Compensation Escrows – August 2022 | Goulston & Storrs PC

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Market trends: what you need to know

As the American Bar Association’s private target M&A deal point studies show:

  • Indemnification escrows are consistently seen in about two-thirds or more of reported transactions.
  • The level of the compensation baskets as a percentage of the value of transactions, whether average or median, has shown a moderate downward trend.
  • With the exception of a dramatic increase in 2013, provisions making indemnity escrow the exclusive remedy for relevant compensation claims have declined in recent years, from 32% to 1% over the periods covered by the ABA studies.
  • The 2017, 2019, and 2021 ABA studies each show that compensation caps and compensation baskets were lower in reported transactions where representations and warranty assurance (RWI) were referenced in transaction documents, for example. in relation to transactions without such a reference. Similarly, and unsurprisingly, compensation escrows were lower in the transactions of these three studies where RWI was referenced.

Introduction

Merger and acquisition (M&A) buyout agreements typically include indemnification provisions, under which any given party (indemnifier) ​​agrees to defend, hold harmless, and indemnify the other party or parties (compensated) against the specified claims or damages. These generally include claims arising from a breach of the indemnificator’s representations and warranties or covenants set forth in the purchase agreement, or relating to other specific matters.

In most M&A transactions, a portion of the purchase price otherwise payable to the seller is placed in escrow, for a defined period of time, to secure one or more of the seller’s indemnification obligations to the buyer after fence. This article examines trends in the use of indemnification escrows in private corporate mergers and acquisitions transactions.

Merger and acquisition indemnity escrow

Indemnification escrows generally serve as security for Seller’s general indemnification obligations with respect to its representations and warranties, but need not be limited to such obligations. Typically, these escrows are held by a third party independent of the buyer and seller, such as a bank. Sometimes the buyer can keep the escrow as a retainer, but this is less common. In this article, the term escrow is intended to include buyer retainers as well as true third-party escrows, as the difference between the two mainly relates to whether the funds are held by an independent party or not.

The parties may agree to establish a single receiver to secure all potential claims, or to establish several separate receivers, each providing relief for different obligations of the seller. For example, if the buyer discovers something in due diligence that warrants negotiation of enhanced rights and remedies, they can also negotiate a separate escrow, outside of the standard general indemnity escrow, to ensure funds are available. if one of the enhanced remedies is triggered. In addition, buyers and sellers are increasingly establishing separate escrows to secure the buyer’s obligations arising from the adjustment of the purchase price after the closing of the purchase contract.

A general indemnity escrow may, but need not, be tied to different dollar and timing aspects of the underlying indemnity to which it relates. For example, it may make sense to set the duration of the escrow to the normal survival period of the seller’s representations and warranties. However, because there are often exceptions to this survival period, including for specified fundamental representations, there is not necessarily a perfect alignment between the two periods. The parties could agree that escrow should be the sole remedy for compensation claims and as such should function as a cap on compensation. But, as with survival periods, likely exceptions to a normal cap, whether claims arising from breaches of fundamental representatives, covenants, or otherwise, can weaken the case for symmetry. between the amount of the escrow and the ceiling.

Compensation Escrow Trends

Every two years since 2005, the ABA has published its studies on mergers and acquisitions of private targets (the ABA studies). ABA studies examine publicly available transaction purchase agreements involving private companies. ABA studies examine publicly available transaction purchase agreements involving private companies. These transactions vary in size but are generally considered part of the “middle market” for M&A transactions; the deal values ​​of the 123 deals in the 2021 study ranged from $30 million to $750 million.

The nine ABA studies (2005-2021) show that:

  • Indemnification escrows are consistently seen in about two-thirds or more of reported transactions.
  • The level of the compensation baskets as a percentage of the value of transactions, whether average or median, has shown a moderate downward trend.
  • With the exception of a dramatic increase in 2013, provisions making indemnity escrow the exclusive remedy for relevant claims have declined in recent years, from 32% to 1% over the study periods. of the ABA.

For reference, the mean represents the average of all data covered and the median represents the data point separating the lower and upper halves of the overall data, i.e. half of all data points are above above and half are below the median. The median is often considered a more reliable indicator of what is normal or typical when the data distribution is skewed.

The following graphs show how indemnification escrows have been covered in M&A agreements of private companies.

CHART—Source: ABA Private Target M&A Deal Point Studies

CHART—Source: ABA Private Target M&A Deal Point Studies

CHART—Source: ABA Private Target M&A Deal Point Studies

Indemnification Covenants and Warranty Representations and Insurance

The 2017, 2019, and 2021 ABA studies each show that compensation caps and compensation baskets were lower in reported transactions where representations and warranty assurance (RWI) were referenced in transaction documents, for example. in relation to transactions without such a reference. Similarly, and unsurprisingly, compensation escrows were lower in the transactions of these three studies where RWI was referenced. The graph below shows this relationship:

CHART—Source: ABA Private Target M&A Deal Point Studies

Conclusion

Indemnification escrows are an important source of recourse for compensation claims. As ABA studies show, indemnification escrows are commonly used, although their amounts as a percentage of transaction value and their use as the sole remedy for relevant compensation claims have declined since 2005. RWI continues, it seems, to increase the amount a percentage of the transaction value of the blocked indemnity is less.

Reprinted with permission from Bloomberg Law. Copyright ©️2022 by the Office of National Affairs, Inc. (800-372-1033) http://www.bloomberglaw.com

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