In today’s uncertain climate and evolving market dynamics, M&A transactions are taking shape at a faster pace than ever before. Sellers want to capture as much value as possible while buyers want to ensure their investment is a good one and protect against unforeseeable closing and post-closing issues. Appropriately sized M&A escrow funds are a useful tool to ease concerns of both buyers and sellers and can help keep deals moving forward. In addition, it is important to select the right paying agent to make sure distributions of proceeds are as efficient as possible.
SRS Acquiom has managed thousands of M&A transactions and has deep perspective on ensuring M&A payments and escrow agreements run smoothly. In this article, Chris Letang, Managing Director, Escrow & Payment Solutions and Deputy COO at SRS Acquiom, offers views on M&A payments and escrow agreements, issues that can come into play when negotiating payments and escrow provisions, and what you can do to ensure the process is optimized for both buyers and sellers.
Can you characterize the M&A payments environment today?
While the world at large has been dealing with the crisis caused by COVID-19, the pandemic forced parties to focus on certain types of deal terms to get their deals done, such as material adverse effect clauses (MAEs) and earnout provisions. The changing politics around tax policy under the Biden administration has also had an impact. Deal flow is the strongest we have ever seen even in the face of this uncertainty, or perhaps because of it.
Why are M&A escrow accounts important post-close?
Private-target transactions usually have a survival period for the representations and warranties of the target company under the definitive agreement. The escrow fund provides a direct recourse should the buyer incur losses due to a breach of those representations and warranties. After the close of the deal, the buyer has a period, typically 12 to 18 months, where they can inspect the target company to ensure the accuracy of those representations.
Common questions regarding representations may include: Did the target company pay all their taxes? Are there any employee lawsuits? Do they really own all their intellectual properties? If any representations are found to be untrue and the buyer incurs a loss, they have the right to pursue action against the shareholders. The target company’s value and subsequent purchase price can decrease because of these breaches of the representations, and the buyers may be able to claim some of the purchase price back from the escrow fund to ensure a fair transaction.
How often are M&A escrow accounts used today?
The majority of private-target M&A transactions have escrow account clauses or other forms of holdback agreements. In addition to the general indemnity escrow funds, if there are known issues or outstanding litigations prior to closing, then the deal parties might set up separate escrow rights specific to that known issue. For instance, our records indicate that around 90% of transactions have a purchase price adjustment mechanism of some kind. We are seeing a strong increase in M&A escrow funds set up for a possible negative purchase price adjustment, with more of these transactions having adjustment specific escrows than not.
How does a seller benefit from an M&A escrow fund?
An escrow fund can help provide the sellers with certainty about what proceeds they will receive from a transaction. The escrow fund is frequently the only recourse for non-fundamental breaches, which means at closing a seller knows the minimum they will receive in most circumstances and the buyer will be limited in their ability to claw back more than is in escrow to satisfy their claims for losses. It is also usually more palatable for the sellers to have any buyer claims paid from the escrow fund, rather than to have to pay money out of their own pockets to cover any losses post-closing.
How does a buyer benefit from an M&A escrow fund?
The buyer benefits from having the money readily available should they need it to realize the full value negotiated for in the acquisition agreement. They do not have to reach out to claw back money or create tension with people who may have been shareholders, who are on the board, or who remain involved with the company in some way. An escrow fund is less burdensome to all involved. An escrow fund can also speed along the process of closing a deal as it provides post-close security to the buyer.
How should I structure stock in an M&A escrow agreement?
We have seen an increase in deals that include stock as part of the consideration, and as a result, we do see stock escrows. The key component of a stock escrow is to negotiate how the escrowed shares are held by the agent. There are two main ways this can be structured: (1) to have one stock certificate held in the name of the escrow agent; and (2) to have individual stock certificates in the name of each shareholder based on their pro rata ownership of the escrow fund. If you use the second option in an instance where the buyer does claim shares from the escrow fund, then every stock certificate would need to be reissued with the newly calculated and reduced ownership amount of each individual shareholder. This can be administratively burdensome, especially if there are a lot of shareholders. As such, option one is generally preferable, as this allows for only one certificate to be updated anytime there is a reduction in the escrow value. When the escrow payments are released, then the buyer can cut new certificates for each shareholder based on the remaining value of the escrow fund and each shareholders pro rata ownership.
What is the general size of an M&A escrow fund?
In general, the median escrow size as a percentage of transaction value has been holding steady at 10% when no M&A insurance is used. We are also seeing an increase of representations and warranty insurance. If there is representations and warranty insurance, the size of the escrow we see drops significantly, usually 0.5% or less as a percentage of transaction value.
What is the best way to manage documentation for shareholder payments?
In a digital age, secure online portals have become the preferred method for handling documents associated with consideration payments. M&A deal parties need to be able to securely collect and track letters of transmittal, account details, and other personally identifiable payment information to ensure prompt, accurate payment distribution to shareholders. In the past, parties relied on a paper-based process prone to delays and inefficiencies. With our online portal, we provide deal parties with a convenient view of their document collection and payment status anytime, 24/7. Data is highly protected at rest and in transit, reducing risk for all parties involved.
Why is using a professional M&A paying agent important for successful M&A deals?
A professional paying agent can collect tax information, is knowledgeable about tax reporting, and might be able to handle the compensatory payments, thus, relieving administrative burden from deal parties.
We see two alternatives to hiring a professional paying agent, both of which have their downsides. One option is to use the escrow agent to also distribute M&A deal proceeds to shareholders. Usually, escrow agents will only agree to do this if there are a small number of shareholders to pay. The escrow agent is not the party responsible for collecting letters of transmittal, including payment instructions and tax forms at closing. As such, the parties must coordinate how to deliver this information to the escrow agent in a format in which they can receive it. Additionally, escrow agents may not conduct certain tax reporting. So, that responsibility could remain with the buyer.
If the shareholder representative is the party making payments, then they could face certain regulatory issues, depending on their structure in receiving and holding the funds. If the shareholder representative were to become insolvent, the transaction consideration could be at risk of being claimed by debtors. And, the shareholder representative may not have the knowledge to properly conduct tax reporting, especially if there are foreign holders involved in the transaction.
What kinds of things should M&A deal counsel prepare prior to negotiating a paying agent agreement to ensure a quick turnaround for clients?
Tax reporting is often an area of confusion for deal parties. While transactions with gross proceeds are fairly standard, once various income components such as dividends, interest, or options come into play, it can lead counsel into unfamiliar territory. If there are options in the transaction, counsel should know whether they were cancelled or exercised and, if exercised, if there are any disqualified dispositions. In addition, counsel should be able to note who may be considered a non-employee optionholder and who is an employee optionholder. If there are foreign holders, then counsel should inquire as to whether the transaction consideration is considered foreign source or domestic source, as that could lead to reporting requirements for the foreign holders for non-gross proceeds. An additional issue counsel should consider is whether the paying agent can solicit deal documents, such as letters of transmittal, joinder agreements, and 280G notices, to help alleviate administrative burden prior to closing.
These issues can be alleviated if the parties have engaged a knowledgeable paying agent who is able to handle all types of M&A payments, including compensatory payroll payments, non-gross proceeds, and transaction expenses at closing.
Managing Director, Escrow & Payment Solutions and Deputy COO 303.957.2855
Chris is the managing director, escrow & payment solutions and deputy COO. In this capacity, Chris manages our relationship manager, relationship associate, and deal intake teams, and works to ensure that our clients are able to navigate the closing and post-closing escrow and payments process as easily as possible.
Chris also has deep expertise in shareholder representation. For over a decade, Chris worked in the SRS Acquiom Professional Services Group where he led the teams that handled post-closing escrow claims, earnouts, purchase price adjustments, distributions of shareholder proceeds and other activities related to serving as shareholder representative.
Before joining SRS Acquiom, Chris practiced corporate law in the Colorado office of Cooley LLP, where he focused on venture capital transactions and mergers and acquisitions. He began his legal career at Cravath, Swaine & Moore LLP in New York City. At Cravath, he primarily represented underwriters in initial public offerings and high-yield debt offerings and lenders in commercial banking transactions.
Chris is a frequent contributor to M&A thought leadership via work on SRS Acquiom’s data studies, articles and speaking presentations. Chris holds a J.D. from Harvard Law School and a B.A. from Rice University.