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M&A transactions involving escrowed stock (or stock holdbacks) continue to be used in private M&A, although on a minority of deals. With a low watermark in 2018 where 13% of deals used buyer equity as part of the deal consideration, use of buyer equity is back up to 31% of deals in 2021 according to the 2022 SRS Acquiom M&A Deal Terms Study. With a higher prevalence of buyer equity as part of the consideration, parties may consider using escrowed stock. As a result, it is important to fully understand the mechanics of stock escrows to maximize efficiency and avoid surprises when it comes time to release the stock to shareholders.
Certificating or Booking Escrowed Shares
A key consideration when negotiating a stock escrow agreement is how the escrowed stock certificates are initially cut or recorded on the issuer’s books as book-entry shares. Deal parties can do this two ways: by issuing individual stock certificates for each shareholder or by having one aggregate stock certificate in the name of the escrow agent and issuing individual stock certificates in the names of the shareholders at the final release. In our experience, one aggregate stock certificate may simplify distribution and recording of shares in the event of an escrow distribution to the buyer (e.g., indemnification claims). However, if no claims are brought against the escrow, both options are essentially the same to manage through the life of the escrow.
If any buyer claims are submitted against the escrow, multiple certificates quickly become problematic because any stock released from escrow to satisfy an indemnification claim requires that every stock certificate be returned to the issuer (or its transfer agent), adjusted to reflect the pro rata amount claimed, reprinted, and sent back to the escrow agent. Similarly, if any disputes remain unresolved at the end of the escrow period, each stock certificate must be returned to the buyer and replaced with two brand-new certificates: one for the disputed amount remaining in escrow and a second for the balance of shares released to each holder. Once the dispute is resolved, often for something less than the full original claim amount, the whole re-cut process must be done again. Deal parties must also address any fractional share implications each time new stock certificates are issued, which could, among other things, require the buyer to pay more cash consideration in lieu of such fractional shares. Issuing individual stock certificates for each shareholder participating in the escrow can become an administrative challenge for deal parties and can create additional and unexpected transactional costs and delays along the way.
Often, the more efficient structure for a stock escrow is through the use of one stock certificate (per series of stock and per escrow fund) issued in the name of the escrow agent for the aggregate amount of escrowed shares. If a successful claim is brought against the escrow, the escrow agent sends the single stock certificate to the issuer to cut a new certificate for the balance of shares remaining in escrow. Upon release of the escrow, the master stock certificate is canceled and the buyer or its transfer agent issues and delivers individual stock certificates in the name of each holder.
If the parties prefer book-entry shares over physical certificates, the escrowed shares are recorded on the issuer’s books in the name of the escrow agent, ensuring the escrow agent is able to maintain control over the shares while in escrow and eliminating the need for physical stock certificates altogether.
One aggregate stock certificate, whether in book-entry form or as a physical certificate, minimizes the need for issuances of multiple stock certificates resulting in far less administrative burden and cost if or when claims emerge.
Fractional Shares
Deal parties will also need to account for fractional shares since the pro rata allocations of the escrowed shares among the shareholders rarely result in whole numbers.
Fractional Shares Example Language
No fractional shares of Escrowed Shares shall be released from the Escrow Account pursuant to this Escrow Agreement. In connection with any release of the Escrowed Shares from the Escrow Account pursuant to this section, the Purchaser shall be permitted to direct the Escrow Agent to “round down” to the nearest whole number to avoid releasing any fractional shares from the Escrow Account. When the Escrowed Shares are “rounded down,” any Party who otherwise would be entitled to receive a fraction of a share of Escrowed Stock shall receive, in lieu thereof, an amount of cash equal to the product obtained by multiplying (i) such fraction by (ii) [agreed share price], rounded down to the nearest whole cent, and the Purchaser shall transfer or shall cause to be transferred to the Escrow Account sufficient cash to enable the Escrow Agent to make any such cash payments to such Party as shall be set forth in the Joint Instruction to the Escrow Agent. The aggregate fractional shares for which Purchaser transferred cash to the Escrow Agent pursuant to the foregoing shall be returned to the Purchaser for cancellation.
Transferability, Voting Rights, Dividends, and Stock Splits
Another important administrative consideration for stock escrows is addressing the mechanical characteristics of equity in the escrow agreement. Restrictions on transferring such shares should be clear and expressed. Escrowed shares are often non-transferrable until released (to ensure they remain as security for any future buyer indemnification claims). The parties may, however, consider allowing transfers of rights to the underlying shares once released from escrow for estate planning purposes or upon a shareholder’s death, disability, or other incapacity.
Deal parties commonly issue escrowed shares in the name of the escrow agent for the benefit of the shareholders participating in the escrow. However, the escrow agent will likely not agree to assume any discretionary responsibility around the administration of such shares, such as deciding how to vote the shares. Allowing individual shareholders to direct the escrow agent on how to vote shares for which such shareholder is potentially the ultimate beneficiary can be tedious, particularly for a large shareholder base. Often, the deal parties will engage a professional shareholder representative to represent the shareholders for post-closing matters, including instructing the escrow agent on how to vote any escrowed shares. If the deal parties are using this approach, the escrow agreement language should reflect such authority of the shareholder representative, who is often already a party to the escrow agreement.
Voting Escrowed Shares Example Language
The Indemnifying Parties will be the owners of the Escrowed Shares in the Escrow Account for all applicable tax purposes, and, with respect to such Escrowed Shares, shall be entitled to exercise applicable voting rights. For greater certainty, such voting rights shall be exercised through the Shareholder Representative by way of written direction to the Escrow Agent. The Shareholder Representative shall not be obligated to provide such directions to the Escrow Agent. In the absence of written directions from the Shareholder Representative, the Escrow Agent need not vote the Escrowed Shares. The Escrow Agent shall promptly distribute to the Shareholder Representative proxy materials and other documents relating to the Escrowed Shares received by the Escrow Agent from the Purchaser.
Additionally, the escrow agreement should address stock splits and dividends. Whether dividends are taxable can affect how they are distributed. Cash dividends delivered to the escrow agent are often distributed to the designated parties, likely through a paying agent for the transaction. Deal parties should consult with securities and tax counsel to ensure the proper and intended treatment of escrowed shares.
Stock Splits and Dividends Example Language
All numbers contained in, and all calculations required to be made pursuant to, this Escrow Agreement with respect to the Escrowed Shares shall be adjusted as appropriate to reflect any stock split, reverse stock split, stock dividend, or similar transaction effected by the Purchaser after the date hereof. The Purchaser shall promptly notify the Escrow Agent of any such stock split, reverse stock split, stock dividend, or similar transaction. In the event of any such stock split or other transaction resulting in additional shares of the Purchaser’s Stock being issued, the Purchaser shall direct its transfer agent to issue in book-entry form the appropriate number of additional shares of the Purchaser Stock in the name of the Escrow Agent as the nominee holder on behalf of the Indemnifying Parties.
During the period the Escrow Account is held by the Escrow Agent, the Indemnifying Parties shall be entitled to receive, pursuant to Joint Instructions to the Escrow Agent, all taxable dividends (if declared by the Purchaser and deposited in the Escrow Account) with respect to the Escrowed Shares, which dividends shall be delivered by the Escrow Agent to the Paying Agent for further distribution to the Indemnifying Parties. Non-taxable stock dividends with respect to the Escrow Shares shall be retained, pursuant to the Joint Instruction to the Escrow Agent, by the Escrow Agent in the Escrow Account in accordance with the terms hereof, and shall not be distributed to any party other than as part of a disbursement pursuant to this Escrow Agreement.
Structure Matters
While not common, M&A deal parties do have the option to use escrowed stock in their deal. If they do, it is important that they contemplate the mechanics and administrative matters of such stock including how to certificate the shares, treatment of fractional shares, transfer restrictions, ownership for tax purposes, voting rights, stock splits, and dividends in the stock escrow agreement.
Kip Wallen
Senior Director, Thought Leadership tel:720-452-5364
Kip Wallen is a senior director leading the SRS Acquiom thought leadership practice. He leverages his extensive expertise and SRS Acquiom proprietary data to produce resourceful content regularly utilized by market practitioners. Kip has broad experience in M&A and provides guidance on market standards and trends.
Previously, Kip was a Director with the SRS Acquiom Transactional Group, where he collaborated with clients and counsel to negotiate M&A documents including purchase, escrow, payments, and other transactional agreements. Before joining SRS Acquiom, Kip was an attorney with a Denver-based boutique business law firm where he assisted clients with M&A transactions as well as general corporate governance and securities matters.
Kip is an avid supporter of the Colorado Symphony, serving as Treasurer and Trustee. He is an active participant on the American Bar Association’s M&A Committee. In 2016, Kip completed Leadership 20 with the Denver chapter of the Association for Corporate Growth.
Kip received his J.D. from the Sturm College of Law at the University of Denver and an M.S. in Economics, B.S. in Economics and B.A. in International Relations from Lehigh University. He is a member of the Colorado bar.