Use of Special Escrows

description http://stephanieolson.com/tag/love-one-another/ [This article was written by Bob Holmen for Fortis Advisors.  Additional articles may be found at Fortis News.]

At the closing of most private M&A transactions, a portion of the consideration (often 10-20%) is either held back by the buyer or set aside in a third-party escrow to secure the selling company’s covenants, representations and warranties made in connection with the M&A transaction.   Based on data that Fortis Advisors has collected from over 500 M&A deals where it has served as the post-closing shareholder representative, 93% of such deals include either an escrow or a holdback.  In addition, the data shows that many deals have a second “special escrow” covering specific matters or issues (as described below).  Fortis Advisors data (available with accompanying analysis in the Forsite™ M&A Deal Tool) shows that 26% of all deals have at least one additional special escrow:

frequency-of-special-escrows

These special escrows work either separate from or in conjunction with the primary escrow, and cover certain specific matters such as (1) adjustment of the purchase price post-closing following determination of all account balances as of the closing date, (2) intellectual property representations, (3) specific existing or threatened litigation or (4) estimated tax issues, with the frequency of these special escrows set forth below:

types-of-special-escrows

Two of these special escrows that deserve particular attention are intellectual property escrows and litigation escrows.

Intellectual property escrows often are included in M&A transactions to enable longer survival periods for IP representations and warranties.  Often the buyer is willing to allow standard representations and warranties made by the seller to expire 12- to 18-months post-closing, at which time escrowed funds are released to the shareholders.  However, the buyer may desire a longer survival period for IP representations and warranties.  The IP may be fundamental to the buyer’s purchase decision, but problems with the seller’s, and then the buyer’s, right, title and interest in the IP may not manifest themselves for three or more years.  Thus, the buyer may insist on an extended escrow period to protect the buyer’s investment in the seller’s company and IP.  Rather than extending the term of the primary escrow, the buyer and seller can compromise by allowing the primary escrow to expire and be released early, with a second, longer IP escrow serving to protect the buyer over IP issues.

A second common special escrow is one established to protect the buyer against a filed or threatened lawsuit known at the time of the closing.  The buyer and the seller typically negotiate an amount for such an escrow equal to the maximum reasonable loss on the claim (regardless of the merits), with the unused funds released to the shareholders immediately on settlement or resolution of the claim.  The buyer benefits from having a dedicated amount in addition to the primary escrow to handle the matter, and the selling shareholders benefit both from immediate release of excess funds on resolution and through the ability to negotiate enhanced control rights over the defense and resolution of the claims.

However, a special escrow covering a filed or threatened claim comes with a significant downside.  At closing, the merger agreement typically is provided to the selling shareholders in connection with seeking approval of the transaction.  The shareholders also receive a complete description of the financial terms and flows of consideration.  Thus, all the shareholders will become privy to the existence of the special escrow.  We have seen a number of cases where, despite confidentiality obligations, the terms and amount of the special escrow has been shared with the claimant (and in some cases, the claimant is also a shareholder).  This has emboldened the claimant to seek the maximum recovery, knowing money has been set aside to pay that recovery.  As a way to deal with this issue, the special escrow amount could be added to the primary escrow, and that “signaling” would not exist.

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