The Expense Escrow or “Fighting Fund”

Every merger agreement contemplates a process for the buyer to make claims and for the selling shareholders, through the shareholder representative, to review and either agree with or dispute the claim. An expense fund or an expense escrow is a voluntary set aside by the shareholders at closing for third party expenses incurred during the post-closing period. The expense fund should cover ordinary fees and expenses that occur when a claim happens and the parties are unable or unwilling to settle.

If an expense fund does not exist, the shareholder representative may not have funds to effectively represent the selling shareholders. Shareholders can always “pass the hat around”, but the window to respond to disputes is typically limited. By the time funds are available, the response period may have elapsed. Buyers also count on shareholders’ unwillingness to reach into their pockets to pay expenses after the initial payout. Many claims are paid because no one wants to take the time or spend the money even on an easily defendable claim.

Litigators we talk to say that establishing an expense fund is one of the biggest deterrents to claims. If the buyers know that the shareholder rep has the resources available to defend against a claim, they will more rigorously evaluate the merits of their claim and the probability of success. No one wants to spend money on a losing battle.

Establishing an escrow fund at closing works in the best interests of all the shareholders, but especially the larger ones. At closing, every shareholder contributes to the expense fund based on a pro-rata basis. At the end of the post-closing period, the balance of the expense fund is distributed back to the shareholders. In contrast, if no expense fund is established and a dispute arises that the shareholders elect to fight, then it is more likely than not that just a few of the large shareholders will end up funding more than their pro-rata of expenses.

So what is the appropriate amount of an expense fund? As with everything in the merger agreement, it depends. Except possibly for pretty small transactions, SRS recommends a minimum escrow expense fund of $50k. However, if the escrow is larger or the earn-out potential is significant, it may be appropriate to reserve between $250-500k. We’ve seen expense reserves established at closing as high as $1m. It really depends on the amount of potential upside versus the complexity of the company or merger terms, but to be a real deterrent to claims being made and a real tool for the former stockholders, it needs to be a reasonable fund compared to the size of the potential claims. Regardless of the amount, SRS considers expense funds a best practice; having funds set aside ahead of time to quickly mount defenses against claims more than offsets any cost of the holdback.