Previously published in M&A Magazine’s September issue.
Given today’s hectic deal making environment, buyers are completing transactions at a quicker pace than ever before. With more cash deals than previous years and higher purchase prices, buyers want to ensure that the company they are buying is worth the high-ticket price and protect against issues unknown at closing. Escrow funds make buyers comfortable that if a problem arises with the target company after the transaction is complete, they will have an available recourse to recoup losses. To talk more about how and why escrow accounts are being used today, M&A Magazine talked with Fiona Boger, director of Escrow and Payments Solutions at SRS Acquiom. Boger develops, implements and oversees processes that help SRS Acquiom clients navigate the closing and post-closing escrow and payments process. What follows is an excerpt of the conversation.
Can you characterize the M&A environment today?
We saw a slight dip in transactions in the beginning of the year; however, we didn’t attribute this to a lack of desire to complete deals, but instead to the ability to get debt financing at the end of last year. Lately, we have seen the market pick back up. Deal flow is the strongest we have ever seen. We’re seeing a strong seller’s market with high valuations and more cash deals than stock.
Why are escrow accounts important post-close?
Each private-target transaction has 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 of time, typically 12-18 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 IP? If any representations are found to be untrue and the buyer incurs a loss, they would have the right to pursue action against the shareholders. The target company’s value and subsequent purchase price could 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 escrow accounts used today?
The majority of private-target M&A transactions have escrows or other forms of holdback. 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 a separate escrow specific to that known issue. For instance, our records indicate that 87% of transactions have a purchase price adjustment mechanism of some kind. We are seeing a strong increase in escrow funds set up just to account for a possible negative purchase price adjustment, with more of these transactions having adjustment specific escrows than not.
We are seeing a strong increase in escrow funds set up just to account for a possible negative purchase price adjustment.”
What kinds of things should M&A counsel prepare prior to negotiating an escrow agreement to ensure a quick turnaround for clients?
For escrow there are couple of things counsel can discuss with their client prior to the negotiations of the escrow agreement. The first is whether the escrow is to be invested in an interest-bearing account. Counsel should know if and how the escrow is to be invested and who the beneficiary of the interest should be, as well as who should be responsible for that interest for tax purposes. We commonly see the shareholder receive the majority of the interest, with the buyer receiving a percent of the proceeds to cover the tax liability of being the owner of the interest. Prior to closing, counsel should also discuss whether the escrow should be released automatically upon the expiration of the representation period, which is more sell-side friendly, or whether a letter of instruction should be required. Similarly, they should know whether a claimed amount will be released automatically to the buyer after a set period of time with no objection from the sell-side or whether a letter of instruction will be required.
How does a seller benefit from an escrow account?
Sellers can benefit from an escrow fund as the buyer may be willing to agree to a higher purchase price due to the fact that the buyer knows there is money available should any issues come up that lower the value of the target company post-close. Additionally, the escrow fund is frequently the only recourse for non-fundamental breaches, meaning that at closing a seller knows the minimum they will receive in most circumstances, and that the buyer will be limited in its ability to claw back more than is in escrow to satisfy their claims for losses.
How does a buyer benefit from an escrow account?
The buyer benefits from having the money readily available should they need it in order to realize the full value negotiated for in the acquisition agreement. They don’t have to reach out to claw back money or create tension with people who may have been shareholders and remain on the board or involved with the company in some way. An escrow account is less burdensome to all involved.
How should I structure my stock escrow?
We have seen a slight decrease in stock escrows and an uptick in cash escrows. However, we do still see stock escrows now and again. The key component 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. In an instance where the buyer does claim shares from the escrow fund, if you use the second option then every stock certificate would need to be re-issued 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 is 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 escrow account?
In general, the average escrow size as a percentage of transaction value was 9.3%, while the median was 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. There hasn’t been much change to the standard 10% escrow size over the years, as it has remained fairly steady. The only changing factor is deal size, as smaller deals sometimes have larger escrows as a percentage of transaction value as compared to larger transactions.
Why is using a professional paying agent/payments administrator important?
We see two alternatives to hiring a professional paying agent/payments administrator, both of which have their downsides. One option is to use the escrow agent to also distribute 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 that is responsible for collecting letters of transmittals, including payment instructions and tax forms at closing. As such, the parties have to coordinate how to deliver this information to the escrow agent in a format in which they can receive it. Additionally, escrow agents do not conduct 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. Lastly, the shareholder representative may not have the knowledge to properly conduct tax reporting, especially if there are foreign holders invoiced in the transaction.
A professional paying agent/payments administrator can collect tax information, is knowledgable about tax reporting and might be able to handle the compensatory payments – thus relieving administrative burden from deal parties.
What kinds of things should M&A counsel prepare prior to negotiating a paying agent agreement to ensure a quick turn-around for clients?
One of the areas where we see the most confusion from deal parties is the issue of tax reporting. 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. These issues can be alleviated if the parties have engaged a knowledgeable paying agent who is able to handle all types of payments, including compensatory payroll payments, non-gross proceeds, and transaction expenses at closing. An additional issue that 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.