In the practice area of acquisitions, Sellers and Buyers alike should be careful about earn outs and escrow accounts provisions in their transaction documents. Although each serves a very different purpose, the aftermath of applying these provisions to a particular situation can be time consuming, expensive and unsettling to both sides of the transaction.

What appears clear at the time these clauses are drafted into the final agreement, becomes less certain as facts emerge which form the basis for interpreting these provisions.

Both clauses play a role in each side getting what they feel is the benefit of the bargain. The Seller sees each clause as part of the Purchase Price that he left on the table to be distributed/disbursed to the Seller at a later date. A mere deferral of the purchase price. The Buyer sees each as protection against ultimately paying too much for the acquisition at hand.

Understandably, both sides have good intentions, but as time passes and events occur, even with well-drafted clauses, there is a natural inclination to interpret these provisions very differently, depending upon your side of the transaction.

Generally an escrow arrangement cannot be eliminated, since almost always there will be conditions that follow the closing of the transaction. In other words, there is a period of time, after the transaction closes, that a Buyer has to make sure that all the promises, representations, etc. the Seller made are indeed true. Some of these, like taxes, take 3+ years from the date of filing of the return in question, while others are assigned a life within the agreement; usually 1 to 2 years. This gives most unforeseen events a reasonable time period to ripen after which it is reasonably safe to assume that there are no un-assumed liabilities to which the Buyer will be subject as a result of the Seller’s operation of the acquired company.

Please understand that these events are not necessarily a result of an unscrupulous Seller, but no one has a way of knowing all events that may be triggered in the future from actions taken during the Seller’s ownership. A disgruntled employee could come forward three years following the occurrence of facts that he claims that the Employer/Seller engaged in that caused him damages.

The earn-out clause is generally put in place because the Seller maintains that it has positioned the company in the market for substantial growth that will likely to take place after the closing. Buyers, by nature, do not like to pay for events that haven’t occurred or that result from their efforts/decisions in operating the business, no matter how strongly the Seller feels that it is responsible for such growth/profit. Hence, this notion provides the basis for an earn-out. Seller and Buyer agree that if certain events transpire as a result of the Seller’s investment decisions made before the closing that Seller will be paid some percentage of the growth/profit experienced within a limited time frame after the closing, usually 1 to 2 years, at the very latest.

Of course the trick is to define specifically what growth/profit the Seller and Buyer are talking about, and the events that define the Seller’s investment versus the Buyer’s or that are the result of the marketplace experiencing growth unrelated to Seller’s investment. Conceptually it seems simple, but drafting such a provision with the specificity necessary to make it understandable and applicable in the future is the real challenge.

As we all know, “the Best Laid Plans of Mice and Men” can go astray.

In conclusion, although not an exhaustive list of things to consider, here are some helpful hints when considering escrow and earn-out provisions:

Escrows

For a Seller, steer clear of extended escrow arrangements, review carefully what you have agreed to in the Agreement, and retain a skilled attorney in this particular area.

For a Buyer, make sure that you have done a thorough job of due diligence (narrowing down your areas of exposure), be clear and comprehensive in the what the escrow applies to, and whether the escrow is the limit of your indemnification or a pool from which to initially draw upon, and, as with the Seller, retain the expertise you will need in this particular area of practice.

Earn-Outs

I generally recommend that both parties steer clear of these arrangements because of the difficulty in defining, and then applying, them in the future.

It may be worth it to both parties to compromise so that the Seller gets paid an amount greater than it would otherwise be entitled to stemming from these alleged investments, and that the Buyer pays slightly more. There may be some jockeying surrounding some of the other provisions: such as the percentage of purchase price that gets paid up front, the amount of the escrow, the term of any note, etc. that accompany such negotiations. Buyer and Seller, must evaluate all these things in light of the entire transaction and not piecemeal, keeping in mind the transaction as a whole and the benefit that they had originally hoped to achieve.

Understand, each party will feel that they have given something up, but that is why it is called a “compromise”.