As described in the previous post, escrow accounts are funds carved out of the seller’s proceeds for the benefit of buyers in order to secure indemnification obligations under M&A transactions. However, there are a couple of additional points that the parties may wish to consider.
The first issue which occasionally is raised by a party is the use of insurance to cover indemnification claims. In practice, this is very difficult in the private technology company context. Unlike fire, flood or other forms of casualty insurance, which are based on actuarial analyses of losses over long periods, every M&A deal is unique and has its own risk profile. As a result, insurance companies that attempt to offer this coverage end up having to do their own due diligence on the seller to try and underwrite the risk and derive an appropriate premium. Even in the best case, this introduces another party into the equation, creates delays and generally raises the risk that the deal won’t close – exactly the opposite of what insurance is supposed to achieve! The reality is that it is very difficult for insurers to quote these policies as the risks to small technology companies are difficult to assess and even harder to quantify. This means that reps & warranties insurance in a real-world M&A deal is likely to be either expensive & very limited in coverage or not available at all.
Another method for shifting risk from buyer to the seller for the post-closing performance of the business involves the use of earnouts or contingency payments as an element of the deal consideration. In these cases, the buyer agrees to pay the seller future amounts contingent upon revenues, profits, retention of customers or employees, achievement of milestones (especially relevant in the life science space where FDA approval is frequently an issue) or other condition agreed to by the parties. Earnout periods tend to be somewhat longer than escrow periods, with goals extending anywhere from 12-36 months into the post-closing future. A somewhat less appreciated feature of earnouts is that the parties can agree to a right of offset providing that indemnification claims can be charged against earnout payments as a supplement to the escrow account. This gives the buyer additional comfort and can result in a smaller escrow or a shorter escrow period, each resulting in a greater percentage of the purchase price finding its way into the hands of the shareholders at the closing.
Please note, however, that offsets will generally be limited to earnout payments that have been actually earned. The alternative, which would allow an offset against a potential future earnout payment, could result in real problems if such payment is not earned, resulting in either a claim against the escrow payment or a clawback against the shareholders themselves.
Escrow accounts are a necessary element of every private company acquisition agreement. With thoughtful planning and creative negotiation, however, escrow terms can be structured to achieve a positive outcome for both sides of the transaction.
For advice on your specific tech M&A concerns, please contact Corum Group to request a confidential consultation.
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