Why Is Part of My Purchase Price Sitting in Escrow?

A lot of my article ideas come out of live deals. Something comes up in a negotiation, the founders react to it, and I realize it is a topic almost nobody talks about until the money is already on the table. Escrow is one of those. On a deal we are working on right now, the seller reached the point in the sale process where they learned a percentage of their proceeds was being set aside for eighteen months, and they were less than happy about it.

That reaction is normal. In my experience it is close to universal.

We actually cover escrow in our pre-engagement discussions with potential clients via our Marketability Assessment & Valuation Opinion (MAVO). It sits in there alongside the working capital mechanics and the earnout discussion. But that conversation happens months before it matters, and escrow does not become real until a Letter of Intent (LOI) is received from a prospective buyer. By then it has been buried under a hundred other things.

It also stings more than the raw percentage suggests, because of where it sits in the structure. If the deal already carries an earnout or a seller note, the founder has already accepted that some portion of the value is not arriving at closing. Then the purchase agreement adds another slice on top of that. A deal that looked like one number in the LOI starts to feel like a series of deductions from it.

So it is worth understanding well before you get there.

What is the escrow actually tied to?

Some quick context, because the escrow does not exist on its own.

In the purchase agreement you will make a long list of factual statements about the business. That the financial statements are accurate. That employees are properly classified. That payroll taxes have been filed and paid. That there is no undisclosed litigation. That the client contracts are what you said they were. These are the representations and warranties, and they are among the most heavily negotiated provisions in the document.

They do not expire at closing. They survive for a defined period afterward, and if one of them turns out to have been untrue, the buyer has a claim against you. The escrow is the money set aside to pay that claim if it happens.

I wrote a longer piece on the representations and warranties themselves, which goes deeper into what you are signing up for and where the negotiation actually happens: What Are Representations and Warranties in a Staffing Company Sale? This article is about the money behind them.

Why does a buyer want money set aside at all?

Put yourself on the other side of the table for a minute.

You have just bought a staffing company. Eight months later, a former contractor files a wage and hour claim covering a period that predates your ownership. Or a state sends a notice for unemployment tax that was never registered in a jurisdiction where the company had been placing people for years. Under the purchase agreement that is the seller's problem, because the seller represented that these things were in order and they were not.

Now what? The seller has taken the proceeds, paid taxes on them, and put the money into a house, a portfolio, or a new venture. The buyer's only remedy is to go find that person and ask for it back, and if the answer is no, to sue. That is slow, expensive, and frequently unsuccessful.

The escrow removes that problem. The money is already set aside, held by a neutral party, and available if a valid claim arises. It is a funded remedy rather than a promise.

This is standard. It is in essentially every deal I work on. And if nothing happens, you get it back.

There is also a reframe worth sitting with. The liabilities an escrow covers already exist. They existed before the buyer showed up. If you never sold the company, one hundred percent of that exposure would still be yours, and you would carry it indefinitely, with no cap and no end date. In a sale you are capping it, funding it, and putting an expiration date on it.

Fundamental versus non-fundamental reps, and why the dates matter

Not every representation is treated the same way, and this is the part most founders have never encountered.

Fundamental reps are the foundational ones. That you own the equity you are selling. That you have the authority to sell it. That the company is properly organized. Taxes are sometimes treated as fundamental and sometimes not, and that is a live negotiation. These survive for a long period, often the statute of limitations, and the buyer's recovery on them is generally not limited to the escrow. Exposure there can run up to the full purchase price. Fraud sits in the same category and is always carved out of any cap.

Non-fundamental reps are the operational ones. Financial statements, employee matters, worker classification, client contracts, litigation, compliance, benefit plans. These are the ones that actually get breached in practice, and these are what the escrow is there to cover.

Here is the part that explains the whole negotiation. When the survival period on the non-fundamental reps expires, your obligation ends. A problem that surfaces after that date belongs to the buyer, even if the cause of it predates closing entirely. The clock running out does not just release your escrow, it transfers the risk.

There is a flip side here that founders tend to miss. The buyer is running diligence precisely to find these issues before it closes. It is hiring accountants, employment counsel, and often insurance and tax specialists to go through the classification file, the multi-state registrations, the workers compensation history, and the client contracts. That work is not free and it is not casual. Once a buyer has looked, it starts to own the consequences of what it did not find.

That is really what the survival period represents. It is a bounded window in which problems can still be sent back to the seller, and after which the buyer lives with the limits of its own review. A buyer that examined your payroll tax filings and then received a notice three years later is dealing with the quality of its diligence, not with your representation. The escrow is not an open-ended guarantee that the business was perfect. It is a temporary bridge between what diligence could reasonably surface and what only time reveals.

That is why buyers push for longer survival periods. Twenty four months gives a buyer twice the window to find something that twelve months would give them. It is not suspicion, it is arithmetic on how long these issues take to surface. Wage and hour claims, state tax notices, and audit findings do not arrive on a convenient schedule.

The cap works on the same logic. The cap is the maximum a buyer can recover for non-fundamental breaches. A buyer arguing for a higher cap is arguing that more of any given problem should land on you rather than on them. A seller arguing for a lower one is arguing the reverse. Neither position is unreasonable. It is risk allocation, and it gets priced against everything else in the deal.

How much, and what is the percentage based on?

A typical escrow amount for deals we work on is in the ten percent range, held for twelve to twenty four months. The percentage is normally calculated on cash at close, not on total enterprise value. Earnouts normally get excluded from the escrow calculation. On a structured deal that difference is significant, and it is worth confirming which number the buyer is applying before reacting to the percentage.

Size is also priced on perceived risk. A firm with clean multi-state registrations, a documented classification policy, accrual basis financials, and no open litigation supports a lower percentage. A firm with a large 1099 population and an unresolved workers compensation claim history does not. This is one of the more direct financial consequences of pre-sale housekeeping.

Can an earnout or a seller note serve as the escrow instead?

Sellers ask this, and it is a fair question. If there is already deferred consideration sitting in the deal, why set aside additional cash on top of it?

Sometimes it works. A seller note with a right of setoff is the more achievable version, because the note is a fixed obligation and the buyer knows the money will be there.

An earnout is much harder. From the buyer's perspective an earnout may never be earned, which makes it unreliable as security. Buyers are generally unwilling to accept a contingent payment as their only protection against a claim that is not contingent at all. You can occasionally negotiate a partial arrangement, but I would not build a plan around it.

Can insurance take the place of the escrow?

Representations and warranties insurance is the other way to get there. Instead of the seller funding the buyer's protection, an insurer takes on the risk. The buyer claims against the policy rather than against your proceeds, which can shrink the escrow to a small retention or, in some structures, remove it entirely. More cash at close and a cleaner exit.

The catch is cost, and it is not a small one. There is a premium, an underwriting fee, and the insurer conducts its own diligence review, which adds both time and expense to a process that already has plenty of both. A meaningful portion of that cost is fixed regardless of deal size, so below a certain transaction value it stops making economic sense relative to the escrow it is replacing. Plenty of middle market staffing deals sit below that line.

It is worth pricing in any process, and on a larger transaction it can be the right answer. It is not a default, and it is not for every deal.

Where does the money actually sit?

With a third party, not with the buyer. If a buyer proposes to simply hold the funds on its own balance sheet, that is a holdback rather than an escrow, and it is a materially worse position for you. Your money would be sitting inside the entity you are now in a potential dispute with, and getting it released would depend on their cooperation and financial solvency. Push for a proper escrow agent, typically a bank, governed by a written escrow agreement.

If possible, the funds should also be held in an interest bearing account, with the interest accruing to the seller. It is not a large number, but it is your money and there is no reason to hand over the yield on it.

Can the buyer just take the money?

No, and this is the reassurance most sellers want.

The escrow agreement and definitive purchase agreement set out a process. The buyer has to deliver a written claim notice within the survival period, describing the breach and the amount claimed. You then have a defined window to object. If you do not object, the funds are released to the buyer. If you do object, the disputed amount stays in escrow until the dispute is resolved, whether by agreement, mediation, or whatever mechanism the agreement specifies.

The escrow agent does not adjudicate anything. It releases funds on joint written instruction from both parties or on a final determination. It will not act on the buyer's word alone.

And at the release date, only the amount subject to a pending claim gets held back. The remainder is released on schedule.

The working capital escrow is a different thing

Worth separating these, because they get conflated. Alongside the indemnification escrow, most deals include a much smaller escrow to fund the net working capital true up. In a cash-free, debt-free structure you estimate net working capital at closing and calculate the actual figure sixty to ninety days later. If it came in below the agreed target, the seller owes the difference, and that escrow covers it.

It is short, mechanical, and usually uncontroversial. It has nothing to do with representations and warranties, and it should not be lumped in with the indemnification escrow when you are evaluating how much of your proceeds are deferred.

Get the right counsel

This is not the place to use your longtime corporate counsel because the relationship is comfortable.

The escrow provisions, the survival periods, the basket structure, the cap, the fundamental rep definitions, and the sole remedy language all interlock. The difference between good and mediocre drafting shows up as real dollars. An attorney who specializes in M&A will know which points are genuinely negotiable in the current market and which are not worth spending money on. An attorney who does not will either fight everything or accept everything, and both are expensive.

Where this actually gets decided

The escrow is the place where pre-sale housekeeping turns into a number. How large it is, how long it sits, where the cap lands, and whether a claim ever gets made against it all trace back to what is actually in the business. Those things are determined long before a buyer is in the room.

The issues that trigger escrow claims in staffing are rarely exotic. Worker classification. Wage and hour exposure. Multi-state payroll tax registration. Workers compensation tail. Immigration documentation on an H-1B population. They generally surface in diligence, which means they are findable now, on your own timeline, while they are still a housekeeping item rather than a negotiating point or a claim notice eighteen months after you thought you were finished.

The liabilities an escrow covers already exist. If you never sold, one hundred percent of that exposure would still be yours, indefinitely. In a sale you are capping it, funding it, and putting an expiration date on it.