Both parties involved in a merger or acquisition deal take on some risk. For the buyer, of course, there's the risk that the target company doesn't provide the expected benefits. Perhaps sales aren't as robust as forecast, or expenses spike unexpectedly. Sellers take on risk as well. Even once the deal is inked, the buyer may claim the seller misrepresented the company.
These risks are even greater when the company is smaller and private, since, by definition, little or no public information is available. One way around this is through the use of an escrow account. At the closing of the transaction, a portion of the purchase price is placed in escrow and held until the terms of the agreement are satisfied. About 70-some percent of deals in which the target company is private and the deal size falls below about $1 billion use escrow agreements, says Rocky Motwani, managing director and head of escrow business with JPMorgan.
Motwani and his colleagues have studied the escrow agreements used in M&A transactions over the past several years. In the 2010 M&A Escrow Holdback Report, they looked at 142 deals, out of a universe of 550, in which some claims were made on the escrow account. The average deal size just topped $100 million; 91 percent were unsolicited.
Nearly nine out of ten escrow accounts were cash-only, with a median deposit size of $1.65 million. On average, 10 percent of the purchase price was placed in escrow.
The most recent study included deals completed during the latter half of 2008 and all of 2009, while the previous study covered transactions taking place during 2007 and the first half of 2008 â€“ a period during which deal-mania was peaking. The overall difference between the two? The findings reveal “almost a return to normalcy this year versus the last study,” Motwani says.
For instance, buyers made claims against the escrow accounts in about 40 percent of earlier deals; the number dropped to about 30 percent in the more recent study. Motwani attributes this to more diligence on the part of buyers today. Several years ago, in the midst of “M&A euphoria,” buyers just wanted to get the deals done. Once they were complete, it wasn't uncommon for buyer's remorse to set in. In the most recent study, about one-third of the claims against the escrow account were to adjust the purchase price; another 30 percent were for working capital adjustments.
Similarly, the average duration of the escrow agreements crept up from 12 months in the first study to 18 months today. “We think it's a result of buyers being more diligent,” Motwani says.
What can CFOs and treasurers involved in M&A â€“ from either the buyer or seller side â€“ take from the study? Most prominently, escrow agreements can be an effective risk mitigation tool for both parties. That's particularly key as a greater number of deals cross borders, adding currency and regulatory risk, and in which due diligence becomes more difficult.
When it comes to setting up the escrow agreement, CFOs and treasurers shouldn't simply hand the job off to the company's attorneys, although the lawyers need to be involved. However, the finance folks need to think through how to fund the account and how long the agreement should run. After all, the company's cash may be tied up for year or more.
Contrary to what some business execs might think, the agreements themselves tend to be fairly standard and unlikely to slow down the M&A process, Motwani says. About 60 percent close the same day the deal does. “It's a plain vanilla product.” Setting up an escrow agreement typically runs several thousand dollars; in three-quarters of the deals, this cost was split 50-50 between the two sides.
Finally, the agreements provide some breathing room and allow each side to see just how the company performs over time, so that the final purchase price can be adjusted accordingly. So, both sides can “agree to disagree” when they come to different valuations for the company, Motwani adds. ###