IBA, as the premier business brokerage firm in the Pacific Northwest, is firmly established as a respected professional service firm in the legal, accounting, banking, mergers & acquisitions, real estate, and financial planning communities. Periodically, we will post guest blogs from professionals with knowledge to share for the good of owners of privately held companies & family owned businesses. The following blog article has been provided by Louie Jachim of Northwest Bank (www.northwest-bank.com):
Escrow Holdbacks for a Business Sale Transaction
What is a Holdback Escrow Account and Why Use it?
Buying or selling a business in the private sector demands enormous energy on the “front half” of the transaction. Much time is focused on due diligence, proper valuation, form and type of acquisition, and maintenance to ensure everything goes smoothly leading up to closing. However, once the money is out the door, this does not mark the end of the transactional risk.
Post-closing liabilities can be a major point of concern for both parties. More often than not, M&A transactions contain a holdback escrow element(s) defined in the Purchase & Sale Agreement. In its simplest form, a holdback is a portion of the purchase price that is not paid to the Seller at the closing date, but rather held in a third party escrow account. The funds held back can offer both parties a degree of comfort that funds will be available to mitigate potential post-closing risks. Typical escrow accounts, as a percentage of the total purchase price, are 10-15%.
Examples of Specific Purposes Covered by Escrow Funds
Beyond the good faith deposit, most PSA’s contain contingencies that predetermined conditions and/or timelines be met after closing. These protect both the Buyer and Seller from a variety of circumstances in which a certain aspect of the PSA is not upheld or materially changes after the fact.
A few situations include:
- Post-Closing Purchase Price Adjustments or “True-Ups”
These contingencies often focus on the assets and liabilities of the selling company, which change as a result of normal operations between the time both parties agreed on an original purchase price and the closing date. Frequently referred to as “Net Working Capital Adjustments,” these amounts may be substantial depending on length of time between agreement and execution.
- Indemnification Holdback for Representations and Warranties
This common holdback element serves as a security for the Buyer or Seller, for claims of damages or loss of value because of unknown or undisclosed liabilities related to a breach of representation and warranties in the PSA.
- Specifically Identified Liability
Certain elements of a transaction may be identified up front as a risk. For example, these might be product returns, warranty claims, or pending litigation. Holdback escrow accounts allow for these to be addressed and accounted for independent of other factors.
- Earn-Out Provisions
Clauses in the PSA that outline additional consideration to the Sellers if specific performance goals of the target company are attained. For the Sellers, this can provide assurance going into a transaction that the funds are available if earn-out metrics are achieved, and conversely for the Buyer that potential additional obligated payments are accounted for up front. This type of escrow need is most often managed separately from the items above and can be accompanied by a sinking fund that accumulates earn-out dollars.
Other Considerations for Escrow Accounts
Establishing accounts and depositing funds is only one part of an effective M&A escrow holdback. Below is a list of some other considerations the Buyer and Seller must negotiate and clearly define in the Purchase & Sale Agreement:
- Specific purposes of account(s)
- Term of escrow period
- Requirements for disbursement
- Account type – Interest-bearing, investable, etc.
- Account owner – If interest-bearing, who entitled to interest income?
- Foreign transactions – are there FX risks to consider for a USD escrow? Who bears FX risk?
- Ongoing information (e.g. account balance) requirements/access for each party
Who Provides This Service?
Agents for the holdback escrow accounts can be attorneys, financial institutions, or specific insurance-backed escrow services. Deciding who provides this service for your transaction depends on a number of factors: the agent’s experience with handling escrow accounts, the speed of the account opening process, the ease of doing business, the set-up and transaction costs, and the nature of the account types available.
The actual accounts in which the money is deposited can be insurance-backed escrow investment products, money market mutual funds, or like with the majority of M&A deals, traditional Bank demand deposit or money market accounts.
Each of these options come with their own set of pros and cons, and deciding on which product to use comes down to the scope and needs of your transaction. Important elements to consider are:
- Principal Protection: Will the funds in the escrow account be safe over the duration of the agreement? This answer varies; consider insured collateralized escrow products versus the floating nature of mutual funds. The latter may be a less expensive product, but subject to macroeconomic risk. For most M&A transactions general bank stability along with the FDIC insurance for demand deposit or money market accounts has proven sufficient.
- Yields: Will the funds held in escrow be accruing interest? If so, who (Buyer or Seller) has a right to that interest?
- Fees: If the account is shorter term, will the surety of an insurance-backed account be worth the higher cost to park those funds? Who (Buyer or Seller) bears those costs?
- Accessibility: Depending on what type of account the funds are in, will the disbursements be immediately accessible?
So long as the purpose of the escrow account is clearly defined, and responsibilities and ownership are distinct, both parties can benefit greatly from the “back half” transactional risk mitigation this service provides.
Louie Jachim is an Associate Relationship Manager at Northwest Bank, a commercial bank serving clients and their businesses across the Pacific Northwest. If you have questions about the content of this article or the area of M&A escrow services, please contact him at (206) 621-8718 or email@example.com.
IBA, the Pacific Northwest’s premier business brokerage firm since 1975, is available as an information resource to the media, business brokerage, and mergers & acquisitions community on subjects relevant to the purchase & sale of privately held companies and family owned businesses. IBA is recognized as one of the best business brokerage firms in the nation based on its long track record of successfully negotiating “win-win” business sale transactions in environments of full disclosure employing “best practices”.