At the closing of many merger and acquisition transactions, a portion of the consideration in the deal is set aside to create a shareholder representative expense fund. This expense fund can cover expenses that may be incurred on behalf of shareholders during the post-closing period. For example, the selling shareholders may need to engage an accountant to analyze and dispute the buyer’s calculation of a purchase price adjustment, engage attorneys to defend against an indemnification claim made by buyer or engage attorneys to enforce the selling shareholders’ rights related to a potential earn-out.
In analyzing the data in the Forsite™ M&A Deal Tool, we found that over the past four years, 74% of the transactions where we served as Shareholder Representative included an expense fund. We recommend that every transaction include an appropriately-sized expense fund.
If an expense fund is not established at closing, the shareholder representative may be limited in its ability to engage professional service providers to protect the interests of the selling shareholders. One alternative to establishing an expense fund at closing is, when a post-closing issue arises, to raise funds as needed from the selling shareholders. However, a number of dynamics make that practice difficult:
- Windows to respond to purchase price adjustment calculations, claims, disputes and earn-out analyses can be very narrow, leaving insufficient time to raise the necessary funds.
- Selling shareholders may have different capacities or desires to contribute money post-closing to defend a claim for indemnity or prosecute the selling shareholders’ rights.
- Some selling shareholders—particularly the larger funds—may need to cover a disproportionate amount of the costs if smaller shareholders are unwilling or unable to participate.
- Often times it can be impractical to solicit contributions from all shareholders.
- Non-participating selling shareholders may question or potentially dispute the terms of any expense fund contribution (g., priority of recovery, interest payments and other benefits of participating in providing expenses funds to the shareholder representative).
- The shareholder representative must be cognizant of providing information about a dispute broadly to the selling shareholders. It could be discoverable in litigation.
Setting up an expense fund at closing avoids all of these issues. It both proportionately burdens all selling shareholders with their pro rata contribution and proportionately benefits selling shareholders by providing protection. In addition, buyers are well aware of the amount of the shareholder representative’s expense fund at the initial closing, and that can influence how aggressive a buyer may be in calculating working capital and earn-outs, and bringing claims for indemnification against the selling shareholders.
Moreover, the shareholder representative typically seeks advice and approval from major selling shareholders before engaging professionals and otherwise incurring expenses payable out of the expense fund, allowing the selling shareholders to maintain a level of control over how the expense funds are utilized. Finally, upon resolution of all issues in a transaction, any unused portion of the expense fund is distributed pro rata back to the selling shareholders.
Accordingly, we advise that all selling shareholders establish an appropriately-sized expense fund for the shareholder representative to both protect the selling shareholders’ interests and avoid issues that can arise through attempts to raise an expense fund post-closing.