perceive their financial commitment to due diligence as an equitable substitute for an earnest money deposit. And they are, in fact, correct.

In essence, they believe that the resources invested in conducting due diligence serve as a tangible display of their sincere intent. These costs can swiftly accumulate, ranging from tens of thousands of dollars for smaller transactions to hundreds of thousands for larger ones. These expenses often encompass payments to external advisors such as accountants, attorneys, and consultants, in addition to in-house staff.

Conversely, individuals typically handle due diligence themselves and rarely engage external experts, aside from perhaps an accountant. Consequently, their due diligence costs tend to be considerably lower than those incurred by corporate buyers.

While there are exceptional instances where a competitor’s primary motive is to glean competitive insights, there exist protective measures to safeguard your interests in such scenarios. In such cases, meticulous scrutiny of the buyer’s actions is essential.

Are they investing in professional advisors, or are they swiftly angling for sensitive information like your customer list or proprietary data?

Additionally, you have the option to release information to buyers gradually, reserving highly sensitive data for disclosure later in the due diligence process.

It’s worth noting that earnest money deposits are a rarity in mid-sized transactions, except when the seller holds a commanding negotiating position or multiple parties are vying for the seller’s attention. Otherwise, in the realm of larger business sales, earnest money deposits tend not to be the norm.

Reason #2: An individual is not serious or is overcome by fear.

The second reason doesn’t hold water. While it’s understandable that a buyer may have concerns, giving in to their reluctance will only set unrealistic expectations and complicate managing them throughout the rest of the transaction. When an individual declines to provide an earnest money deposit, we proceed cautiously, or in some cases, we may not proceed at all.

Our decision to work with a particular buyer depends on the specific circumstances. If the individual is a seasoned entrepreneur with a track record of owning multiple businesses, particularly if they don’t have a competitive business, we’re inclined to work with them. However, we carefully evaluate whether to grant this buyer exclusivity.

If the buyer owns a competing business and necessitates access to sensitive information, we firmly insist on an earnest money deposit. In such cases, we dedicate substantial effort to crafting and negotiating the letter of intent (LOI), incorporating protective provisions like milestones and clauses addressing any attempts at renegotiation.

Conversely, when dealing with a corporate professional transitioning into entrepreneurship with no prior business ownership, we diplomatically request an earnest money deposit. While we may provide reassurances to some extent, we exercise caution not to overcommit in this regard. If the buyer is unwilling to commit a refundable earnest money deposit, we consider them unserious and move forward accordingly.

It’s essential to keep the buyer’s motivations and actions in perspective. Does the buyer appear genuinely committed? Do they possess a competing business? Are they financially qualified? How much liquid capital are they prepared to invest? How many other businesses have they explored? How long has their search for a business been ongoing? Have they made any previous offers? Are their expectations grounded in reality?

Evaluating a buyer’s intentions can be a challenging task, especially if you lack extensive experience in selling businesses. If you find yourself uncertain, seeking advice from an experienced professional is a prudent step to ensure your protection.