In M&A transactions, an escrow or a holdback is used to ensure that certain conditions are met by the seller before an agreed amount of funds is released. These structures help allocate risk between buyer and seller and are common in middle-market business sales.

If an escrow is used, a third party known as the escrow agent holds the funds until receiving instructions that certain obligations have been satisfied and the funds can be released. Most of the time, the escrow agent is a large, reputable bank or trust company that provides this service.

In middle-market transactions, escrow and holdback structures are often heavily negotiated and can materially impact a seller’s net proceeds, timing of payment, and overall risk exposure.

How Escrow Accounts Work

The escrow agent holds the funds pursuant to an escrow agreement executed at closing. That agreement governs how claims are submitted, the required notice procedures and timelines, dispute resolution mechanisms, the conditions for release of funds, and the investment of escrowed funds along with the allocation of interest.

In most transactions, escrow funds are invested in low-risk instruments. The interest earned is typically paid to the seller upon release, although this is negotiable.

Despite the fact that escrow accounts are very common in M&A transactions, the specific terms can vary greatly. The average escrow amount typically ranges between 10 percent and 20 percent of the purchase price. The holding period generally ranges from 12 to 24 months following closing. In certain situations, however, both the percentage and the duration may be increased depending on the perceived risk of the transaction.

Why Escrows Are Used

Escrows are designed to protect buyers against unforeseen financial losses after closing. Buyers are often concerned that undisclosed liabilities may surface once the transaction is complete.

Funds are typically released to the seller at pre-agreed times. Sometimes, partial releases occur as early as six months after closing. It would be unusual for the entire escrow to be released that early, but buyers and sellers frequently agree to release portions after six or twelve months if no claims have been made.

The funds are released only if all agreed obligations have been fulfilled. If unknown liabilities arise, or if the seller fails to meet certain pre-agreed conditions outlined in the Purchase and Sale Agreement, the buyer may have the right to recover amounts from the escrow.

Provided the agreed conditions are met, escrow funds ultimately belong to the seller. Buyers do not expect escrow funds to be returned to them. Rather, the escrow serves as a protection mechanism in the event issues arise.

Because the funds are held by a neutral third party and can only be released in accordance with the escrow agreement, escrows can reduce a seller’s risk of not being paid.

The Alternative: Holdbacks

The alternative to an escrow is a holdback. In this structure, the buyer simply retains a certain percentage of the transaction consideration instead of depositing it with a third-party escrow agent.

In some transactions, a holdback is used to secure a specific known risk such as a pending tax matter, while general indemnification risk is covered through a separate escrow.

The primary risk of a holdback is that the funds remain in the buyer’s possession. If the buyer were to go bankrupt or otherwise become unable to pay, the seller could face increased credit risk. While such situations are uncommon, this risk is one reason many sellers prefer the added protection of a formal escrow arrangement.

Representation and Warranty Insurance (RWI)

In recent years, representation and warranty insurance, often referred to as RWI, has become more prevalent in middle-market transactions. RWI allows an insurance policy to cover certain breaches of representations and warranties, which can reduce the need for larger escrow amounts.

For sellers, this can increase cash received at closing, reduce post-closing exposure, and improve overall deal competitiveness. However, RWI does not eliminate escrow entirely and often excludes known risks. It is typically used as a complement to traditional escrow structures.

Escrow accounts and holdbacks are important tools for allocating risk in M&A transactions. While they are standard components of many deals, their structure, size, and duration can significantly affect a seller’s ultimate proceeds and risk profile.

Written by Donald Grava

Versailles Group, Ltd.

Founded in 1987, Versailles Group is a boutique investment bank that specializes in international mergers, acquisitions, and divestitures. Versailles Group’s skill, flexibility, and experience have enabled it to successfully close M&A transactions for companies in the middle and lower-middle market. Versailles Group has closed transactions in all economic environments, literally around the world.

Versailles Group provides clients with both buy-side and sell-side M&A services and has been completing cross-border transactions since its founding in 1987.

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Versailles Group provides clients with both buy-side and sell-side M&A services and has been completing cross-border transactions since its founding in 1987.

If you are considering selling or acquiring a company, we welcome the opportunity to discuss your objectives and offer a clear perspective on your options.

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The decision to sell your business is one of the most difficult decisions a person will ever make. It is not only a major financial decision, but a personal decision as well. Each instance is unique and the selling of a business requires attention to detail on many issues, some of them complex.

 
There are several reasons why it may be time to consider selling.

• If it’s difficult to raise the capital needed to grow the business or you believe it is too risky to do so.

• If too much of your net worth is “locked” in your company, you may feel it is time to diversify this wealth.

• If you are nearing retirement or are experiencing health problems, you may want to find a new owner or partner to continue your legacy with your employees, customers, etc.

• If you want to pursue a new business or hobby, you may want to “unlock” the value of your company and be compensated for all the hard work and time you have put into it.

Versailles Group’s eBook, “When to Sell Your Business” has a more detailed look at these issues. It can be downloaded from our website.

After deciding that you may want to sell and have determined that it is a good time to do so, there are some important items to address: (i) What is the expected value of the company? It is important to have a realistic expectation of what a buyer will pay and always be mindful of the fact that this is an important decision for the buyer as well. (ii) How are you going to engage the right buyers and get them interested in your company? The best way to do this is through a broad based approach that searches for potential buyers around the world. The best buyer for your company may not always be the obvious one or one in your country or even on your continent.

M&A experts can help you address these and the myriad of other issues that come up when selling a business. Selling your company is an important process and it should be done professionally in order to maximize the value and terms. It is also important to have proper legal and accounting representation.

There are two possible ways to purchase a business; one way is through the acquisition of the company’s assets and the other is effected by buying the company’s shares or capital stock.

Asset acquisitions occur when the buyer purchases all of the company’s tangible and intangible assets from the seller. Tangible assets usually include everything from the company’s accounts receivable, inventory, furniture and fixtures, customer lists, logos, etc. Intangible assets would include things like proprietary technology and know-how, etc. In certain situations, buyers may also assume certain liabilities of the company to be acquired. In yet other circumstances, the acquirer may buy only selected assets.

A stock transaction occurs when the buyer simply purchases the capital stock or shares of the company for sale; in effect, eliminating the transfer of title of all the assets within the company. In this type of transaction, the buyer also “acquires” all of the debts and liabilities of the company.

Tax considerations are often times one of the major determinants in deciding which type of sale is used. When an asset acquisition takes place, the buyer steps-up the tax basis of the assets acquired, which results in increased depreciation and lower taxable income in future periods. In an asset acquisition there may be higher taxes for the seller because the company will have pay tax on the gain from the sale of the assets. The shareholders may also have to pay taxes on their individual gains when funds are distributed from the company. Usually, a good tax advisor can help the selling company and the shareholders to mitigate the taxes related to an asset transaction. Sometimes, these tax considerations complicate the negotiations, but a good M&A advisor should be able develop a fair way to resolve the issue(s).

From a liability standpoint, the acquisition of the company’s capital stock or shares increases the risk for the buyer because all actual or potential liabilities with regard to the selling company are acquired with the capital stock. Consequently, the due diligence process is often times more meticulous in a stock purchase due to these assumed liabilities and the enhanced risk of the transaction. This risk to the buyer can be mitigated by transferring liability back to the seller in the purchase agreement via representations and warranties. The buyer may also require a larger escrow and a longer time period if there are real or perceived risks related to undisclosed or even unknown liabilities.

Acquisitions can be a very productive way to grow a company and to build shareholder value. More specifically, companies make acquisitions for either offensive or defensive reasons.

The key to leveraging acquisitions into a competitive advantage requires the buyer to focus on four specific capabilities, which include (i) carefully developing M&A objectives, (ii) managing your reputation as an acquirer, (iii) maintaining the strategic vision of the target, the buying company, and the transaction, and (iv) managing the integration, especially the expected synergies over time.

M&A objectives need to be clearly outlined. In other words, what is the purpose of the acquisition? A company may make an acquisition to bolster its client list or cover a broader or new geography. Similarly, a company may buy another company for defensive reasons, for example, they may not want a competitor to have the benefit of acquiring the target company. In order to develop proper M&A objectives, a company must go far beyond any initial growth strategy and get to the core of how a potential target will add value. This involves considering the unique characteristics of their own business, their customers, their market, etc. Many times, companies don’t spend enough time developing their M&A objectives. If one is not careful in this analysis, the end result is wasted time, effort, and sometimes the loss of large amounts of money.

It is imperative that an acquirer manage its reputation as a buyer by having positive interactions with sellers. A buyer should always deal with targets fairly, and to the extent possible, in a transparent fashion. The acquiring company should communicate how the target will be assimilated so that the seller understands how it would fit into the bigger, long-term strategy of the buyer. In most cases, the buyer will not, and does not need to, divulge all of its strategies, but sellers like to understand how their companies will add value to the acquirer in the future. When buyers share their vision, sellers usually contribute to that discussion, which only adds more value. By dealing with targets in this way, the buyer builds a positive reputation in the marketplace and ends up by attracting more and better targets over the long term. Some of the world’s largest corporations have done this well and the end result is that even small targets perceive them as attractive buyers. “Attractive buyers” are able to complete more and better transactions whereas buyers that breach confidentiality agreements or do not operate in a professional and ethical way usually find themselves not being able to acquire any companies.

It’s vital that the buyer maintain and/or revise, over time, its strategic vision of itself, the target, and the projected synergies in order to create a truly successful transaction. For many buyers, this connection gets lost during the due diligence phase. Smart buyers will complete not only the standard due diligence, but also strategic due diligence, which will test the hypothesis that the target is in fact a synergistic acquisition. This additional diligence will help insure the long term success of the transaction.

Finally, it’s important for the buyer to keep reassessing the acquisition over the long term. The one constant of every business is that things keep changing. Therefore, the buyer needs to keep assessing the synergies between itself and the acquired company. Synergies that were apparent at the closing of the transaction may nor may not be available 12 or 24 months later. Like all parts of business, value will be created or destroyed as the buyer and seller continue to integrate their businesses over the longer term. If this integration process is managed properly and reassessed regularly, value will be maximized.

In the end, acquisitions can help companies grow and prosper, but only if the M&A process and the subsequent integration are conducted diligently and properly. If done correctly, acquisitions can bolster a company’s offensive position so that it can build shareholder value or enable it to build adequate defenses to protect shareholder value. In most cases, a professional M&A advisor can help guide this process to a successful transaction.

Worldwide, across all sectors, M&A deal volume, for the ten months ending October 2014, has been robust. The four most active sectors in M&A this year have been Financials, Consumer Discretionary, Industrials, and Information Technology. The following chart shows the transaction volume of these four sectors.

Private Equity buyers have a reported US$1 trillion to invest and large corporates are also looking to put their record cash balances to work. With debt financing readily accessible at favorable rates, leveraging acquisitions has proven to be beneficial for some acquirers. These factors are leading to increased demand and higher M&A multiples as demonstrated by the following chart.

There are many steps that need to be taken when organizing the acquisition of a company, division, or product line. Initially, an acquisition strategy needs to be developed. An acquisition strategy is essentially a business plan which acts as a road map for completing a successful acquisition. The objectives of the acquisition search need to be clarified, and potentially, written down. Another important aspect of this plan is to detail the guidelines to be used when screening acquisition candidates. One does not want to get caught wasting time on a target when the probability of closing is too small or on a target that will not add value in the future. A defined acquisition strategy will give the buyer a method to evaluate potential acquisition candidates relative to the stated objectives of making such an acquisition.

Another crucial aspect of a well-defined acquisition strategy is establishing an acquisition team. An acquisition team must have their responsibilities and authorities clearly mapped out. It is also important that different parts of the company are represented within the acquisition team since they may have conflicting interests within the organization. Typically, the owner or CEO is responsible for selecting team members and being aware of any conflict of interests that may exist between parts of the company. For example, the sales people may be focused on selling low margin products whereas finance may only want to acquire targets with high gross margins.

The acquisition team should be comprised of product specialists, finance, legal, marketing, etc. so that the target can be understood at multiple levels. Like any team, the CEO needs to guide the team members to insure that objectives are met, conflicts are minimized, and the resulting acquisition is successful.

Every company is unique in its own way and management knows better than anyone what makes their company different. It is important to understand current market share, manufacturing costs, whether or not you are on the low or high end of the market, where working capital is being utilized, how much marketing is being done, etc. By analyzing these aspects, the buyer will be able to develop an acquisition strategy that compliments the buying company’s strengths and mitigates its weaknesses.

One of the most challenging aspects in structuring an M&A transaction is not necessarily the determination of a purchase price, but rather how that purchase price is allocated between the assets being sold. The major conflict at the core of this issue is the existence of tax polarity between the buyer and the seller. Generally speaking, the seller of the business is trying to maximize after tax proceeds while the buyer is trying to minimize the consideration relative to the after tax cash flow of future operations. Given these concerns, sellers typically look to sell stock while buyers usually want to buy assets. (Many times buyers prefer asset purchases because, in most jurisdictions, it limits liability. In Brazil, for example, it does not limit liability.)

Section 1060 of the IRS tax code attempts to mitigate conflicts regarding the allocation of the purchase price to various assets. Under Section 1060, both the buyer and the seller of a business are required to use the residual method for purchase price allocation. This means that the purchase price is first allocated to assets to the extent of their fair market value and any excess will be allocated to goodwill and going concern value.

A purchase price allocation is important to include in a purchase contract between a buyer and a seller because it gives guidance as to the tax consequences of the transaction. An allocation acknowledged by the two parties will allow the buyer to determine the basis of depreciable and amortizable assets while the seller is able to compute the sales price of the individual assets in order to determine any recapture amounts. With an allocation in place, the seller is also able to determine capital gains and ordinary income from an asset sale.

Although coming to an agreement about purchase price allocation can be challenging, having a tax expert and an experienced investment bank negotiating between buyer and seller will help both parties reach agreement on an allocation that is beneficial or at least fair to both parties and that conforms to IRS standards.

When determining the value of a business, there are three basic approaches that can be used to determine the fair market value. These three approaches are the underlying asset approach, the market comparable approach, and the income approach.

The underlying asset approach is a technique in which the assets of the business determine how much it is worth. The assets being valued are both tangible and intangible which means they are considered in the valuation regardless of whether or not they show up on the balance sheet. The final value of the business is determined by a simple formula: Assets – Liabilities = Value of the Business.

Another common method of valuing a firm is the market comparable approach. This is where one compares a business to publicly held firms whose stock is trading. A value is derived by examining the public firm’s EV/EBITDA or EV/Revenue multiples and applying a similar multiple to the non-public, target firm. (EV = Enterprise Value and EBITDA = Earnings Before Interest Taxes, Depreciation and Amortization)

The third way of valuing a company is the income approach. The income approach is based on the company’s potential earnings in the future. The most common way of doing this is by using the discounted cash flow method. The discounted cash flow method (DCF) is where one projects the cash flows that the business will generate and then discount these returns to their present value.

No matter which approach is used, the accuracy of the valuation will depend on the level of detail and depth of analysis that is used in deriving that valuation. It is important to ensure the accuracy of all inputs used in these valuation approaches as these inputs will ultimately impact the value calculation of the target company.

One final note on valuations; “paper” valuations are interesting and useful, but they may or may not be an indication of what a willing buyer may pay a willing seller. Versailles Group has sold a number of businesses for more than any “paper” valuation would have indicated. The key to achieving such a valuation is to have the right buyers and a strong auction.

When a business owner is considering the possible sale of their company, one of the first questions he or she is probably going to ask is who wants to buy it?

There are typically two types of possible buyers in an M&A transaction. The first type of buyer is financial sponsors usually called private equity firms. These firms look to make acquisitions as financial investments. The second type of buyer is strategic buyers who look to make an acquisition of a business that is a potential fit into their current operations or enables them to achieve strategic goals.

The financial buyers generally are more concerned with the valuation and risk of an acquisition compared to strategic buyers. The financial buyers care much more about the target company’s current and projected financials and are generally in constant contact with financial advisers and intermediaries looking for possible acquisition candidates to pursue. By definition, financial buyers are very value conscious.

Strategic buyers are generally looking for companies that can fit into their own operations and, other than the obvious candidates, can be more difficult to identify. Strategic buyers or just “strategics” usually are competitors, suppliers or other companies that operate in the seller’s industry or related industries. The advantage of these types of buyers is that they tend to operate a similar a business so it may be easier for them to understand the seller’s operations, motives for selling, and possible risks.

Depending on an owner’s motives for selling and his or her desire for involvement post-closing, either type of buyer may be appropriate. Having an experienced M&A adviser to identify, contact, negotiate, and structure a transaction with these buyers is essential in order to ensure the most value for the business and the best terms to make sure that the owner is properly compensated and, if wanted, a desirable role with the company after the acquisition is complete.

As the chart below shows, M&A activity has expanded rather dramatically over the last five years. We expect this trend to continue, but not forever!

Are you prepared for the next bear market?

We all know that the world’s economies are cyclical. The current bull market has been going for about 5.5 years versus an average of 4 years. Given this simple fact, it’s important to focus on your M&A goals and strategies. To be clear, we do not believe that the next bear market is imminent. We do; however, believe in being ahead of the curve.
Now is a good time to start a transaction that will either close by year-end or early next year. Too many entrepreneurs and companies procrastinate only to find it’s too late to maximize value or miss valuable opportunities. The question is, given the current strength of the M&A market, why wait to pursue a transaction?