Escrows and Earn-Outs
An “escrow” account is an account set up by attorneys to hold funds that will be used in the transaction, until that transaction is actually closed. Escrow provides protection for the buyer company in the event there are breaches of contract by the target company.
Escrows are standard in mergers and acquisitions, but their terms can vary significantly. Typical terms include a dollar amount (usually 10 percent to 20 percent of the overall consideration) with an escrow period (usually one to two years from the closing date).
Earn-out is a pricing structure where the target company must "earn" part of the purchase price, based on performance of the business after the acquisition. In an earn-out, part of the purchase price is paid after closing based on the target company achieving certain financial goals.
Less common than escrows, earn-out provisions are usually employed to bridge a valuation gap between buyer and target. The target company (and/or its stockholders) receives additional consideration if it achieves certain business performance goals, such as future revenue and other financial metrics. It’s important that these milestones be objective. For the target company, the concern with earn-outs is potential loss of control of the company and decision-making authority after closing.
The best type of earn-out clause is one that is never used. That would mean there are legal problems after the transaction—problems that can be time-consuming, frustrating, and expensive to solve. For that reason, both buyer and target companies should be hyper-diligent in crafting earn-out provisions in their transaction documents—which means these should probably be handled by a very good merger/acquisition attorney.