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Why Earnest Money Deposit Requirements Can Be High

Contributed by Tawnya Gilreath, CBB

I was speaking with a prospective business buyer the other day as we were sitting in the conference room preparing an offer. He said he wanted the business; however, he was uncomfortable putting down a 10% deposit. The business was $350,000 and he asked if we would lower the deposit requirement to $5000. He said his brother was a real estate agent and his brother told him 10% was way too high and a ridiculous requirement on our part. Additionally, the buyer said he would have to pay interest on that $35,000 since it was coming from an equity line.

Earnest money deposits serve two purposes. First, they show the seller that you are serious about buying the business. Secondly, in the event that you as the buyer default on the purchase agreement after due diligence and other contingencies have been removed, the earnest money deposit typically serves as liquidated damages to the seller. Would you as a business owner take an offer for your $350,000 business seriously when it was accompanied by a good faith deposit of only $5000? Would you allow someone to tie up your business for 30, 45, 60 days or more with only $5000 in escrow?

On occasion a buyer will write an offer, provide a 10% deposit check and then ask that be held for two to four weeks or more until all contingencies have been removed. A good faith deposit that can’t be deposited is no good faith at all. The contingencies in a purchase agreement protect you as the buyer and if you walk away from the transaction before the contingencies have been released, your deposit will be returned to you less any escrow costs incurred. It is your good faith deposit that is supposed to help protect the Seller in the transaction. If the check can’t be deposited then what good is it? The buyer is literally asking to tie up the Seller’s business for two to four weeks or more with nothing. The basic rule is this – When there is no money, there is no Buyer. A 10% deposit shows good faith, shows your intent to purchase the business and separates the buyers from the shoppers.

Buying a business is a serious process and offers should not be made lightly. If you don’t know enough about the business to be confident enough to put down a 10% deposit, continue your research until you are more confident. When you are ready to make an offer, show the Seller you are serious about buying his/her business. You will find that your offer will be more readily accepted when it is accompanied by a standard 10% deposit. If you really want to stand out above the rest, provide a cashiers check for the deposit. Then you truly have shown the Seller your intention to buy the business.

As for the prospective buyer I referenced at the beginning, despite my best efforts to educate him, he refused to provide more than a $5,000 deposit. He said the seller could always counter and request a higher deposit if it was important to him. When his offer was presented, the seller essentially considered him a time-waster and declined his offer without countering back. No surprise there.

About The Author: Tawnya Gilreath is a business advisor at LA Business Pros. LA Business Pros provides business consulting, sales preparation, value maximization, acquisition targeting, due diligence assistance, transition planning and implementation, and business intermediary services for business buyers and sellers. They specialize in working with business owners and buyers to maximize the value of their business investments. Tawnya can be reached at 818-781-0082.

Posted on August 25, 2011 | Email This Blog Post | Print This Blog Post | All Contributions From Tawnya Gilreath, CBB

Categories: BizBen Blog Contributor, Buying A Business, How To Buy A Business, How To Sell A Business, Selling A Business

Comments:

I agree completely with Steve Fitzgerald. I take into account the thinking of the buyer, and given the fact that I can't verify the seller's information as being 100% correct, I prefer the non binding LOI type offer, but limit the time for the due diligence so that the business is not tied up indefinitely. I believe that we should be able to test whether we have a real buyer with factors other than just their willingness to put down a cash deposit, especially when our sellers are reluctant to provide buyers with the most relevant information until after the offer is made and cash deposit received.

Posted by: Jeff Weiner, Page Olsen

I think it is worth noting that the deposit amount also protects the buyer from the seller defaulting on the sales transfer. With smaller deposits, the seller can take better offer and decide to pay off the first buyer and go with another deal. In cases of stubborn buyer, I make it a point for the seller to counter with 10% deposit on smaller deals and something reasonable on larger deals. Majority of the offers I write are written with two parts, a prior to escrow condition for due diligence and books and records review and approval. With the offer, the buyer's deposit check is made out to escrow company and held with broker till the opening of escrow. Secondly, as part of escrow, I have the buyer take a cashiers check for 10% to escrow for deposit and opening of escrow with third party conditions and physical observation as the condition of the escrow. This is a reasonable solution to buyers who do not want to tie up large funds for long time. If some one objects and regarding legality of consideration when the check is made out to the escrow company not to the seller, then they can go find out and let me know. I think this is the most practical way and to take measured steps and actually moving forward with a workable buyers and sellers.

Posted by: Lincoln Jeon, Pacific Business Brokers

Nice article, Tawnya. I agree with Greg and Steve as to larger deals. 10% would be too high in most instances. Once the purchase price reaches $1M, I'm happy with 1% - 5%.

Posted by: Michael Cross, Briskin, Cross & Sanford, LLC

The deposit amount should be considered according to the information the broker or seller willing to provide. Most of the brokers either do not have doccumented P/L or the seller does not provide it truthfully. Even some brokers make up the unrealistic figures and price. You will not be able to know the real story behind it. Why should a buyer has to put 10% GFD when the truth is not told about the business? Only the seller or broker insists for 10% GFD when they are know the buyer will walk away when he finds truth but then it will be too late for buyer. Money does not grove on the tree so a buyer will walk away without any reason. Nobody just want to tie up some one's business just to lose money. A 10% GFD deposit is a like forced sale.

Posted by: Paul Patel

Tawnya, I completely agree with you. In many cases as I am sure you know the size of the deal will dictate the buyer's willingness to deposit a specific amount into escrow. Many buyers of main street businesses are under the mind set that they will forefit their deposit if the deal does not go through so I try and educate as much as possible. I appreciate you making potnetial buyers aware of the guidelines. Gregg Tobin

Posted by: Gregg Tobin, Pacific Coast Business Brokers

The size of the deposit should depend on the amount of information the buyer is able to receive to evaluate the subject business. Many brokers have nothing more than a gross revenue number and a cash flow number to share. There is no reason for a buyer to put up a significant amount of earnest money just to get a look at what should have been available from the start. It also depends on the size of the deal, a five million dollar purcahse price would never require a $500,000 earnest money deposit.

Posted by: Steve Bauer

I was asked many times about putting a $ 1,000 - $ 3,000 deposit check on deals smaller than $ 100k. Our company has minimum of $ 10,000.

James Jun at Business Team

Posted by: James Jun, Business Team

Getting a buyer to put up what can be called a "serious" deposit, is one way to tell if that buyer is serious. We've discovered, time and again, that the people who want to conduct all of their due diligence before putting in an offer, and who want to "low ball" a seller, are usually the same people who think a few hundred dollars is a sufficient deposit for their offer.

Posted by: Steve C.

We take a different approach with our clients. We work with Non-Binding Letters of Intent and no earnest money at all. Our reasoning is that a prospective buyer must do a thorough due diligence prior to funding the transaction, and there may be circumstances where the due diligence causes them to not want to purchase the company. Having them feel pressured to buy a company they are uncomfortable with to not sacrifice their deposit can be a recipe for a lawsuit. This practice has worked for us for more than 25 years.

Posted by: Steve FitzGerald, Acquisition Services Group

I made the mistake of negotiating with someone who made an offer for my business with a lame deposit. I think it was $1,000. The broker said not to worry about the size of the deposit. But the guy actually tied me up for over a month with due diligence and then flaked out. That's when I went to another broker and had more success. The people who bought it put up half their total downpayment as a deposit with their offer.

Posted by: Jeff K.

I agree completely. The larger the deposit the more sincere the buyer is. Small deposits are easy to walk away from. Buyers think twice about backing out after approval of due diligence when the deposit is serious. Secondly, you comment on buyers wanting you to wait to deposit a check. That can be construed as an unenforcable contract. No consideration, no contract.

Lee Petsas at UBI Business Brokers

Posted by: Lee Petsas, UBI Business Brokers

Glad to have you talk about this. You are right about showing the seller that you--as a buyer--are willing to put your money where your mouth is. I can tell all kinds of horror stories about so-called "buyers" who didn't want to put up enough of a deposit to show they were serious. I think it's a test, early on, about whether you have a real buyer.

Posted by: Alex Max