Escrow accounts are funds that are carved out of the sellers proceeds for the benefit of buyers in order to secure indemnification obligations under M&A transactions. However, there are a couple of alternatives to fully funded escrow accounts that both parties may wish to consider.
Increasingly, buyers and sellers are turning to M&A insurance in order to provide additional protection for liability concerns, effectively transferring some or all of the risk associated with indemnification claims to a third-party insurer. Either party may pay a premium in the 3-5% range of the total limit of the liability, in order to further protect themselves from losses arising from unknown or undisclosed liabilities including: pending or threatened litigation, environmental contingencies, tax exposures, and/or specific warranty/indemnity obligations. This option does necessitate additional effort and costs for both the buyer and seller, as the insurance carrier will need to perform its own, independent due diligence on the deal prior to agreeing to any transactional insurance.
If and when the parties become deadlocked over liability and indemnification issues during the negotiation of the purchase agreement, or fear the conflict of post-closing litigation, it makes a great deal of sense to at least consider the option of using this risk management strategy. Clearly, the use of Representations and Warranties Insurance to minimize the risk of certain liabilities and avoid adjusting the purchase price more than offsets the cost of the insurance.
Another approach or adjunct to fully funding escrow accounts involves the use of earnouts or contingency payments, which is a performance-based component of the final purchase price. In these cases, the buyer agrees to pay the seller a future amount (i.e., a percentage of revenues or profits generated over a 2 to 3 year period) as shareholder consideration subject to satisfying certain performance criteria. One of the conditions of the earnout is that it can be used as the first priority to settle any indemnification claims prior to making a demand for reimbursement from the escrow account. This scenario is more likely to occur when a privately held organization is being acquired, and while it does not eliminate the need for an escrow account, it can reduce the amount placed into escrow, and subsequently increase payout to shareholders at closing.
Recognize that while earnouts are employed to help close the gap between seller expectations and the buyers offer, there are no assurances or guarantees that the earnout will be earned, and thus run the risk of short changing the escrow account, and potentially increase the likelihood of litigation.
Escrow accounts are a necessary element of every acquisition agreement. However, there are other ways to help reduce the risk, or total dollar amount actually placed into accounts, provided both parties (and their advisors) are flexible, open-minded and creative during the negotiation process.
A version of this article originally appeared in Soft•letter and Software Success.