Letter of Intent: Escrow
Jason and I continue our Letter of Intent series with one of our “favorite” clauses (sarcasm intended). The escrow is another hotly negotiated term that often is left ambiguous in the LOI. The escrow (also known as a “holdback”) is money that the buyer is going to hang on to for some period of time to satisfy any “issues” that come up post financing that are not disclosed in the purchase agreement.
In some LOIs we’ve seen extensive details – with each provision of the escrow agreement spelled out – including the percentage of the holdback(s), length of time, and carve outs to the indemnity agreement. In other cases, there is simply a declaration that “standard escrow and indemnity terms shall apply.” Since there really isn’t any such thing as “standard terms” this is another trap for deferring what can become a brutal negotiation to the post LOI stage. Since whatever the escrow arrangement is, it will decrease the actual purchase price should any claim be brought under it, the terms of the agreement can be very important since they directly impact the value that the seller receives.
While there is no typical mechanism or agreement, we can say in our recent experience an escrow is set up which is the sole remedy for breaches of the reps and warranties, with a few exceptions (also called “carve-outs.”) Normally between 10% and 20% of the aggregate purchase price is set aside for between 12 and 24 months to cure issues. You should note that while this is usually where the deals end up, it can take a herculean effort to get there. It’s not uncommon for a buyer to start by asking for uncapped indemnity if anything goes wrong, personal liability of company executives and major shareholders, and – in some cases the ability to capture more value than the deal is worth.
The carve-outs typically include fraud, capitalization, and taxes. Occasionally a buyer will also press for intellectual property ownership to be carved out. We’ve also started to see liabilities resulting from lack of 409A compliance be carved-out in escrow agreements under the argument that 409A is like “taxes.” In all cases, the maximum of the carve-out should be the aggregate deal value (e.g. you shouldn’t have to come up with more than you got paid to satisfy an escrow claim).
A lot of buyers will say something like “well – I can’t figure the specifics out until I do more due diligence.” We say “bah” to that – we’ve yet to meet a buyer that was unable to put an initial escrow proposal – with some detail – in the LOI – subject to due diligence of course.
Finally, the form of consideration of the escrow is important. In a cash deal, it’s easy – it’s cash. However, in a stock deal (or cash and stock deal), the value of the escrow will float with the stock price. There are lots of permutations on how to best manage this on the seller side – you should be especially thoughtful about this if you have concerns that the buyer’s stock is particularly volatile. Imagine the situation where the stock price declines but the buyer’s escrow claims are of greater value then the stock in escrow represents. Reasonable people should be able to agree that the seller doesn’t have to come up with extra money to satisfy the claims (note the “reasonable people” assumption.)