The Use of Escrow Contracts in Acquisition Agreements
University of Colorado at Boulder - Department of Finance
University of Arizona - Department of Finance
Lubomir P. Litov
University of Arizona - Department of Finance; University of Pennsylvania - Wharton Financial Institutions Center
June 14, 2014
A large fraction of private stand-alone firm and subsidiary acquisition deals make use of an escrow contract, whereby a fraction of the total sale proceeds is placed in an escrow account. These contracts give the bidder the opportunity to lay claim on these funds subsequent to the acquisition if the seller fails to meet specific terms of the acquisition agreement or it is found that negative information about the target was hidden from the bidder. We hypothesize that escrow contracts are an efficient contracting mechanism that helps buyers and sellers to manage acquisition-related transaction risk and that the use of these contracts reduces bidder acquisition-related costs and consequently leads to a creation of real value. Supporting our hypothesis, we show that the likelihood an escrow contract is used in a private stand-alone firm or subsidiary acquisition is higher when buyer or seller transaction risk is larger. Further, we document that escrow contracts enable sellers to obtain a higher sale price and that the use of these contracts positively impacts the extent to which private firm and subsidiary acquisitions result in an increase in bidder firm shareholder value.
Number of Pages in PDF File: 54
Keywords: mergers and acquisitions, escrow contracts, financial contracting
JEL Classification: G34
Date posted: May 29, 2013 ; Last revised: July 22, 2014
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