Market trends: what you need to know
As the American Bar Association’s private target M&A sweet spot studies show:
- The use of separate escrows for purchase price adjustments has grown fairly steadily since 2007 (with a slight drop in 2021 from the 2019 peak).
- Separate escrows for purchase price adjustment were present in 47% of transactions reported in the 2021 study.
- In the last three ABA studies to examine the issue, single remedy limitations on adjustment escrows have increased in use from 11% to 26% to 39%.
Introduction
In mergers and acquisitions (M&A) transactions, the definitive purchase agreement, whether it is an asset purchase agreement, a stock purchase agreement or a merger, generally contains provisions relating to post-closing purchase price adjustments. Typically, these adjustments are intended to reconcile changes in the target’s financial position at the closing of the transaction, typically measured against a prior date or against representative or average historical financial measures. In many purchase price adjustment M&A agreements, the parties agree to escrow a portion of the purchase price for a limited period after closing. This article examines trends in the use of separate escrows for purchase price adjustments in private enterprise mergers and acquisitions transactions.
Purchase Price Adjustment Provisions
Purchase price adjustments are designed to ensure that the parties receive the full benefit of the agreement that was agreed upon at signing. For example, on January 1, a trade is valued or priced at $10,000,000 when the target has inventory worth $100,000. If, at the close of the deal, all other financial metrics being equal, the seller reaches the goal with $500,000 of inventory, the seller will expect to be paid, often dollar for dollar, for the $400,000 additional measurable added value. Alternatively, if at closing the target’s inventory is valued at $50,000, the buyer would expect a $50,000 reduction in the purchase price due to the value of the depleted inventory. Since adjustments to the purchase price are intended to put the parties on an equal footing, as of the closing date, such provisions are not normally considered to favor either buyer or seller.
Once the parties have agreed on a purchase price and include a purchase price adjustment in the purchase agreement, lawyers are often asked to remember three aspects regarding the purchase price adjustment :
- The particular financial measures to be used;
- Set the reference amount against which the corresponding closing amount must be measured; and
- The specific methods for calculating the adjustment before or after closing.
In addition to these aspects, buyers and sellers are increasingly considering establishing a separate escrow to secure payments due as a result of a purchase price adjustment.
M&A escrows
In most M&A transactions, a portion of the purchase price otherwise payable to the seller is placed in escrow for a defined period to secure one or more of the seller’s obligations to the buyer after closing. 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. 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.
A seller’s potential obligation to make payments to the buyer as a result of a post-closing purchase price adjustment could, like any other obligation of the seller, be subject to a separate escrow. . Typically, a post-closing purchase price adjustment is determined soon after closing, within 6 months, whereas the seller’s general indemnification obligation may last much longer. Perhaps even more importantly, buyers and sellers generally have a reasonable understanding at closing of the likely financial parameters for post-closing adjustment. This is especially true if the adjustment is based on fundamental financial measures, such as working capital. This allows the parties to implement a portion of the expected adjustment at or before closing, thereby reducing the risk that one party will owe the other a large unanticipated amount after closing. Given these practical considerations, until recent years purchase price adjustment escrows were only seen in 20-35% of private enterprise M&A transactions. More recently, however, such receiverships have become more common.
Purchase Price Adjustment Escrow Trends
Every two years since 2005, the ABA has published its Deal Points Studies on Private Mergers and Acquisitions (ABA Studies). 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.
ABA studies show that the use of separate escrows for purchase price adjustments is increasing. Now the majority approach, in the 2021 study, 47% of transactions reported included a separate escrow for purchase price adjustment. More than 12 years earlier, less than a quarter of reported transactions included a separate escrow for purchase price adjustment. The chart below illustrates this trend.
Source: ABA Private Target M&A Deal Point Studies
The ABA’s last three studies for 2021, 2019 and 2017, respectively, examined whether separate adjustment escrows were the only recourse for adjustment recovery. As noted below, the prevalence of these types of “single remedy” provisions is on the rise.
Source: ABA Private Target M&A Deal Point Studies
Conclusion
Many provisions of an M&A purchase agreement reflect an allocation of risk between seller and buyer, such as those relating to financial matters, or compliance with laws or labor and employment, which , taken together, reflect a compromise between the different perspectives of the parties. On the other hand, purchase price adjustments are considered neutral between the parties. These provisions are tied, often dollar for dollar, to the purchase price, for amounts that should be determinable shortly after closing. Adjustment provisions, while generally straightforward, are nonetheless important in ensuring that the parties receive the negotiated economic outcomes, and may therefore be the subject of a separate escrow. Separate escrows for purchase price adjustments are increasingly seen in private enterprise mergers and acquisitions transactions, and “single remedy” limitations on such escrows are increasing; Lawyers for buyers and sellers should be prepared to deal with these receiverships (and exclusive remedy provisions) as they become more common.
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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