An indemnity escrow holds part of the purchase price with a third party after closing; a holdback leaves it with the buyer; representations and warranties insurance replaces much of both with a policy. An escrow is funded out of the price at closing; a holdback is owed to the seller later and behaves like debt. The lender cares where claim money goes and wants the buyer's rights assigned to it. Where there is a seller note, setting claims off against it is often cleaner than a cash escrow, but the senior lender's subordination terms have to allow the setoff.
- Indemnity escrow
- Part of the price held by an escrow agent for an agreed period after closing
- Holdback
- Part of the price kept by the buyer and paid later if no claims arise
- Rep-and-warranty insurance
- A policy that pays the buyer for breaches, in place of most of the seller's exposure
- Setoff against a seller note
- Claims reduce what the buyer owes the seller; the subordination agreement must permit it
- The lender's interest
- A collateral assignment of the buyer's rights, and recoveries kept in the company
Four ways to back the seller's promises
In a purchase agreement the seller makes representations and warranties about the company: the financial statements are accurate, the taxes are paid, the equipment is owned, there is no undisclosed litigation. The seller also agrees to indemnify the buyer if any of them prove untrue. An indemnity is only as good as the buyer's ability to collect on it, and once the seller has been paid and has moved on, collecting can be hard. Deals solve that in one of four ways, often in combination.
| Mechanism | Where the money sits | How a claim is paid | What the lender watches |
|---|---|---|---|
| Indemnity escrow | With a third-party escrow agent, out of the price paid at closing | Released to the buyer on a joint instruction or a final ruling | That claim proceeds reach the borrower and its rights are assigned to the lender |
| Holdback | With the buyer, owed to the seller later | The buyer keeps the amount of the claim | An unpaid obligation to the seller that behaves like debt |
| Rep-and-warranty insurance | With an insurer, for the cost of a premium | The insurer pays the buyer, above a retention | The premium in sources and uses; rights under the policy as collateral |
| Setoff against a seller note | Nowhere: the buyer simply owes less | The note's principal is reduced by the claim | Whether the subordination agreement allows it |
The glossary entry on escrows and holdbacks has the short definitions. Separate from indemnity, many deals also use a small escrow for the working capital adjustment, and a special escrow for a known issue, such as an open tax audit or a pending claim, sized to that issue alone.
How the money moves at closing
An escrow is not extra money. It is part of the purchase price, and the lender and the equity fund the price in full. On the closing date the loan proceeds and the buyer's equity go to the closing agent, who pays out the price in pieces: most to the seller, part to the seller's lenders to release their liens, part to the escrow agent. The other uses, such as legal costs and lender fees, are paid from the same funds.
In plain numbers, on a price of 4,000 with an indemnity escrow of 200 and seller debt of 300 being paid off, the seller receives 3,500 at closing, the seller's lender 300 and the escrow agent 200. The sources and uses table shows the full 4,000 as a use either way; the funds flow memo shows where each piece goes.
A holdback works differently. The buyer does not pay the held-back amount at closing at all, so the uses are smaller and the buyer owes the seller that amount later, on the terms the purchase agreement sets. If the holdback is to be paid whatever happens, lenders treat it much like a seller note. If it is released only when no claims have been made, it is a contingent obligation the lender will want to understand before closing, and usually to subordinate.
An escrow funded at closing is spent money as far as the borrower's balance sheet is concerned. A holdback is an obligation the company still owes.
How lenders view escrowed proceeds and claims
The senior lender's interest is in two things: that the buyer's rights under the purchase agreement are part of its collateral, and that money recovered from a claim goes back into the company rather than out of it. Lenders usually take a collateral assignment of the purchase agreement, the escrow agreement and any insurance policy, so that if the borrower defaults the lender can enforce the indemnity itself. Many credit agreements also say what happens to recoveries: they may be required to prepay the loan, or be allowed to be reinvested in the company, sometimes depending on their size.
The logic is straightforward. A successful claim means the company was worth less than the price the lender financed, because a liability was hidden or an asset was not what it seemed. The recovery is compensation for exactly that, and the lender expects it to repair the company the loan was made against.
Lenders draw a line between an escrow released on the absence of claims and one released on the company's future performance. The second is contingent purchase price, an earnout by another name, and the lender will subordinate and condition it like one; how earnouts interact with acquisition debt draws that line in more detail.
Rep-and-warranty insurance
Representations and warranties insurance lets the buyer claim against an insurer instead of the seller. The seller walks away with more of the price, and the buyer's recovery does not depend on the seller's willingness or ability to pay. Lenders like it for the second reason: an insurer's balance sheet is a better counterparty than a retired founder's.
It is increasingly used in lower-middle-market deals, but it is not free. Policies carry a premium, a retention the buyer bears before the insurer pays, underwriting diligence of their own, and exclusions for anything the buyer already knew about and for issues the diligence did not cover. For a company with a thin diligence file or a modest price, those costs weigh heavily against the cover, and many deals rely on an escrow, a seller note or both instead. Where a policy is used, its premium is a use in sources and uses, and lenders commonly ask for rights under the policy to be assigned to them.
Setting claims off against the seller note
When the seller is financing part of the price, the buyer already holds money that is owed to the seller. A setoff right in the note and the purchase agreement lets the buyer reduce the note's principal by the amount of a successful indemnity claim. No cash is locked up with an escrow agent, the buyer does not have to chase the seller for payment, and the seller is only worse off if a claim is made and upheld. That is why, in deals with a seller note, setoff is often cleaner than a cash escrow.
| Cash indemnity escrow | Setoff against a seller note | |
|---|---|---|
| Cash tied up after closing | Yes, for the escrow period | None |
| Buyer's recovery if the seller disputes a claim | Held by the agent until the dispute is resolved | Buyer withholds from the note while it is resolved |
| Money available for claims after the escrow period | None | Whatever remains on the note, for claims made within the survival period |
| Seller's position | Waits for release of cash it earned at closing | Paid over time in any case; claims reduce what is owed |
| Senior lender's position | Generally comfortable; wants recoveries back in the company | Comfortable only if the subordination terms allow it |
The catch is the senior lender. A seller note in a financed deal is subordinated to the senior loan, and the subordination agreement the seller signs usually restricts payments on the note and any change to its terms without the lender's consent. A setoff reduces the note without paying the seller anything, which most senior lenders are glad to see, but only if the agreement says so. If it is silent, a reduction of the note could be read as an amendment the lender did not approve, and a dispute over a claim could become a dispute the seller tries to take to court while the senior loan is outstanding. Seller note subordination terms covers the rest of that agreement.
What the documents need to say
- The purchase agreement names the escrow, holdback, insurance or setoff as a source of recovery, the survival period for claims, and the caps and baskets that limit them.
- The seller note contains an express right to set off indemnity claims against principal, and says a setoff is not a default by the buyer.
- The subordination agreement states that a setoff under the purchase agreement is permitted and is not a payment on the note, and limits the seller's remedies while the senior loan is outstanding.
- The escrow agreement sets release dates and the joint instruction needed to release funds, and is assigned to the lender as collateral where the lender requires it.
- The credit agreement says whether recoveries prepay the loan or may be reinvested.
Most of this is settled between lawyers, but the terms affect the financing, so they belong in the file the lender sees. Midas Partners's lender package describes the indemnity structure alongside the seller note and sources and uses, so the lender's counsel is not meeting it for the first time in the closing documents. The package is built in a day once the documents are in; see what the package contains.
Common questions
- Does the lender fund the escrow?
- Indirectly. The escrow is part of the purchase price, which the loan and the buyer's equity fund in full at closing. The closing agent then pays that portion to the escrow agent instead of the seller.
- Is a holdback treated as debt?
- If it will be paid whatever happens, lenders treat it much like a seller note. If it is released only when no claims are made, it is a contingent obligation, and lenders usually want it subordinated.
- What happens to money the buyer recovers from a claim?
- It goes to the borrower, and the credit agreement often says what happens next: in many deals recoveries must prepay the loan or be reinvested in the company.
- Is rep-and-warranty insurance worth it in a lower-middle-market deal?
- Often, where the diligence is thorough and the price large enough to carry the premium and retention. On smaller or thinly diligenced deals, an escrow or a seller note setoff may do the same job more cheaply.
- Can a seller refuse a setoff clause?
- They can negotiate it like any term. Buyers usually argue that setoff costs the seller nothing unless a claim succeeds, which is also when the seller would owe the money anyway.