In last week’s post, we went into detail on what exactly representations (reps) and warranties are, including examples of each type of reps and warranties. But they are meaningless unless one side has some recourse against the other. Enter indemnification escrows.
Indemnification means one side is providing security against a loss for the other side. Almost every transaction I have been a part of (except for smaller ones – under $2M) have some sort of indemnification escrow as part of the agreement.
In larger M&A transactions, it is very common to find an indemnification amount listed on the Letter of Intent. This comes as a surprise to most sellers because they don’t anticipate having to leave some of the sales proceeds behind at close. But it is a necessity to allow for security against the representations and warranties.
Basically, this is a small portion of the purchase price held in escrow that can serve as a fund to satisfy indemnification claims against the seller. Escrow amounts are typically calculated as a percentage of the purchase price, and can range from less than 5% to greater than 15%.
Most escrow periods typically run 12 to 18 months, in part to allow for a tax return to be filed with extensions or an audit to be performed post-transaction, which may catch additional items not accounted for initially. Sometimes there can actually be more than one indemnification escrow, especially when a particular “deficiency” is uncovered.
For example: Seller thought they were paying all the sales tax in each state they do business in, but after the Quality of Earnings Report was completed, it was determined that several states were underpaid and, in a few states, sales tax was never collected when it should have been. In this case, the buyer imposed another 100K escrow in addition to the typical general indemnification escrow mentioned in the LOI. This escrow had a separate life of two years, at which point all funds would be remitted to the seller if no claims had been made or if the seller rectified the situation on their own. If this escrow time period was longer, it would be better to establish a separate escrow vs combining it into the general escrow.
Sometimes you can renegotiate the escrow amount after all the financial due diligence is done, especially if your numbers were spot on or had little changes. The buyer might then be comfortable enough to reduce the escrow amounts, but typically not the period of time.
Who Holds the Escrow Amounts?
Most escrows are held by a third party independent of the buyer and seller, such as a bank. Occasionally, the buyer may retain the escrow as a holdback (they hold it), but this is less common. In this article, the term escrow is intended to include buyer holdbacks as well as true third-party escrows, since the difference between the two relates primarily to whether the funds are held by an independent party or not. This might also determine if interest is paid on the escrow amounts and what percentage. I typically require all escrow amounts (regardless of size) to draw some form of interest. After all, someone is sitting on your money, which you could be earning interest on in the bank or in a money market account.
Nickel-and-Diming – That’s Where a “Basket” is Used
Indemnification escrows are clearly set up for the larger issues that may arise, but we all know that small amounts may show up that no one accounted for: specifically, unaccrued expenses. For example, you decided to terminate an equipment lease early, but didn’t realize there was an early termination fee. This was discovered after the close and no accrual was made for the termination fee. That’s when the concept of “baskets” comes into play. Instead of nickel-and-diming each other with relatively small damage claims, the parties often agree not to seek money from each other until the net claims reach a certain amount, called a basket.
Tipping Basket vs True Deductible Basket
The “basket” requires the seller to incur a certain amount of indemnifiable losses before it can seek indemnification. There are two types. The “True Deductible” basket means that basket serves as a deductible, and the indemnifying party is responsible for all losses exceeding the basket amount. The “Tipping Basket” or “Dollar-One Basket” means that the indemnifying party is responsible for all losses once those losses reach the basket amount.
For example, you have established a basket for $50,000 in the agreement. The buyer won’t ask you to reimburse them for any amounts until you reach the 50K limit. At which point one of two things can happen: you either pay for all the amounts in the basket once you hit 50K (tipping), or you just pay for anything over 50K (true deductible). In either case, if you hit the basket limit, these are usually then deducted from the larger escrow amounts already being held.
One question I get a lot is whether there can be one or the other, or if there are always both? Meaning, do you have a general indemnification escrow and a tipping basket? In most cases, I see both. But on small deals, I might only see a tipping basket or no basket at all.
On the flip side, I have also seen multiple indemnification escrows, each with a different specified value and length or term along with a basket.
The good news in all of this is that you usually get all of it back in 12 to 18 months and it will be treated as the original transaction was taxed, but just in a different year.
If you want to learn more about escrows, holdbacks and all other aspects in a deal, you might want to check out my course, Ready…Set…SELL; in Module 5, I review all of this in detail.
Reps and Warranties – Time to Tell It All