What is a good faith deposit? Let’s start with the definition of good faith. “Good faith” refers to a sincere intention to be fair, open, and honest, regardless of the outcome of an interaction.
A good faith (or earnest money) deposit is payment made by the buyer at the time of signing the letter of intent (LOI). The buyer puts forth a portion, often 5-10% of the purchase price, to be placed in an escrow account. If diligence proceeds smoothly, the funds will be used toward the down payment at closing. If the deal falls through, the buyer may or may not be able to reclaim the deposit.
The buyer may be able to reclaim the earnest money deposit if something that was specified ahead of time in the letter of intent goes wrong. For instance, the earnest money would be returned if the real estate or equipment doesn’t appraise for what the seller is asking, or the inspection of the financials reveals a serious defect – basically the buyer can get the deposit back for any contingencies that are listed in the letter of intent.
Of course, earnest money isn’t always refundable. For example, the seller gets to keep the earnest money if the buyer decides not to go through with the purchase for contingencies listed in the letter of intent, or if the buyer fails to meet the timeline outlined in the contract. And, not surprisingly, the buyer will forfeit the earnest money deposit if he or she simply has a change of heart and decides not to buy.
Earnest money is always returned to the buyer if the seller terminates the deal.
The high-level purpose of the deposit is to provide the proper incentive for the buyer and seller to continue diligently toward consummating the transaction, but there is more to it than that.
Good faith deposits are effective for multiple reasons. First, it proves to the seller that the buyer is serious about purchasing the company and has the financial wherewithal to do so. Would you feel a buyer is serious about acquiring your business if he or she refuses to escrow 1/10th of the total purchase price even though they plan to consume a lot of your time and energy during the due diligence process? Business owners are practical and appreciate evidence of buyer seriousness.
The good faith deposit also provides insurance against a buyer’s default on the purchase agreement. In this case, the deposit typically serves as liquidated damages to the seller. Due diligence after signing an LOI requires a lot of the seller’s time and attention. The good faith deposit is used to aid the seller in knowing that his or her time cannot be completely wasted during the due diligence process, which can take several months, even if the buyer backs out.
As a buyer, submitting a good faith deposit and getting the letter of intent signed is crucially beneficial. This step takes the business off the market and the buyer receives the seller’s undivided attention. Most LOIs are nonbinding, meaning that while certainly the buyer does not want to waste time and money in due diligence, he or she is generally free to walk away. If the buyer does choose to walk away, it puts the seller in a difficult situation. The seller will likely have to relaunch the marketing process – not always easy to do without the initial momentum. It will also cause questions to arise from new buyers about what happened, leading to additional buyer uncertainty.
In our experience, buyers that are unwilling to make even small refundable good faith deposits end up not being serious and pulling out of transactions. When offers include good faith deposits, it separates buyers from shoppers. To the seller, these offers are much more serious and much more likely to be accepted.