Latest / The Acquisition Talk with Fexingo: Mergers, Buyouts, and Business Sales for Operators / The Most Dangerous M&A Clause Nobody Reads
Transcript
- Lucas: A couple of years ago, a software company I know closed at fifty million dollars. The seller—founder, previous guest on this show—thought he was done. Wire hit the account. He took his family to Cabo. Then the letters started arriving from the buyer's law firm. Luna: What kind of letters? Lucas: Indemnification claims. Every quarter for two years. The buyer had held back twenty percent of the purchase price—ten million dollars—in an escrow account. And they just kept filing small claims: a broken API integration, a customer churn dispute, a trademark filing that was allegedly incomplete. Every claim ate into the escrow. Luna: So the seller never saw that ten million? Lucas: He got back about four million, after legal fees. The escrow trap drained six million dollars from his pocket. And the worst part? The clause that allowed it is in virtually every acquisition agreement. Most sellers never read it. Or if they do, they don't understand what it actually means. Luna: So this is episode ninety-one of our trap series—and we've covered a lot of these. What makes this one the most dangerous? Lucas: Because it's invisible until after you sign. The earnout trap, the non-compete trap—those are obvious. You know you're giving up something. But the indemnification escrow looks like standard boilerplate. It's just a few paragraphs in the middle of the agreement. And it can swallow your entire payout if the buyer is aggressive. Luna: Walk us through the mechanics. How does it actually work? Lucas: Sure. In a typical deal, the buyer and seller agree to a purchase price. But the buyer doesn't hand over all the cash at closing. Instead, a percentage—usually ten to twenty percent—gets put into a third-party escrow account. That money sits there for twelve to twenty-four months, sometimes longer. Its purpose is to cover any indemnification claims the buyer may have after closing. Luna: Right—so if the seller misrepresented something in the agreement, the buyer can draw from the escrow rather than suing. Lucas: Exactly. In theory, it's efficient. But the problem is the definition of 'claim.' In a standard agreement, the buyer can file a claim for any breach of representation or warranty—even for things that are trivial, or that the seller would have fixed if given the chance. And the buyer is the sole judge of whether the claim is valid, subject to a dispute resolution process that takes months. Luna: So the buyer has a pile of cash—ten million, in your example—and they can nibble away at it with small claims. The seller has to spend money on lawyers to fight each one, or just let it go. Lucas: Exactly. And the math works against the seller. If the buyer files a claim for five hundred thousand dollars, the seller has to decide: do I spend a hundred grand in legal fees to fight it? Or do I settle for three hundred? Either way, the escrow shrinks. And because the claims are small, they often fall below the deductible—the 'basket' in the agreement—so the seller bears the full cost. Luna: We talked about the indemnity basket in episode eighty-nine. For listeners who missed it: the basket is the threshold below which the buyer can't make claims. But if the buyer structures claims to stay under that threshold... Lucas: Then the seller pays anyway. But there's a bigger issue. Many escrow agreements have a 'true-up' provision. At the end of the escrow period, any remaining money is released to the seller. But if the buyer has made claims, the escrow agent might hold back more than the claimed amount—sometimes double—until the dispute is resolved. That can tie up the seller's money for years. Luna: So the seller is effectively financing the buyer's indemnification for free. That money could have been reinvested. At a ten percent return, that's a million dollars a year on ten million. Lucas: And the buyer knows it. That's why they insist on the escrow. It's a cheap source of leverage. In our software deal, the buyer was a private equity firm. They had a playbook. They knew exactly how to use the escrow to squeeze the seller. Luna: If these conversations have moved your work forward in some small way, there's a low-key way to help keep them going. Lucas: Yeah, a couple of dollars a month is genuinely what keeps these shows ad-free—buy me a coffee dot com slash fexingo, if you've gotten something out of them. Luna: No guilt, no perks. Just a simple way to say this content matters. Lucas: Alright—back to the escrow trap. So the question is: what can a seller do about it? The first thing is to understand the two types of escrow: 'true-up' and 'holdback.' Luna: What's the difference? Lucas: A true-up escrow is funded by the seller at closing, but the buyer contributes as well. The idea is that both sides share the risk. If there's a claim, the escrow covers it, and then both parties replenish it pro rata. That's actually fair. But most buyers insist on a holdback—where the seller alone funds the entire escrow. That's the trap. Luna: So if you're a seller, you should push for a true-up structure. Lucas: Absolutely. And you should also negotiate the size of the escrow. In a clean deal with no material issues, there's no reason for more than ten percent. In fact, I've seen deals with five percent for cash-rich buyers. The bigger the escrow, the more incentive the buyer has to go fishing for claims. Luna: What about the duration? Two years seems excessive. Lucas: Standard is twelve to eighteen months. But you can push for a staggered release: half after twelve months, half after eighteen. Or even a monthly dribble. The key is to not let the buyer hold all the money until the very end. That gives them maximum leverage. Luna: And the claims process itself—can you cap the buyer's ability to make claims? Lucas: Yes. The indemnification cap—usually the purchase price or a percentage of it—is standard. But the trap is that the escrow is often the exclusive remedy for claims up to a certain amount. So the seller can't even argue that the claim is baseless without going through the escrow process. You want to negotiate that the escrow is not the exclusive remedy—that you can challenge claims in court if needed. Luna: That sounds expensive. Most sellers don't have the appetite for a lawsuit over a half million dollar claim. Lucas: Exactly. So the real protection is in the definition of 'claim.' You want to limit claims to material breaches—not every minor representation. And you want a minimum claim amount, say twenty-five thousand dollars, below which the buyer can't even file. That eliminates the death-by-a-thousand-cuts strategy. Luna: What about the cap table trap? We covered that in episode eighty-five. If you have minority holders, they're even more vulnerable because they have less control. Lucas: That's a great point. In our software deal, the founder had brought in angel investors who owned twenty percent of the company. They had no say in the negotiation. The escrow was funded entirely from their portion of the proceeds. So they lost six percent of their payout to the trap, while the founder lost only four percent because he had a larger stake and could absorb the legal costs better. Luna: So the escrow trap disproportionately hurts minority sellers. Lucas: Yes. And that's why you need to read the clause yourself, or have a lawyer who specializes in seller-side M&A. Most corporate lawyers default to the buyer's template. They'll say 'this is market standard.' But market standard is exactly what the buyer wants you to believe. Luna: Give listeners one concrete thing to look for in their next agreement. Lucas: Look for the section titled 'Indemnification Escrow' or 'Purchase Price Holdback.' It's usually buried in Article Two or Three. Check three things: one, the percentage—anything above ten percent is a red flag. Two, the duration—more than eighteen months is aggressive. Three, the basket—make sure claims below a certain threshold are not allowed. If you see a zero basket, run. Luna: And if you're already in the middle of a deal? Lucas: You can still negotiate. The buyer wants to close. They don't want to kill the deal over escrow terms. Use that leverage. Push for a true-up structure. Offer to extend the representations and warranties insurance instead—that shifts the risk to an insurer. It's actually cheaper for the buyer and safer for the seller. Luna: Any other hidden traps within the escrow clause? Lucas: One more: the 'release conditions.' Some agreements say the escrow agent can release funds only upon joint instruction from buyer and seller. That gives the buyer veto power. If they're unhappy about something unrelated, they can block the release. You want the release to be automatic on the expiration date, unless a specific claim is pending. Luna: So it's not just about the size of the escrow—it's about who controls the tap. Lucas: Exactly. And the worst part is, most sellers never see it coming. They focus on the headline price. They celebrate the valuation. But the escrow is where the real money can disappear. Our software founder told me afterward: 'I would have taken forty-five million with no escrow over fifty million with a ten million holdback.' And he was right. Luna: Because the six million he lost was more than the five million premium he thought he got. Lucas: Precisely. So next time you're selling a business, don't just look at the number on the term sheet. Look at the escrow. It might be the most expensive clause you never read.