The Use of Escrow Contracts in Acquisition Agreements

1. September 2014 The Use of Escrow Contracts in Acquisition Agreements Sanjai Bhagat (Univ. of Colorado - Boulder) Sandy Klasa (Univ. of Arizona) Lubomir P. Litov (Univ. of Arizona & WFIC, Univ. of Pennsylvania)

2. Escrow Contracts in Acquisition Agreements • A form of contingent payment contract, where buyer and seller agree that seller will deposit a fraction of purchase price (usually 12.2% of it) into a treasury account for a certain period of time (usually 17.4 months). • Employed in private firm and subsidiary acquisitions but not used in acquisitions of publicly traded targets. • In our sample, escrow accounts used in 52.1% of all unlisted target deals. • More commonly used in (i) stock purchase acquisitions and (ii) acquisitions of stand-alone targets.

3. Institutional Detail Use of Escrow Contract Funds - EBITDA & Purchase Price Adjustments. - Working Capital Adjustments (A/R, A/P, Inventory, other current assets). - Environmental Liabilities. - Pending Litigation. - Obligations Related to Collective Bargaining Agreements. - Unpaid Taxes Due. - Certain Other Non-Fraudulent Breach of Representations & Warranties. Escrow Agreement Disputes Resolution - Binding Arbitration. - Non-binding Mediation. Escrow Agreements vs. Transaction Insurance - Insurance more expense, and limited in coverage.

4. Preliminary Sample Statistics All Deals Sample Deal with Escrow Contract

5. Syntax-Brillian & Vivitar Stock-for-stock Merger; - Escrow Agreement Duration: 12 months; • Escrow Agreement Size: 15% of transaction value; - Target Value: $26M; - SEC Docs: Link Example (seller) (escrow agent) (cap on liability) (claims process)

6. Hypotheses Main Hypothesis The use of escrow contracts in unlisted target acquisitions is an efficient contracting mechanism that: • Facilitates completion of these acquisitions by allowing buyers & sellers to manage acquisition-related transaction risks, and 2) Allow parties to overcome information asymmetry problems.

7. Hypotheses • Several implications of the main research hypothesis follow through. • Use of Escrow Contracts - Transaction Risk Predictions • Stand-alone targets are likelier to use escrow contract. • Subsidiary targets less likely to use escrow contract. • Larger targets (relative to acquirer) are likelier to use escrow contract. • Targets with dominant shareholders are likelier to use escrow contract (to manage joint & several liability if post-acquisition breach of reps. & warranties). • Stock purchases (as opposed to asset purchases) are likelier to use escrow contract.

8. Hypotheses • Use of Escrow Contracts - Informational Asymmetry Risk Predictions • Different industry acquisitions likelier to use escrow contract. • Targets w/ higher degree of earnings managementlikelier to use escrow contract. • Targets in industries w/ higher earnings volatility likelier to use escrow contract. • Targets in industries w/ lower analyst coverage likelier to use escrow contract. • Distressed targets (i.e., w/ lower interest coverage) likelier to use escrow contract. • Use of Escrow Contracts – Other Risks Predictions • Escrow contracts are used if reverse insurance, in the form of liability cap limitations (or caps) is included (caps are on average 2.4 times escrow size).

9. Main Findings Escrow agreements are more common when transaction risk is high, i.e., for: • Stand-alone private targets, targets with dominant shareholders, larger targets (relative to acquirer). • Escrow contract use shortens time-to-complete transaction by 35.5-51.0%. Escrow agreements are more common if information asymmetry riskis high, i.e., for: • Targets in cross-industry acquisitions, targets w/ high accruals, targets in industries w/ high earnings volatility or low analyst coverage, targets that are financially constrained. Escrow agreements are more common when other risksmay be present, i.e.: • If no reverse insurance in form of liability cap limitations (or caps) is included.

10. Main Findings Escrow contracts are associated with significantly smaller target discount: - Adoption of escrow agreement increases valuation of a private target (price-to-sales multiple compared to similar public target) by 3.5-6.1%. - Valuation impact stronger for stand-alone targets (7.4-9.1%) and weaker for subsidiary targets (0.8-2.2%). Escrow contracts benefit bidder: - For every dollar in escrow contract deposit, market capitalization to bidder shareholders is increased by 89 cents. - Bidder benefits from reduced losses (due to unrecorded or uncovered target liabilities), reduced information gathering (due diligence) costs, and reduced litigation costs (in case of dispute with target after closing).

11. Prior Literature Contingent payments Limited literature on contingent payments in private target acquisitions: - Anecdotal evidence in Deal Pointsstudies, 2008-2012 (by American Bar Association). More academic research for such payments in public target acquisitions: - Stock payments - Officer, Poulsen, & Stegemoller (2009). - Earnouts - Kohers & Ang (2000); Datar, Frankel & Wolfson (2001); Cain, Denis & Denis (2011). - However, escrow contracts & earnoutsusually address different frictions. - Other - Officer (2004) – collars. - Burch (1996) – lock-up provisions. - Bates & Lemmon (2005) – termination fees. Private Target Discount Officer (2007) – unlisted target discount & liquidity.

12. Data Collect Data from a novel databaseBusiness Valuation Resources LLC data. - Information on private target financials from 8K, DEF 14A, 10Q, & 10K. Collect data on 943acquisitions: - Involve private target & public acquirer. - Target value above $25 million. - Completed 1994-2009. - Available information on target financials & consideration structure. We hand collect data on the presence of escrow contracts, caps, & earn outs. Collect data on size,maturity & type of consideration offered in escrow contract. Other: exclusive access to J.P. Morgan Chase escrow services client proprietary data.

13. Univariate Sample Statistics Table I. Panel A. Escrow Contracts and Target Price Discount Characteristics. All Deals Sample Deal with Escrow Contract Unlisted Target Price Discount (Means)

14. Univariate Sample Statistics Table I. Panel B. Target Characteristics.

15. Use of Escrow Contracts and Other Deal Characteristics Table II. Panel A. Deal Characteristics. Table II, Panel B. Sub-sample Comparisons.

16. Target Industry Distribution (Table III) (continued)

17. Target Industry Distribution (Table III, continued)

18. Determinants of Escrow Contract Use in Unlisted Target Acquisitions (Table IV) (continued)

19. Endogeneity & Instrumental Variables Choice Adoption of escrow contract is endogenous w.r.t. valuation. Need instruments that are both (i) relevant & (ii) exclusive to determine choice of escrow adoption. Two instruments: - Propensity of peer target industry group to use such contracts. - Bidder reputation to use hybrid securities (including escrow contracts). Verify validity of such instruments through series of tests: - Overidentification test (Sargan stat). - Underidentification tests (partial R-squared, F-stat excluded instruments).

20. Determinants of Escrow Contract Use in Unlisted Target Acquisitions (Table IV) Industry proxy Escrow Use Reputation proxy

21. Economic Significance of Estimates in Determinants Model Model of Escrow Contract Use Determinants

22. Due Diligence Costs Analysis Bidders use escrow accounts to diminish due diligence costs. No direct proxy for such costs. We proxy for due diligence costs by time-to-deal completion. - Due diligence costs proportionate to time-to-deal completion. We find supporting results using litigation propensity. - Due diligence costs may be direct or indirect. - Inexpensive due diligence may result in future losses & litigation. - We can use litigation as another proxy for such costs. Our findings support hypothesis that escrow contracts diminish due diligence costs.

23. Time-to-Deal Completion Analysis (Table V)

24. Unlisted Target Discount We select to study valuation impact for target based on deal-value-to-sales multiple. - Officer (2007) uses deal-value-to-EBITDA multiples. - We do not use such multiples because: * EBITDA could be <0 (for public bidder or private target). * EBITDA defined discretionary across private targets.  We calculate discount as ratio of private target multiple to similar public target multiple (net of one). Matching of public to private target counterparts: - Same industry (2-digit SIC). - Within 20% difference ideal size. - Within 36-months window centered on acquisition announcement date.

25. Analysis of Unlisted Target Discount Table VI. Panel A.

26. Economic Effects OLS estimate shows reduction by 8.4% in discount (24.3%) to 15.9%. 2SLS estimate shows reduction by 11.0% in discount (24.3%) to 13.3%. Such estimates do not account for claims from escrow fund by bidder after closing. - Escrow Services at J.P. Morgan Chase report average 60% of escrow funds returned to seller. - This implies that 4.9% (=0.4*12.2%) of sales proceeds are kept by bidder. - Reversal in discount is approximately: 3.5% = 8.4% -4.9% (OLS) 6.1% =11.0% - 4.9% (2SLS)

27. Economic Effects Estimates higher for stand-alone targets: - discount 17.1%. - reversal 12.6%-14.3% (before deducting funds kept by bidder). - net reversal is 7.4%-9.1% (net of 0.4*13% funds kept by bidder). Estimates lower for subsidiary targets: - discount 33.3%. - reversal 4.4%-5.8% (before deducting funds kept by bidder). - net reversal is 0.8%-2.2% (net of 0.4*8.9% funds kept by bidder).

28. Analysis of Unlisted Target Discount: Interactions (Selected Estimates) Table VI. Panel B.

29. Analysis of Bidder Announcement Returns (-1 days to +1days) Table VII. Panel A.

30. Analysis of Bidder Announcement Returns: Interactions (Selected Estimates) Table VII. Panel B.

31. Implications If both bidders & sellers gain on average by using escrow contracts, shouldn’t all unlisted target acquisitions use it? Potential reasons for why these contracts are not used in all deals: • Sellers who are aware of potential misstatements in reps. and warranties. • Discord among target shareholders with respect to including an escrow. • Sellers with urgent need of liquidity (escrows reduce liquidity). Positive association b/n use of escrow contract & bidder acquisition announcement returns does not imply all bidders should use escrow contract.

32. Conclusions • Escrow contracts are commonly used in unlisted target acquisitions. • Used in 52.1% of all unlisted target acquisitions. • Common for stand-alone targets (75.6% of escrows) and stock purchases (80.0% of escrows). • Efficient contracting mechanism, aimed at reducing transaction risk and reducing informational asymmetry and related due diligence costs. • Has important valuation impact on target & increases bidder acquisition announcement returns. • On average, reduces unlisted target discount by 3.5-6.1%.

33. Acknowledgements We are indebted for proprietary data access by: JP Morgan Escrow Services We recognize use of proprietary data from J.P. Morgan Escrow Services. Kevin Ryan (VP) (Chicago) Daniel Levin (NYC) And for discussions, comments and suggestions by: Greensfelder LLP Joseph Lehrer (Head, Corporate Group) Bryan Cave LLP Bob Newmark (Vice President, St. Louis Office)

34. (Show if time permits) Post-Deal-Closure Litigation Analysis (Not in Paper) (continued)

35. (Show if time permits) Post-Deal-Closure Litigation Analysis (Not in Paper)

36. (Show if time permits) Claims Post-closing (source: J.P. Morgan Chase Escrow Services, 2009)