It is common in a private company sale transaction to have an escrow in place that holds a portion of the sale proceeds to cover the seller’s post-closing indemnification liability. It also common to have an earn-out component, through which payment of a portion of the sale proceeds may be tied to the business’s achieving specified future performance metrics. However, unforeseen complexities may result when compensatory payments to employees of the business, such as the cash-out of stock options or the payment of sale bonuses, are subject to an escrow or earn-out.
For example, if there is an escrow in place for 10% of the sale proceeds and stock options are being cashed out for a payment at closing, 10% of the payment attributable to the cashed-out stock options may be held back in escrow. This commonly used structure ensures that the optionholders are subject to the same indemnification escrow as other shareholders. However, because most escrows are fully funded arrangements, careful consideration must be given to any compensatory amounts that are subject to the escrow.
Sections 409A and 83 of the Internal Revenue Code must be considered when drafting and structuring escrows or earn-outs. Section 409A permits delayed settlements of certain transaction-based compensation, but only if the payouts are appropriately aligned with earn-out or indemnity payments to shareholders generally (subject to a five-year maximum holdback period). In addition, to ensure that the escrowed compensatory amounts are not immediately taxed on funding of the escrow under section 83, those amounts must remain subject to a substantial risk of forfeiture or be made subject to the claims of the company’s general creditors in insolvency. These issues must be carefully analyzed in each transaction because every indemnification escrow and earn-out structure is different.
In Part 2 of our Earn-Outs and Escrows blog posting, we will discuss a recent Delaware Chancery Court decision that held that a holdback of option proceeds pursuant to an escrow was not permitted under the stock option plan.