Escrow
M&A / Merger ModelPart of the purchase price paid to a third party and released after an agreed period, so there is something for the buyer to claim against.
Also written: escrow account, indemnity escrow
A warranty is only worth what the person who gave it can pay. Escrow answers that by parking part of the price with a third party for a defined period, usually matched to the survival period of the general warranties, and releasing what is left once the period expires. A holdback does the same job with the buyer retaining the money instead, and a bank guarantee achieves it without cash moving at all.
The size and the period follow the risk rather than a convention. A larger escrow held for longer is normal where the seller is an individual who will be hard to pursue afterwards, where the business has a long tail of potential claims, or where the buyer's diligence has been compressed.
The cost to the seller is larger than it looks, because it is not only the risk of a claim. Money released later is worth less than money at completion, so an escrow imposes a real cost even where no claim is ever brought.
For a private equity seller the cost is larger again, because a fund with money sitting in escrow cannot make its final distribution and cannot close. That is the specific problem warranty and indemnity insurance was adopted to solve, and it is why insurance displaced escrow in European sponsor auctions rather than in owner managed deals.
Worked example
Illustrative. A business sells for 400 with a tenth of the price, 40, held in escrow for eighteen months.
If no claim is ever brought, the seller still receives that 40 later rather than now. At an illustrative 10% cost of capital it is worth about 34.7 at completion, so the escrow has cost roughly 5.3 of value for nothing.
A warranty and indemnity policy over the same 40 of cover at an illustrative 2% premium costs 0.8. The comparison is what moved the market, before counting the ability to wind the fund up.