SRS Acquiom believes that the selling shareholders should establish an expense fund in most merger transactions. An expense fund is a voluntary fund set aside out of merger consideration by the shareholders at closing for potential third-party expenses that might be incurred during the post-closing period. Such costs or expenses typically include legal or accounting fees that need to be incurred in protecting the shareholders’ interests should any disputes arise relating to the merger transaction.
Perhaps the best reason for establishing an expense fund is that many top litigators suggest that its existence can be one of the biggest deterrents to claims. Most sophisticated strategic buyers would prefer not to bring a claim. They will do so if necessary, but they will generally approach deals with the hope that everything about the target company was accurately represented to them, and they acquired the company they were expecting to acquire. Some buyers, however, may look at the escrow as an opportunity to get some money back to improve their returns on the deal. If these buyers know that the shareholder representative has the resources available to defend against a claim, they will more rigorously evaluate the merits of their claim and the probability of success.
If an expense fund does not exist, the shareholder representative may not have funds to effectively represent the selling shareholders. Shareholders can always pass the hat around, but the window for responding to disputes is usually limited. By the time funds become available, the response period may have elapsed. Buyers also may count on shareholders’ reluctance to reach into their pockets to pay expenses after the initial payout.
Establishing an expense fund at closing generally works in the best interests of all the shareholders, but especially the larger ones. At closing, every shareholder contributes to the expense fund on a pro rata basis. At the end of the post-closing period, the balance of the expense fund is distributed back to the shareholders. In contrast, if no expense fund is established and a dispute arises that the shareholders elect to fight, it is likely that a few of the large shareholders will end up funding more than their pro rata portion of expenses. For investment funds, this may require them to use a portion of their management fees to fund such expenses or require a claw-back of merger consideration previously distributed to their limited partners. In either case, establishing an expense fund at closing mitigates this exposure.
Buyers may want an expense fund to be available if there are terms in the merger agreement that obligate the parties to split the expenses of items such as escrow banking fees, audits or arbitration. Many agreements contain a mechanism stating that the parties will attempt to resolve any disputes for some defined period and, if they are unsuccessful, an independent accountant or arbitrator will be appointed. If the expenses of the accounting firm or arbitrator are to be split between the buyer and the selling shareholders, or if expenses are to be paid by the loser in the dispute, the buyer will want some comfort that the selling shareholder group will be able to meet its portion of any such obligations. An expense fund provides an easy means of collection.
What is the appropriate amount for an expense fund? As with most issues in a merger agreement, it depends. Except possibly for small transactions, SRS Acquiom recommends a minimum escrow expense fund of $100,000. If, however, the escrow is larger or the earnout potential is significant, it may be appropriate to reserve between $250,000 and $500,000. We’ve seen expense reserves established at closing as high as $4 million. It really depends on the amount of potential upside and the complexity of the merger terms. To be a real deterrent to potential claims and a real tool for the former shareholders, the size of the fund needs to be meaningful compared to the size of the potential claims. According to the 2014 SRS Acquiom M&A Deal Terms Study, the average size of an expense fund was 5% of the escrow amount if the deal included earnout provisions and 3% of the escrow amount for deals without earnouts.
Regardless of the amount, SRS Acquiom considers expense funds a best practice. Having funds set aside to quickly mount defenses against claims more than offsets any cost of the holdback in most deals. As a general rule, while SRS Acquiom understands the desire not to tie up funds unnecessarily, it is better to have more money than needed in an expense fund than to not have enough. Having too much just means that some merger proceeds were delayed in disbursement, but having too little means that the major shareholders have to navigate the issues they were seeking to avoid when setting up the fund in the first place.
Typical language might include the following:
Buyer shall deduct the Escrow Expense Amount from the Total Consideration and deposit with the Escrow Agent such Escrow Expense Amount without any act of the Indemnifying Parties, such deposit of the Escrow Expense Amount to constitute a separate escrow fund to be governed by the terms set forth herein. The Escrow Expense Amount shall be available solely to (i) compensate the shareholders’ representative in accordance with the terms hereof, and (ii) pay any third-party expenses incurred by the shareholders’ representative in connection with the defense, investigation, or settlement of any claim from an Indemnified Party or any Third-Party Claim under or related to this Agreement, as well as any costs and expenses associated with the Escrow Expense Amount. The shareholders’ representative shall have full discretion over the Escrow Expense Amount, and the Escrow Agent shall follow any lawful directive of the shareholders’ representative regarding the use or disbursement of all or a portion of the Escrow Expense Amount to third parties and in amounts authorized in writing by the shareholder’s representative.
As an alternative to forming an expense fund or to better enable the selling shareholders to realistically assume control of costly third-party litigation matters, some parties add a term stating that the selling shareholders’ portion of third-party expenses will be paid from the escrow. If the parties take this route they should include a clear mechanism for payment in the merger agreement to avoid complications in timely payment of monthly legal bills.
In rare circumstances SRS Acquiom has seen expense funds established through a voluntary holdback of some of the buyer shares distributed in a non-cash acquisition. Depending on the marketability of the buyer’s securities, this can be problematic when a dispute expense is incurred. Selling shares may delay deployment of dispute resources, create additional transaction expenses or, if the buyer’s shares decline in value, may be insufficient to cover costs. If this occurs, selling shareholders, particularly the larger ones, may have to contribute to a new cash expense fund. Therefore, SRS Acquiom recommends that shareholders establish expense funds using company cash, if available (with a corresponding reduction in consideration paid to stockholders), or allocating any cash proceeds to the expense fund prior to distribution to the shareholders. In rare cases, because expense funds also have benefits to the buyer, some buyers may be willing to distribute limited cash to fund the expense fund, even in those transactions primarily structured as a non-cash (stock) transaction.
Some selling shareholders establish the funding for defense of claims separately through a contribution agreement. If all the indemnifying stockholders are likely to have significant cash resources for the foreseeable future and are ongoing entities, a contribution agreement, which requires the signatories to contribute for a specified purpose if called upon by the stockholder representative, may avoid the need to tie up cash in an expense fund, while also providing the deterrent effect and resources in the event of a later dispute. This type of arrangement carries risks, of course, as it is difficult to predict if a particular indemnitor will be able and willing to honor the contribution commitment at a later time. Indemnitors will also be reluctant to sign such an agreement unless there are caps on their funding obligations.