Due to issues that have been going on in the market from a legal and regulatory compliance perspective, escrows are being used in most Accounts Receivable Management (ARM) sales transactions today. Nevertheless, escrows are becoming an increasingly contentious component of a transaction. The following transaction advisory considers the escrow process from both the buyer and seller sides of the financial transaction and offers insight into how to make sure an escrow request does not torpedo a deal to sell a business.
What is escrow?
Basically, escrow is a third party account where a buyer and seller will mutually agree on a percentage of the total enterprise value or purchase price of a business transition that will go into a third party interest-bearing account. These funds will then be drawn on in the event an undisclosed legal event occurs.
What could happen that necessitates an escrow account?
It could be a variety of things, including an ongoing TCPA lawsuit or a credit reporting issue that has a fixed dollar amount of potential exposure. When and if the claim is settled or resolved, the funds in the escrow account will be used to pay for the particular item that is noted and agreed to by the buyer and seller. Typically, whether it is a stock or an asset deal in an M&A transaction, we tend to see escrows ranging from 5% – 20% of the total purchase price.
Why is there is such a broad range?
Every company in the ARM industry is dealing with a different set of issues. If there isn’t a significant ongoing issue confronting the business, typically the amount will be closer to 5%. However, if we are dealing with an active employee-related lawsuit or a TCPA class-action lawsuit, the escrow amount can go up to 20% or higher.
There are different ways of dealing with the process to release escrow funds following the sale of a business. It doesn’t mean the escrow account will be open indefinitely for claims to be submitted by the buyer. There could be intervals where some portion of the escrow account is released at 6, 12 or 18 months, or some other interval. The release could also be timed to the particular settlement of a pending legal issue.
Often, sellers get spooked when funds are placed into an escrow account. However, the reality is the escrow funds go into a third party bank account. Funds could also be held by an attorney. The party selling the business will typically feel more comfortable when he understands why the funds are being held in escrow, and who is holding the funds.
Another hot button when it comes to escrow is interest. If there is a significant amount of money going into an escrow account, a seller would like to see any accrued interest returned at the end of the escrow period. This is a reasonable request and is another negotiating point for both parties to work through.
Should sellers be concerned about escrow?
We advise companies to not be concerned about the concept of an escrow. Escrow occurs in a majority of ARM sales transactions, as well as in other areas of OBS. They are a part of the M&A process.
How do you assign a percentage to escrow when selling a business?
Escrow can be a negotiated item. It usually comes into play when a big issue may drive the escrow up, like a TCPA claim. It is lower when there isn’t a great deal of exposure the buyer is concerned about.
How can a seller approach an escrow negotiation?
We advise sellers and sell-side representation they have to disclose everything. If a sticking point comes up later and there is no escrow, a lawsuit will typically occur. The seller should disclose any legal matters to the buyer, along with the potential dollar exposure to the company. As long as the buyer understands what the issues are, the seller and buyer can have a meeting of the minds on what will and won’t be covered by the escrow. Sometimes a floor or ceiling will be assigned to an escrow account. If it is below a certain amount no funds will be drawn against the escrow account. If it reaches a certain level, funds will be drawn from the escrow account. As a result, there will be fewer proceeds going to the seller.
How about buyers and escrow?
When getting deals done in today’s environment with all the regulatory noise that exists, there shouldn’t be fear on the buyer’s side that you can’t buy a company because it will cause undue risk or harm after the deal because of what the previous owners may have done. There are ways of protecting yourself in the form of an escrow because it protects you in the event something happens post-closing.
How about sellers?
If you are selling a business and you wish to get a deal done, know there is likely to be an escrow. This is because the ARM space is a highly regulated industry. There are many compliance issues, and it is a people-intensive business. You must accept that a buyer will come to the table with an escrow arrangement. You shouldn’t be scared of it. It will be a fact of the deal.
Disclose, disclose, disclose. Know if you disclose everything to a buyer you are likely to come out ahead because a lot of the claims that could come through the escrow could get settled for less or dealt with differently. As a result, a sizeable portion of the funds in the escrow account when you transition your business will come back to you.
CAS oversees and executes on M&A engagements, investment opportunities, compliance/regulatory assessments, valuation and expert witness litigation matters for constituents of the Outsourced Business Services (OBS) sector.
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