June 19, 2014

The Escrow vs Cap Debate

Most of our clients are laser focused on the amount of any proceeds held in escrow to cover breaches of reps and warranties and pay much less attention to the indemnification cap (“Cap”).  The logic behind such discrepancy is oftentimes misguided as sellers are solely focused on that coveted “cash at close” amount.  The escrow is set aside and held by a 3rd party typically for 12-18 months and is the first place a buyer goes to collect damages for breaches of reps and warranties but the Cap serves as the maximum amount the seller can be liable for such breaches.  After the escrow is exhausted, the buyer goes directly to the selling shareholders to recoup breaches above the escrow up to the Cap.  There are arguments to be made on both sides as to which of the escrow or cap is more important:

For Escrow Argument

  • You can’t spend what you don’t have – If money is placed into escrow it’s not your money and you can’t do with it what you want (i.e. spend or invest)
  • Going to the escrow is easy for the buyer – If there are breaches the buyer doesn’t have to give too much thought to making a claim against the escrow because that is its purpose.  Buyers (and sellers) may not view it as “taking money back” and may not be concerned about the message it sends.  By contrast, when a buyer makes a claim above the escrow they have to go directly to shareholders and this is a much more difficult process and has a much higher chance of creating conflict between buyer and seller.  This is particularly important in services deals where the people are the primary asset and the buyer is often reluctant to create any ill will towards the asset they just acquired.

For Cap Argument

  • The Cap is the maximum a seller could be liable for in the event of breaches of reps and warranties irrespective of the escrow.  Looking at total $$ and limiting a sellers downside post close should be the primary objective.
  • Any claims made by the buyer   for  breach of reps and warranties whether it is part of the escrow or not, needs to go through an adjudication process.  The seller has the right to argue their case whether the claim is within the escrow or not.  As a result, any claim creates the potential for conflict and most buyers will view it accordingly.

At the end of the day both are important aspects of a negotiated definitive agreement.  We are seeing more instances of tying the two together so that the escrow also serves as the Cap.  There is certainly good reason to align the two and it oftentimes is in everyone’s best interest.  There is no right answer here, but solely focusing on escrow is a risky and short sighted perspective for a seller to take.