Allocating Escrows and Earn-Outs

From time to time on the blog, we're going to focus on terms or negotiated points that often arise in negotiating early stage financing documents. One such term is a mandatory allocation of escrow provision in the context of a sale event that is often addressed in charters in venture financings.  Under the typical venture-backed company charter, the preferred investors have a liquidation preference that comes off the top before proceeds are distributed to the holders of common.  The question that is often unanswered in charters is how any contingent payments in connection with a sale event, such as earn-outs and escrows, are allocated among the stockholders. 
Many charters are silent on the allocation, which requires the Board of Directors and stockholders to approve the allocation at the time of the liquidity event. It's noteworthy that the NVCA flags such an allocation as a possible basis for litigation against the Board should an aggrieved party prove unhappy with the allocation. As a solution, the NVCA proposes a provision requiring that the merger consideration in the sale transaction be allocated at closing as if there is no escrow or earn-out thereby effectively shifting the contingency risk of the earn-out or escrow away from the preferred and to the common.  Another (and more founder-favorable) solution is to allocate the full escrow and/or earn-out among all the holders (pro rata between the preferred investors and the holders of common) as though all of the consideration was being paid at closing. Just one of many points worth keeping an eye on in early-stage financings since those documents drive the outcome on many issues, such as this one.

This post on Company Financings was authored by Ryan Sansom.


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