Hi, it's CJ Gustafson and welcome to Looking for Leverage.

Every week I take one term, clause, or mechanic from the PE world and break it down in plain English… the kind of thing that comes up in a room full of bankers and lawyers where everyone assumes you already know it.

Today's terms: escrow and earnout. Two things that both shrink the check you get at closing, for completely different reasons, and buyers are bad at telling you which one they're talking about when they say "the holdback."

(“But… you’re holding them both back!?”)

The last real negotiation in selling my company wasn't about the price. We'd agreed on the headline number weeks earlier. It was about how much of that number I'd actually see in our bank account, and when.

I was at the table (well, on zoom) trying to work out how much of the total consideration was coming out of our pocket versus theirs… and then realizing that the framing was already wrong, because chunks of it were being carved off and set aside before a dollar ever hit our account.

Some of it would come back to us if certain risks never materialized. Some of it would come back if the business hit certain milestones after close.

Either way, the headline number I'd been quoting to myself was bigger than the number that would actually clear the wire.

If you've sold a company, this moment is familiar. If you haven't yet, it's coming (and has the potential to sneak up on you).

You already know the shape of it. When a company sells, the buyer doesn't hand over the full price at closing. They keep some back. Some of it releases based on an agreed upon calendar, and some of it only shows up if things go a certain way.

That's the simple textbook version, and it gets you in trouble, because it lumps two completely different mechanics into one bucket called "the holdback." Their absence look the same on the wire (as the money you didn't get at close) but they behave very different.

Escrow is the buyer's insurance against the past.

When you sell, you sign a long list of representations and warranties: the financials are accurate, you own your IP, there's no lawsuit you forgot to mention, and taxes got paid. The buyer can't verify all of it before wiring the money, so they hold a slice of the price back, park it with a third-party agent, and leave it there for a survival period, usually 12 to 24 months. If one of those reps turns out to be wrong and it costs them, they claim against the escrow instead of coming after you personally.

Historically these ran at 5% to 15% of the price, with 10% as the number you’d hear most quoted. However, Reps and Warranties insurance has changed the amount. A buyer who buys an R&W policy can shrink the escrow to 1% or less, because the insurer absorbs the risk. Keep in mind it comes with a sizable fixed cost (sometimes in the hundreds of thousands of dollars for mid market PE deals), and you negotiate over which side pays.

Net net, the thing to hold onto here: you expect escrow back. It's your money, temporarily fenced off, and barring a real problem it releases on schedule.

An earnout runs the other direction in time. It's the buyer's hedge against the future… against paying today for growth that hasn't happened yet.

Earnouts show up when the two sides can't agree on what the business is worth. You think next year's EBITDA lands at $20M; the buyer thinks $15M and won't pay for the extra $5M until they see it. Rather than walk, they make part of the price contingent: hit a target over the next one to three years and you collect the rest, miss it and you don't.

Functionally it serves as a bridge to a valuation.

The metric can be revenue, EBITDA, a product milestone, a retention target, even a business unit profit target… whatever the forecasting difference of opinion is really about. Your mindset going in should be to assume you might not collect it. And not because buyers are crooks, but because the day after close you usually don't control the levers anymore. The buyer sets the budget, the headcount, the pricing, and may make it difficult for you to reach your metric.

Say you sell for a headline of "$100M, plus up to $30M in earnout." Everyone at the closing dinner repeats it as a $130M deal.

Here's what actually moves.

Now run it forward three ways.

This is all the same deal, but a $34M spread between the best and worst version.

Back to the table, staring at how the total got partitioned.

What I finally understood is that the two pieces coming back to me were not the same kind of dollar at all. The escrow piece was mine, delayed but hopefully not denied. Barring any unforeseen state tax trip ups I felt really good about it. The milestone piece was a maybe, since it was linked to the revenue of a new product line, and there was no guarantee once the deal closed that they’d invest appropriately to execute against that roadmap. Some of it was out of our hands (despite the target being squarely over our head).

So I stopped treating "total consideration" as one number and started sorting it by the question each piece answered.

This helped me better frame the guaranteed payout to my investors and fellow management team, rather than overpromising and underdelivering in 18 months when milestones were not met.

There are two angles here - if you are working against your own earnout / escrow currently, or have acquired a company that has their own.

Wishing you a small escrow and an earnout you actually collect,

CJ

Looking for Leverage breaks down one PE term, clause, or mechanic each week, written for the CFOs and finance leaders who actually have to live with these things. If this got forwarded to you, subscribe at lookingforleverage.com. If there's a term you want broken down, reply and tell me. I read everything.

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