Escrow agreements remain steadfast and significant for M&A deals. The most recent data suggests that the average percentage of transaction value set aside in escrow is returning to historical norms, even with the increasing use of representations and warranty insurance (RWI). In addition to determining the size and duration of the escrow, deal parties must negotiate the separate M&A escrow agreement. Sophisticated M&A parties and their counsel focus their negotiating aptitude on obtaining the best escrow terms and smoothest and quickest release mechanics. Based on the experience SRS Acquiom has accumulated from working on over 2,950 M&A transactions, this article highlights seven key points that deal parties should consider when negotiating M&A escrow agreements and is supported by advice from industry experts from the SRS Acquiom Business Development team.
1) Opening the Escrow M&A Account
First, determine who will be the parties to the escrow agreement. Any parties to the escrow agreement are responsible for opening the escrow account and are, therefore, subject to know-your-customer (KYC) requirements. The parties to the escrow agreement should also determine who will be their authorized representatives; typically, entities should have at least two authorized representatives to accommodate the escrow agent’s security procedures for any escrow release. Keep in mind that escrow agents typically need a few business days to process KYC information.
Pro Tip: Ask the M&A escrow agent up front what information is required for KYC
The M&A escrow agent will guide the parties through what information is required and how detailed to be when completing the documentation. Some escrow banks have internal KYC policies that may require them to ask for more information; escrow agents that are familiar with M&A deals can often work with the parties to tailor KYC requests to what is absolutely required. Aaron Soper, Senior Director of Escrow and Payments Administration at SRS Acquiom, suggests that “parties should think about KYC requirements well in advance to avoid delays in opening the escrow account.” As an example he mentioned, “some banks require extensive KYC for foreign entities, but there might be a simpler solution, especially if the foreign entity is at least 51% owned by a U.S. entity.”
2) The M&A Escrow Agreement
Start by requesting the escrow agent’s current form of escrow agreement. Escrow agents update their forms from time to time to better position themselves competitively and to account for regulatory changes, and it can be helpful to take advantage of those updates. Ali Bryson, Senior Director of Escrow and Payments Administration at SRS Acquiom, notes though that, “regardless, a sophisticated escrow agent can accommodate the parties’ preferred form of escrow agreement and work together with the parties’ counsel to ensure it is suitable for the specific deal.”
Pro Tip: Include the M&A escrow release mechanics in the Escrow Agreement
While there is no clear standard in the market for where to put the release mechanics for the escrow, parties often find it convenient post-closing to have everything together in the escrow agreement. Additionally, escrow agents will require any provisions related to their role to be included in the escrow agreement, regularly deleting any cross references to the merger or purchase agreement. Remember that the escrow agent will likely still require and rely on joint instructions for most releases (see Joint Instructions vs. Unilateral Instructions vs. Automatic Releases below). Ali adds, “release mechanics should be clear about how to treat segregated adjustment escrow funds and indemnification escrow funds.”
3) Joint Written Instructions vs. Unilateral Instructions vs. Automatic Releases
Escrow agents prefer joint written instructions (JWI) from both parties for any M&A escrow release. JWI are straightforward and do not leave room for ambiguity or conflict. A thorough escrow agreement will list out the information that should be included in JWI or any instructions, such as the amount to be released, the party to whom the funds should be delivered, payment instructions and tax characterizations, or alternatively attach an instructions template to the escrow agreement. Any instructions to the escrow agent should be in writing and signed by the authorized representatives of the requisite parties.
The structure of the deal and purpose behind the escrowed funds may call for unilateral instructions, including in the event of a final, non-appealable court order. Quite often, the party who is not providing the unilateral instructions is given a set amount of time to object before the escrow agent is obligated to act.
Automatic releases, where the escrow agent is directed under the terms of the escrow agreement to release escrow funds upon a certain date, can be convenient for the parties but are not always advisable. Automatic releases are generally subject to any pending indemnification claims or conflicts, notice of which the parties will be required to provide to the escrow agent. Escrow agents may rely on notices provided prior to the date of the automatic release or may require one or both parties to provide a good faith estimate of any amount to be held back from the automatic release.
Pro Tip: Parties should receive contemporaneous copies of any notices to the escrow agent
It may seem like an obvious point, but some escrow agreements do not require copies of notices to go to all parties, or at least do not expressly require that such copies be sent at the same time. Aaron recommends that “parties mindful of protecting their interests and rights under an escrow agreement should negotiate to receive simultaneous copies of all notices.”
4) Interest or Non-Interest, that is the Question
The last thing parties want is for the escrow principal to be at risk. Ensure the escrow funds are held in an FDIC-insured account or similarly safe product with a reputable escrow agent. Most escrow agents do offer an interest-bearing escrow deposit option, but parties should focus on the security and liquidity of the escrow principal and not necessarily expect high yields. While the interest amount earned may be worthwhile for the parties in certain circumstances, keep in mind that interest-bearing escrows require additional mechanics in the escrow agreement covering tax reporting and calculation of amounts to be released.
Pro Tip: Gain something better than minimal interest gains
Non-interest-bearing escrows are simpler, and the escrow deposit option can be traded by the parties. Ali offers, “when the parties agree to forego interest, escrow agents can often waive fees and offer higher service levels.” Ali also adds, “the parties may also get better pricing if they bundle payments services and escrow administration with the same provider.”
5) Ownership of the Escrow Funds for Tax Purposes
If the parties consider an interest-bearing deposit option, they must also account for the related tax obligations each year. With the vast majority of M&A escrows bearing interest, the buyer is the owner of the escrow funds (and, therefore, any interest or earnings) for tax purposes. This is the easiest approach, making items like tax reporting simple.
Pro Tip: Consider automatic annual releases to cover any tax obligations
It is common for the parties to build in mechanics for an automatic release of a portion of the interest income on the escrow funds to the deemed owner to cover any tax obligations. Aaron adds, “a single buyer as the deemed owner of the escrow funds keeps tax reporting and any automatic release of the interest straightforward.”
6) Escrows That Include Capital Stock of the Buyer
For M&A deals where the consideration is in cash and stock, the parties may choose an all-cash escrow or a mix of cash and stock. Escrow agents are not transfer agents or stockbrokers but may agree to hold stock in escrow. The escrow agreement will need to clearly specify the mechanics for each of the cash and stock portions of the escrow. The parties should address whether escrowed assets are paid out first from stock or cash or some proportion of both.
Pro Tip: Use a single physical certificate for escrowed stock
Given the uncertainty of how escrowed shares will be released, it is often best to issue one physical certificate to be held in escrow by the escrow agent and add a covenant in the escrow agreement that the buyer will, or will cause its transfer agent to, issue new stock certificates for the escrowed shares in accordance with any JWI. Ali shares, “sometimes detail-orientated deal counsel will offer to send pre-cut stock certificates issued in the names of the sellers and for the applicable number of shares, thinking the escrow agent can mail them to the sellers upon release, but that plan may go awry if a portion of the escrow shares needs to be released back to the buyer.”
7) The Escrow Agent’s Protections
Market standards and the particular parameters of an M&A deal can all guide the parties as they negotiate the escrow agreement. However, escrow agents will generally resist changes to their indemnification, ability to rely and act upon instructions and permitted course of action in the event of a dispute (such as depositing the escrow funds with the registry of a court). Escrow agents carefully consider their exposure and risk, weighed against the escrow size and duration and the parties involved, when considering changes to such provisions.
Pro Tip: Focus on the provisions where you can get the most out of the Escrow Agent
Parties may make more progress seeking expanded service levels or lower fees rather than seeking carve outs to the escrow agent’s indemnification, for example.
Escrows in M&A are not going anywhere, and M&A counsel should keep their Escrow Agreement negotiation skills current and fine-tuned. While escrow agreements are relatively short ancillary agreements to the larger M&A deal, they are still important and particularly relevant in the current M&A market. M&A counsel should prioritize the escrow terms most vital and applicable to their client and negotiate the escrow agreement accordingly. Additionally, deal parties and their counsel can stay current on escrow market standards with MarketStandard®
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