While parties to an M&A transaction do not expect to encounter major post-closing liability issues, transactions involving privately held sellers tend to contain escrow provisions to address buyer concerns over the seller’s financial ability to satisfy indemnification provisions contained in the definitive agreement.
This is especially true in stock acquisitions where the “sellers” are really the selling stockholders in the target. In addition to the founders, this group often includes venture capital funds, angels and even the friends & family of the founders. None of these folks want to be hauled into court for claims against the target, leading sellers as well as buyers to propose an escrow holdback to satisfy claims by the buyer.
Escrow Size: To guard against any post-closing financial loss, buyers insist on placing a portion of the purchase price in an escrow account managed by a third-party (generally a bank). The size of the holdback is typically calculated as a percentage of the purchase price. For private technology companies this can range from less than 10% to more than 20%. Currently, most deals get done in 10% to 15% range.
Escrow Duration: These funds are held for a set period of time in interest bearing accounts. Although one occasionally sees escrows as short as or, the vast majority of private company deals see escrows between 12 to 18 months. 6 months as long as 3 years Two fairly common wrinkles that we see are a portion of the escrow is released earlier with the balance held back for the duration of the period; and different durations with respect to different claims, with IP-related claims most commonly lasting the longest.
Generally, there are three types of claims against escrow accounts: (1) financial adjustments to the closing working capital balance sheet— like an unforeseen increase in liabilities, costs or accounts payables, or a decrease in receivables (A/R) deemed uncollectible; (2) loss of value attributed to unknown or undisclosed liabilities resulting from a breach of any of the representations or warranties contained in the purchase agreement—most frequently these result from litigation or tax assessments against the target; or (3) claims for which the buyer requests specific indemnification by the seller – again a particular lawsuit is the most common item here although product returns, recalls, warranty claims, or cybersecurity breaches are all possible.
Baskets and Deductibles: Buyers would certainly like dollar-for-dollar compensation on any post-closing loss. However, most M&A agreements stipulate that no reimbursement should take place until post-closing losses reach a certain threshold, resulting in the use of various “basket” provisions to handle claims.
There a few basic types of baskets. The first is a true deductible, in which the seller is responsible for all losses exceeding the basket amount. The second type, known as the “tipping” (or dollar 1) basket means that the seller is responsible for all losses, once those losses exceed the threshold of the basket. In either case basket sizes will vary with purchase price. In deals less than US$5 million, a $50,000 basket is typical. For deals between US$10 and $20 million, a $100,000 basket is quite typical. For larger deals the basket is often calculated as a percentage of the purchase price, resulting in multimillion dollar baskets in the larger megadeals.
An additional variation that is becoming increasingly common is the use of a “mini basket” an additional deductible on individual claims. For example, a seller agreeing to a $50,000 basket will not want the buyer to be able to bundle together 50 little $1,000 claims in order to satisfy the basket. As a result, seller may request a mini basket equal to $5,000 (5-10% of the total basket is common) in order to ensure that de minimus claims are avoided.
For advice on your specific tech M&A concerns, please contact Corum Group to request a confidential consultation.
We engaged Corum to obtain liquidity for some of our shareholders. With their assistance we were able to accomplish this objective and the preparation work helped us to eventually secure a significant investment from the venture capital community…we are happy with the outcome.