Latest / The Acquisition Talk with Fexingo: Mergers, Buyouts, and Business Sales for Operators / The Earnest Money Trap in M&A Deals
Transcript
- Lucas: If you're buying a house, you put down earnest money — usually one to three percent of the purchase price — to show the seller you're serious. If you back out without a good reason, you lose that money. Luna: Right, it's a good-faith deposit. But in M&A, earnest money works differently — and a lot of first-time buyers misunderstand the stakes. Lucas: Exactly. In a business acquisition, the earnest money isn't just a gesture. It's often the single biggest cash at risk moment before closing. And the rules around when you can get it back — or when you lose it — are surprisingly specific. Luna: But Lucas, a lot of our listeners are operators or small-business owners who might be thinking about selling. Why should they care about earnest money from the seller's side? Lucas: Because the size and structure of the earnest money deposit tells you how serious the buyer is. I've seen sellers accept a letter of intent with a token ten thousand dollar deposit, only to have the buyer drag them through a six-month due diligence and then try to re-trade the price. The earnest money is your leverage. Luna: And if you're a buyer, you don't want to put down so much that you're trapped in a bad deal. But you also want to signal that you're credible. Lucas: Which is why the negotiation over earnest money is actually a negotiation over who bears the risk of the deal falling apart. And I've got a concrete case to walk through today. Luna: Before we go deep — we keep these episodes ad-free by design. No sponsors, no mid-roll breaks. If you've gotten value from these conversations, you can support that choice at buy me a coffee dot com slash fexingo. Appreciate it. Lucas: Yeah, it's a small way to keep this show independent. And it really does help. Alright, so the case I want to look at — the sale of a mid-sized industrial parts distributor based in the Midwest. Revenue about four hundred fifty million, sold to a New York private equity firm in late 2023. Luna: Right before the Fed's last rate hike in that cycle. Timing was tight. Lucas: Exactly. The purchase price was two hundred eighty million dollars. The buyer put down earnest money of four point two million — exactly one and a half percent. Standard range. But what made this deal interesting is what happened in the escrow agreement. Luna: What do you mean? Lucas: The earnest money was held in a non-interest-bearing escrow account at a regional bank. The contract said the buyer could only get the money back under three conditions: if the seller breached a representation that materially impacted the business, if a material adverse change occurred, or if the buyer couldn't obtain financing despite using 'best efforts.' Luna: And 'best efforts' is a famously squishy standard. It's not 'reasonable efforts' — it's higher. But it's still not 'hell or high water.' Lucas: That's the key distinction. A hell-or-high-water clause means the buyer must close regardless of financing. No out. But in this deal, the buyer had a financing contingency, but they had to use best efforts. So when the buyer's lender got cold feet two weeks before close — interest rates had ticked up — the buyer tried to walk. Luna: And what happened? Did they lose the earnest money? Lucas: The seller argued that the buyer hadn't used best efforts — they hadn't approached alternative lenders, hadn't offered a higher rate to keep the original lender. The dispute went to mediation. The buyer ended up forfeiting half the deposit — two point one million dollars — and the seller kept the rest of the earnest money plus got a breakup fee from the buyer's PE fund. Luna: So the seller got paid for the time and disruption, even though the deal didn't close. That's the real purpose of earnest money — it's not just a deposit, it's liquidated damages. Lucas: Exactly. And this is where the reverse termination fee comes in. In a lot of PE deals, the buyer's obligation is limited. They might put down earnest money, but if they walk for a financing failure, the seller's only recourse is to keep that deposit. No lawsuit for specific performance. Luna: So the earnest money essentially caps the buyer's downside. The seller knows that even if the buyer screws up, they get maybe a few million, but they can't force the buyer to close. Lucas: Right. And that's why sellers push for a larger earnest money deposit — sometimes three to five percent — especially if the buyer has a financing contingency. The bigger the deposit, the more painful it is for the buyer to walk, and the more likely they are to fight for financing. Luna: But what about the buyer? If you're buying a company, you don't want to put down five percent of a two-hundred-million-dollar deal — that's ten million dollars locked up for months. Lucas: And you're tying up that capital, earning no interest, and it's at risk. So buyers push for a smaller deposit, or they ask for a 'release mechanism' — conditions where they can get the money back easily. For example, if due diligence uncovers a material issue, or if the seller's financials were misrepresented. Luna: That's standard. But what about the situation where the buyer just changes their mind? No material issue, just cold feet? Lucas: Then they lose the earnest money. Period. Unless they can prove that the seller breached something. And that's why the definition of 'material adverse change' is so heavily negotiated. In the industrial parts deal, the seller's EBITDA dropped by eight percent between signing and closing because of a temporary supply chain issue. The buyer tried to claim that was a MAC. Luna: Let me guess — the MAC clause had a specific carve-out for supply chain disruptions. Lucas: You nailed it. The contract said that general economic conditions, industry-wide supply chain issues, and changes in laws didn't count as MACs. So the buyer couldn't use it to walk. They had to close — or lose the deposit. Luna: That's a good lesson for sellers: be very specific about what does and doesn't count as a material adverse change. And for buyers, understand that the MAC clause is narrower than you think. Lucas: One more nuance: earnest money is typically non-refundable after the due diligence period ends. The standard timeline is a thirty-to-sixty-day exclusive due diligence period. During that time, the buyer can walk for any reason and get their deposit back. After that, the deposit goes hard. Luna: So the real negotiation is over when the deposit becomes hard. A longer due diligence period gives the buyer more time to find problems and walk without cost. A shorter period forces the buyer to commit sooner. Lucas: Exactly. And in competitive auction processes, sellers often demand a very short due diligence window — sometimes just twenty days — and require the deposit to go hard at signing, not after due diligence. That's a signal that the seller has multiple bidders and wants to lock in the winner. Luna: Which is brutal for a buyer. You're putting down serious cash before you've fully kicked the tires. Lucas: It happens more often than you'd think. But sophisticated buyers protect themselves by doing a lot of preliminary due diligence before signing the letter of intent. They've already seen the data room, talked to management, run the financial models. The official due diligence period is just for verification. Luna: So the earnest money amount isn't just a number — it's a strategic signal. A high deposit says 'we're serious, we're not going to nickel and dime you.' A low deposit says 'we might be tire-kickers.' Lucas: And sellers should treat it that way. I talked to a middle-market M&A advisor last month who said he tells his seller clients to reject any offer where the earnest money is less than one percent of the enterprise value, unless the buyer is cash-rich and has a track record of closing. Luna: What about the tax treatment of earnest money? If a buyer forfeits their deposit, can they deduct it? Lucas: Generally, yes — the forfeited earnest money is treated as a capital loss for the buyer, and as ordinary income for the seller. But there are nuances. If the deposit is considered a 'security deposit' rather than 'liquidated damages,' the tax treatment can differ. Always worth running by a tax advisor. Luna: One more thing — in the industrial parts deal, what ultimately happened? Did the buyer close? Lucas: They did. After the mediation, the buyer found a new lender — a regional bank that was willing to lend at a slightly higher rate — and they closed about six weeks late. The seller got the full purchase price, plus the two-point-one million forfeited deposit as compensation for the delay. Luna: So the earnest money actually served its purpose: it kept the buyer at the table, and it compensated the seller for the risk of a broken deal. Lucas: Exactly. And that's the core lesson. Earnest money isn't just a procedural formality. It's a risk-allocation tool. The amount, the release conditions, and the timing all determine who bears the cost if the deal falls apart. Luna: For our listeners — whether you're buying or selling a business — what's one concrete takeaway? Lucas: For sellers: don't accept a token deposit. Push for one to three percent of the purchase price, and make sure the deposit goes hard after a reasonable due diligence period, not at signing. For buyers: negotiate a clear list of conditions under which you can get your deposit back, and do your homework before you sign the letter of intent. The deposit is leverage — don't give it away. Luna: Good advice. Next episode, we'll look at something different — earnouts, and why they often lead to post-close disputes. Lucas: That's a great one. Until then, if you found this useful, you know where to find us.