M&A escrow

Escrow accounts and escrow agents can take many forms and are used in a variety of situations. For the purposes of this guide we are looking at the operation of escrow accounts and escrow agents within Mergers & Acquisitions (“M&A“).

Academic research[1]  has found that escrow contracts are employed in 52.1% of acquisitions with an average of 12.2% of the sale proceeds placed in escrow for approximately 17.4 months.

An escrow is a contractual arrangement whereby a third party receives and, subsequently, disburses money or documents on behalf of the principal contracting parties, subject to the fulfilment of certain independent conditions.

The Escrow Agent is the third party that holds and administers the assets that are subject to the escrow. The Escrow Account is the segregated bank account used to hold the cash or, in some circumstances, assets that are the subject of the escrow.

Escrow is primarily a risk mitigation tool and is used to ensure that funds are available without having to obtain the funds directly from the other party. Set out below are a variety of circumstances when escrow can be used, although the primary use is to help reduce the due diligence costs in M&A and manage the risks presented by the asymmetry in knowledge between the buyer and the seller.

Indemnities and Warranties Rather than carrying out extensive due diligence on the target, the seller(s) will provide extensive indemnities, representations and warranties on the state of the target. These will be backed by a sum held in escrow, to assure the buyer that funds are available to satisfy the covenants. As set out further below, this can lead to an increase in value for both the buyer and the seller(s).
Good faith deposit Where the seller is investing considerable time, money and/or risk in entering the sale process, they can ask for a deposit to be placed in escrow. This will be released to the seller in the event that the buyer withdraws.
Adjustment of purchase price Where the purchase price is likely to be adjusted, for example by way of completion accounts or an earn out, a portion of the purchase price can be placed in escrow, subject to finalisation of the relevant metrics.
Government approval / conditional completion Where completion is conditional upon a third party event, most commonly approval of a government authority, such as the competition commission, some or all of the purchase price can be placed in escrow, subject to such approval.

Escrow arrangements are often most valuable when they are used in the acquisition of an entire private firm, rather than the acquisition of a subsidiary of a larger group (where the buyer would have recourse against the remaining group for an indemnity/warranty claim). As a result escrow contracts are used in 65% of private firm acquisitions compared with only 32% of subsidiary acquisitions[2].

Escrow arrangements are also particularly helpful when there is large information asymmetry about the target value, between the buyer and the seller(s). For example, where the buyer is not an expert in the trade of the target. Such information asymmetry increases the transaction risk for the buyer and, consequently, the due diligence costs of the transaction.

Academic research[3] has shown the following benefits of using an escrow arrangement:

  • 50% reduction in due diligence costs: Use of an escrow arrangement can reduce the time spent on due diligence by an average of 50% and the benefits are most likely to be seen when there is significant asymmetry in the knowledge of the buyer and the seller regarding the target
  • 6% increase in proceeds received by the Seller(s): Even after controlling for potential claims on the escrow account, sellers typically receive a 6% increase in proceeds when an escrow account is used
  • Increased value to the buyer: Not all of the benefit from the escrow account is passed to the sellers and the share price reaction of public companies acquiring private companies using an escrow arrangement is more positive than those not using one.

[1]The use of escrow contracts in acquisition agreements, 14 June 2014, Sanjai Bhagat, Sandy Klasa and Lubomir P. Litov 
[2]The use of escrow contracts in acquisition agreements, 14 June 2014, Sanjai Bhagat, Sandy Klasa and Lubomir P. Litov 
[3]The use of escrow contracts in acquisition agreements, 14 June 2014, Sanjai Bhagat, Sandy Klasa and Lubomir P. Litov 

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