4 Commonly Asked Questions About Expense Funds
M&A is inherently exciting. For many, it’s a once in a lifetime event. There are large amounts at stake. There are press releases.
The same cannot be said for the expense fund provisions of a merger agreement. Often the expense fund is one of the last items discussed before closing, when everyone is tired and just wants to get the deal done. But expense funds are crucial and stockholders, lawyers, and buyers should know what they are, how they are established, and what affects their size. Below are the four most common expense fund questions we get, and answers based on our experience.
1) What is an expense fund and how does it differ from an escrow?
- An expense fund is a “rainy day” or “fighting” fund set aside at closing to fund legal, accounting, and other expenses that stockholders and their stockholder representative may incur after closing. Like the escrow fund, the expense fund is typically made up of pro rata contributions from all stockholders.
- While the buyer can make claims against the escrow for indemnification claims, the expense fund is solely for the use of the stockholders and their representative. Absent specific and highly unusual agreement to the contrary, the buyer can never claim expense funds for any reason.
- While an escrow sits with a bank or other third party for a defined time period, the stockholder representative typically holds the expense fund until the stockholders determine that all open issues in the deal are finished. That end date can mean the claims period has expired with no issues, all milestones have been met or otherwise concluded, or any final disputes holding up the escrow has been resolved. The stockholder representative then directs the distribution of the remainder of the expense fund directly to the sellers.
- Escrows and expense funds may be treated differently for tax purposes because, unlike an escrow, the money in the expense fund has already been relinquished by the buyer. Consult your tax professional regarding treatments of your merger proceeds.
2) Why does my deal need an expense fund?
- Post-closing disputes are far more common and expensive than most people think – nearly two-thirds of deals have a post-closing claim against the escrow. While not all disputes require tapping the expense fund, many do. Disputes that call for an outside firm include formal litigation or arbitration, disputes that are headed in that direction, or issues requiring very specialized legal or accounting knowledge.
- Without an expense fund, or if the fund is too small, individual stockholders may need to cover post-closing expenses with voluntary contributions from their own accounts. While it is sometimes possible for these contributions to be reimbursed from the final escrow release, post-closing contributions are inconvenient for all parties, and involve an outlay of post-closing cash from stockholders on short notice.
3) How do the stockholders establish or refill an expense fund?
- The stockholders usually work with their stockholder representative to establish the expense fund shortly before signing the definitive agreement. At closing, the expense fund is then deducted off the top of any closing proceeds before their distribution to holders.
- The expense fund is usually referenced in the merger agreement, the escrow agreement, or both. A typical expense fund establishment provision reads: “Upon the Closing, the Buyer will wire US$250,000 (the “Representative Expense Amount”) to the Stockholder Representative, which will be used for the purposes of paying directly, or reimbursing the Stockholder Representative for, any third party expenses pursuant to this Agreement and the Escrow Agreement.”
- When the definitive agreement provides for an expense fund, all of the deal parties, including the buyer, will know how much the stockholders have set aside. The definitive agreement generally does not require disclosure of any future additions to the expense fund by stockholders.
- If additional contributions are necessary, the stockholder representative can enter into a side agreement with contributing stockholders under whatever terms the representative and contributing stockholders consider necessary for the best interests of all stockholders. Typically, such an agreement would provide for reimbursement, if possible, from the escrow fund when the escrow is released. However, whether reimbursement is possible depends on the structure of the deal.
4) How much to put into the expense fund?
It depends on deal structure and risk factors. Absent special circumstances, we recommend $250K or more to adequately fund defense of escrow claims for a standard deal with no known issues or earnouts. Even that will rarely be enough to actually litigate a post-closing dispute. Our data reveals that deals with the following factors may benefit from a larger expense fund:
- Working capital adjustments. Working capital adjustments often require post-closing work and increase the likelihood that expense escrow funds will need to be used. If so, that would then decrease the funds available for other possible claims. Therefore, all else being equal, the selling shareholders should consider having a larger expense fund when working capital adjustments are included in the transaction than when such a mechanism is excluded.
- Milestones or earnouts. Deals with contingent consideration timelines years beyond closing are more likely to require use of counsel at some point to interface with buyer counsel, or formally amend earnout obligations by buyers. Data from the SRS Acquiom 2017 Life Sciences Study reveals that on average, 30% of milestones in life sciences are paid without some sort of dispute. Of the unpaid milestones, about half are disputed by sellers and about half of those disputes lead to formal renegotiations. In other words, there is approximately a one in three chance that your deal will require serious milestone advocacy post-closing – and this is on top of the risk of dispute inherent in non-milestone deals. If these terms are included in your deal, you might want to consider an expense fund that is several times larger than what might be included in a deal without milestones and earnouts because the associated legal costs and amounts in dispute can be substantial.
- Intellectual property assets. Litigation over technology assets is a common post-closing issue. While IP litigation costs are falling, they are still high. To control a litigation dispute, “the median cost for a patent infringement case with $1 million to $10 million at stake” was still around $1.7 million in 2017, according to the American Intellectual Property Law Association’s 2017 Report. It may cost less than $1.7M for the stockholders to monitor IP litigation controlled by a buyer, but the outlay can still be significant. Since the behavior of third party patent trolls can be unpredictable, this should be considered even when the sellers feel they have taken appropriate steps regarding their intellectual property prior to closing.
- Disclosed litigation. If litigation against the company is ongoing at the time of closing, the spending is not likely to stop once the deal closes. In some deals the representative controls that litigation and is responsible for the resulting legal expenses. Even where the buyer controls litigation, there is significant risk of a dispute about the final indemnity of the matter.
- Multiple escrow releases. In our experience, deals with an escrow to be released in several tranches, e.g. half of the escrow six months after closing and the other half after one year, lead to increased claim activity and disputes, which are more likely to require involvement of outside counsel to resolve.
- Cross-border components. Deals where the buyer, selling company, or subsidiaries are located outside the U.S. often require specialty counsel to resolve disputes. Examples include hiring counsel or tax experts to deal with foreign tax audits, or counsel that specializes in employment laws of foreign countries. Certain jurisdictions are also more expensive to litigate in.
- A “Buyer Power Ratio” over 100. A 2017 joint study between SRS Acquiom and the American Bar Association revealed that in deals where the buyer’s market cap is more than 100 times the deal the purchase price, many negotiated deal points will likely come out in the buyer’s favor. This can increase the types of possible indemnification claims and/or the length of representation survival periods, which can in turn require increased use of outside counsel or tax experts.
- Stockholders include funds at the end of their life-cycle or individual investors. Some stockholder groups have no problem contributing additional funds in the event of litigation. Others find it a challenge. In our experience, individual investors are less interested in contributing funds post-closing. Similarly, investment funds that are looking to wind-down may not have funds available to contribute. They should plan ahead by creating a larger expense fund.