What it means
The agreement is where a handshake deal becomes enforceable. Everything agreed in the term sheet is restated in binding language, and everything nobody wanted to discuss during negotiations has to be resolved before signature.
Most of the document is about risk allocation rather than price. Warranties are statements of fact the seller makes about the business, indemnities are specific promises to cover named risks, and the limitation clauses cap how much and for how long the seller can be pursued.
Buyers push for wide warranties and long claim windows, sellers push for narrow ones and a hard stop. The price section is more complex than a single number.
A deal is usually agreed on a cash-free, debt-free basis, meaning the headline enterprise value is then adjusted for the actual debt, cash and working capital in the business on completion day. Those adjustments routinely move the final cash amount by several per cent in either direction.
Timing creates the other major structure. Exchange is when both parties sign and become committed, completion is when money and ownership actually move, and between them sit conditions precedent such as regulatory clearance, landlord consent or third-party approvals.
In a simple deal exchange and completion happen on the same day. Payment is often staged rather than paid in full at completion.
An escrow or retention holds back a slice of the price for twelve to twenty-four months to cover warranty claims, and an earn-out ties a further slice to the performance of the business after the sale. Both mechanisms exist because the buyer cannot verify everything before writing the cheque.
In practice
Real-world examples.
Example
A family bakery sells to a regional food group for $4,500,000. The agreement includes a warranty that all food safety certifications are current, and when a lapsed certificate surfaces two months later the buyer recovers $85,000 of remediation cost from the escrow account.
Example
A logistics firm buys a competitor's depot as an asset purchase rather than a share purchase, so the agreement lists exactly which vehicles, contracts and staff transfer and explicitly leaves an outstanding tax dispute with the seller. That single carve-out is the reason the deal proceeds at all.
Example
A software founder accepts $6,000,000 upfront plus an earn-out of up to $2,000,000 tied to two years of recurring revenue. The agreement spells out how recurring revenue is defined and bars the buyer from moving customers onto a different product line, because those definitions determine whether the earn-out is ever paid.
Formula
Calculation
Equity value = enterprise value - debt + cash +/- working capital adjustment, with escrow deducted from the amount paid at completion.
A buyer agrees an enterprise value of $12,000,000 for a specialist packaging firm. At completion the business carries $2,500,000 of bank debt and holds $400,000 of cash. The agreed normal level of working capital is $1,800,000, but the actual figure on completion day is $1,650,000, giving a shortfall of $150,000 that is deducted. Equity value is therefore $12,000,000 - $2,500,000 + $400,000 - $150,000 = $9,750,000. The agreement holds 10% in escrow for eighteen months, so $9,750,000 x 0.10 = $975,000 is retained and the seller receives $9,750,000 - $975,000 = $8,775,000 at completion.Case study
Seen in the real world.
Pennyroyal Foods is an invented company used only as an illustrative example of how these agreements bite. Its owners agreed to sell for an enterprise value of $12,000,000 and, keen to close before year end, accepted a working capital target based on a twelve-month average without checking how seasonal the business was.
Completion fell in February, the quietest month, when receivables were low and the actual working capital was $1,650,000 against the $1,800,000 target. The mechanism worked exactly as written and $150,000 came off the price, followed by $975,000 into escrow. The sellers walked away with $8,775,000 at completion rather than the roughly $9,900,000 they had described to their families.
The fictional lesson is not that anyone behaved badly, because every number followed the agreement the sellers signed. It is that the price adjustment mechanism deserves as much attention as the headline figure, and that the completion date itself is a commercial decision in a seasonal business.
Watch out
Common mistakes.
- Focusing on the headline price and ignoring the adjustment mechanism, when working capital, debt and cash definitions can shift the final proceeds by hundreds of thousands of dollars.
- Treating disclosure as an admission of weakness. Properly disclosing a known problem against a warranty is what stops the buyer claiming for it later.
- Agreeing an earn-out without defining how the metric is measured and who controls the business during the earn-out period.
Questions
People also ask.
What is the difference between a share purchase and an asset purchase?
A share purchase transfers the whole company including its history and liabilities, while an asset purchase transfers only the specified items and generally leaves past liabilities behind.
Why is money held in escrow?
It gives the buyer a ready source of funds if a warranty claim arises, rather than having to sue a seller who has already spent the proceeds.
Can a signed agreement fall through before completion?
Yes, if conditions precedent such as regulatory approval or a landlord consent are not satisfied by the long stop date, either party can usually walk away.
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