Friends, Marijuana Business Daily published on Wednesday my Four tips to navigate cannabis mergers and acquisitions in a distressed market. (link) One of my Musings' readers who also read the article asked a highly-relevant question – could an escrow help address some the problems I identified in the article? The short answer is yes. The longer answer is yes, sort of.
In an acquisition context, an escrow usually refers to some sort of holdback or set aside of proceeds (cash and/or equity). It could be all of the consideration (meaning, what’s paid for the company) or just a portion, depending on the purpose (which I’ll discuss below). Traditionally, the escrow is held by a neutral third party (usually a financial institution) – the buyer wants to know that the seller isn’t going to refuse to fund, and the seller wants to know that the buyer isn’t going to disappear. The terms of the escrow typically have strict, objective conditions for when the escrow is disbursed (meaning, paid out), either to the seller or back to the buyer.
Looking at the four categories from my article, an escrow could play an important role in each:
- Purchase Price – escrows can be useful for both a price adjustment and an earn-out, two ways to address valuation. The post-closing purchase price adjustment mechanism tries to deal with the changes in assets and liabilities of the target between an earlier date and the closing date. The earn-out is conditional, post-closing purchase price that’s paid if certain metrics are hit, as a way to sort-of “test” the seller’s claims about the company’s true potential (and thus, valuation). Often, a portion of the purchase price is held back into escrow for these kinds of adjustments.
- Change of Control – regulatory approvals (for license transfers, but also for antitrust clearance when needed) can take time, and in the deal world, time means risk. (link) Indeed, deals have fallen apart after getting signed because required approvals were taking too long and company valuations changed dramatically (something we saw happen in 2019 (link)). In a deal with regulatory consents, escrowing a portion or all of the purchase price can be a way to make sure the buyer is able to fund as soon as the consents are in-hand.
- Legacy Liabilities – as I discussed in the article, one of the many challenges with acquiring a distressed company is protecting the buyer against unknown (and sometimes hidden) liabilities– a distressed company might have more problems than it wants to admit. In addition to doing due diligence as a buyer (or as an investor - link), scrubbing the target company to suss out liabilities and risks, the buyer will almost always get the seller to make representations about the nature and operations of the business, typically also getting indemnified by the seller from unknown third-party claims (meaning, very generally, the seller will reimburse the buyer if there’s a claim against company that wasn’t disclosed). An escrow can be used to hold back a portion of the sale proceeds for a period of time (typically 12-18 months) after closing to pay back the buyer if the representations aren’t true or there’s an indemnity claim.
- Dealing with Debts – unknown and undisclosed debts are addressed by the representations and indemnity, but what about known liabilities? Say the target company (e.g., a CBD knish company that’s fallen on hard times) owes money to the state taxing authority, but the amount isn’t yet settled by closing. The buyer could escrow enough of the purchase price to cover the maximum amount of the tax liability once it’s settled (or, to use financial parlance, “crystallized”), with the difference being paid to the sellers afterwards.
So yes, an escrow is a key tool in M&A. It’s not necessary for every situation, but can play a vital role towards getting the deal done.