In my last post, I discussed the dynamics behind materiality scrapes with respect to purchase agreement representations and warranties, and indemnification provisions. Another tool utilized by buyer and seller parties to an M&A deal that affects allocation of risk is a concept known as the escrow holdback, normally effectuated through a separate escrow agreement. While sellers want the entirety of their sale proceeds yesterday, that mindset is not always practical considering the parties’ negotiating positions and resulting leverage.
As previously examined, representations and warranties allocate risk between buyer and seller, and serve as the foundation for an indemnification claim in case of a breach or inaccuracy. Again, claims are most frequently brought by a buyer, who is more likely to suffer a post-closing loss so indemnification typically provides buyer with recourse after the transaction closes.
There are a variety of potential escrow holdback categories (e.g. working capital adjustments, earn outs, and special indemnities uncovered through the due diligence process). However, this post will focus on the standard general indemnification scenario.
The initial purchase agreement escrow holdback reference can usually be located in the section describing purchase price mechanics and will often resemble the following:
- Applicable escrow holdback provision: “The Buyer shall deliver to the Escrow Agent, by a wire transfer of immediately available funds to the account or accounts designated by the Escrow Agent, an amount equal to the Escrow Amount, which shall be distributed in accordance with the Escrow Agreement”
If the parties agree on an escrow holdback, a shrewd seller’s attorney will be sure to include language in the purchase agreement that commits the buyer to satisfy indemnification claims through such holdback prior to bringing any type of action directly against the seller.
Example: “If a Buyer Party incurs any Losses and is entitled to indemnification from the Seller hereunder, the Buyer Party shall proceed first against and exhaust the Escrow Amount prior to pursuing any other right or remedy against the Seller hereunder or otherwise.”
The referenced escrow agreement sets forth the terms and conditions by which an escrow agent (often a third-party bank or other financial institution) will hold and distribute the portion of the purchase price placed in escrow to satisfy certain post-closing obligations of the seller. Predictably, buyers and sellers deeply negotiate the scope of the escrow holdback and escrow agreement. Sellers will push for a reduced escrow holdback duration and amount, while buyers covet an extended period as well as a high percentage of the purchase price.
A recent Citi Private Bank analysis on escrow trends in private M&A transactions (gleaned from over 1,330 escrow deals closed in 2018) uncovered several interesting escrow holdback outcomes, some of which are listed below:
Duration: General range from less than 12 months (13% of transactions) to 18 months (17%), with a sweet spot at exactly 12 months (52%).
Amount: The average and median percent of purchase price held in escrow was 10% and 9%, respectively, for deals under $50 million (deeper look below); and 5% and 3%, respectively, for deals both between $50 million and $100 million, and between $100 million and $250 million.
For deals between $0 and $25 million, the average and median percent of purchase price held in escrow were 12% and 10%, respectively, whereas for deals between $25 million and $50 million, the average and median percent of purchase price held in escrow were 6% and 5%, respectively.
Claim Types: The most common types of claims were Tax (32%), Financial Statements (28%), Litigation (22%), Intellectual Property (7%), Regulation (5%), Accounts Receivable (3%), Accounts Payable (2%), and Environmental (2%).
- 22% of the deals observed resulted in a claim against the escrow holdback
- Average claim amounted to 34% of the escrow holdback
- 35% of claims notices are presented in the first 6 months of the escrow holdback duration, of which 78% are disputed
- 39% of claims notices are presented in the last 30 days of the escrow holdback duration
- 52% of claims submitted are paid out within 30 days of the claim
One additional pertinent side note, 22% of the deals examined were in the healthcare industry.
David Kahn practices in the area of healthcare law, concentrating on Mergers and Acquisitions.