An escrow and a buy-side warranty and indemnity policy priced side by side on one illustrative sale, with the seller's return that makes them equal.
Price both in present value: an escrow costs the seller the return it forgoes on the money held back plus the claims expected to be paid out of it, and W&I insurance costs the premium, tax and fees. On an illustrative EUR 150.0 million deal, a 10 per cent escrow held for 18 months costs the seller 1.43 million against 0.30 million for a policy with the same 15.0 million limit. The escrow is cheaper only if the seller's own money earns less than 2.41 per cent.
Worked in full in Closing the Deal by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
A private equity seller sells a business for an equity value of 150.0 million, enterprise value 170.0 million. The buyer wants recourse for breaches of the warranties up to 10 per cent of the price. Two routes are on the table: cash held back in escrow, or a buy-side warranty and indemnity policy with the seller's liability capped at a nominal amount. All figures are illustrative, and premium levels vary with the market, the sector and the diligence.
| Item | Escrow | W&I policy |
|---|---|---|
| Protection | 15.0 held for 1.5 years | 15.0 limit |
| Interest earned on escrow | 2.0% | |
| Seller's return on its own money | 8.0% | |
| Premium, rate on line | 1.2% | |
| Insurance premium tax (UK rate) | 12% | |
| Underwriting fee and broker fee | 0.04 + 0.06 | |
| Retention borne by the buyer, 0.5% of EV | 0.85 |
Claims: a 90 per cent chance of none, 7 per cent of a 1.0 million claim and 3 per cent of a 5.0 million claim. The expected loss is 0.22 million. The same breaches happen whichever route is chosen; what changes is who pays and when.
Carry cost = escrow − escrow × (1 + escrow rate)t / (1 + seller's rate)t
= 15.0 − 15.4522 / 1.081.5 = 15.0 − 13.7675 = 1.2325
Expected claims, in present value = 0.22 / 1.081.5 = 0.1960
Escrow cost to the seller = 1.2325 + 0.1960 = 1.43
Excel: =15-15*(1+2%)^1.5/(1+8%)^1.5+0.22/(1+8%)^1.5
The carry is the larger part. The escrow earns 2.0 per cent while the seller, here a fund with a return target, would earn 8.0 per cent on the 15.0 million if it were distributed. The claims are a cost on either route, but under an escrow the seller bears them.
Premium = 15.0 × 1.2% = 0.1800; tax at 12% = 0.0216
Policy cost = 0.1800 + 0.0216 + 0.04 + 0.06 = 0.3016, or 0.201% of the price
The seller receives 149.70 million at completion against 135.0 million with an escrow, assuming it bears the policy cost, which is a matter of negotiation: on many deals the buyer buys the policy and the cost is reflected in the price. What the policy does not cover is the retention. The first 0.85 million of losses falls on the buyer, and claims above it on the insurer.
| Claim | Probability | Escrow pays | Buyer, W&I | Insurer |
|---|---|---|---|---|
| None | 90% | 0.00 | 0.00 | 0.00 |
| Small breach | 7% | 1.00 | 0.85 | 0.15 |
| Large breach | 3% | 5.00 | 0.85 | 4.15 |
| Expected | 0.22 | 0.09 | 0.14 |
A buyer moving from escrow to insurance gives up 0.09 million of expected recovery, plus whatever the policy excludes: known matters, forward-looking warranties, and anything diligence did not reach. A seller who compensates the buyer for the retention in the price pays 0.39 million all in.
The escrow costs the seller 1.43 million, the policy 0.30 million, or 0.39 million if the seller also pays for the buyer's retention. The saving is between 1.04 and 1.13 million on a 150.0 million deal. Almost all of it comes from releasing 15.0 million eighteen months earlier, not from any difference in the claims themselves.
Escrows are also used for the price adjustment under completion accounts, which is a different exposure: sized from the lines that can move, and not insurable. See how a completion accounts price adjustment is calculated.
| Seller's return on cash | Escrow carry | Expected claims, PV | Escrow total | W&I policy | Escrow minus W&I |
|---|---|---|---|---|---|
| 2% | 0.00 | 0.21 | 0.21 | 0.30 | −0.09 |
| 4% | 0.43 | 0.21 | 0.64 | 0.30 | 0.34 |
| 6% | 0.84 | 0.20 | 1.04 | 0.30 | 0.74 |
| 8% | 1.23 | 0.20 | 1.43 | 0.30 | 1.13 |
| 12% | 1.96 | 0.19 | 2.15 | 0.30 | 1.85 |
The break-even is a seller's return of 2.41 per cent. A seller with nowhere better to put the money than the escrow account itself is close to indifferent; a fund that has to distribute and is measured on IRR is not. Lengthen and enlarge the escrow, to 15 per cent for two years, and its cost at 8 per cent rises to 2.62 million, with the policy unchanged.
Everything that separates the headline from the cash, from debt-like items to the peg and the earn-out, is worked in the free workbooks for this book.
It is priced as a rate on line, a percentage of the policy limit, plus insurance premium tax and broker and underwriting fees. At an illustrative 1.2 per cent on a 15.0 million limit, the premium is 0.18 million; with UK tax at 12 per cent and 0.10 million of fees, the total is 0.30 million, 0.201 per cent of a 150.0 million price. Rates vary with the market, sector and diligence.
A buy-side policy is bought by the buyer, but who bears the cost is negotiated: it can be paid by the buyer, split, or passed to the seller through the price. In the worked case a seller who pays the 0.30 million premium and compensates the buyer for its 0.09 million of expected retained losses still saves more than 1.0 million against a 15.0 million escrow held for 18 months.
It is the amount of loss the insured bears before the policy pays, like an excess, often expressed as a percentage of enterprise value. At 0.5 per cent of a 170.0 million EV it is 0.85 million: a 1.0 million claim pays 0.15 from the insurer, a 5.0 million claim 4.15. With a nominal seller cap, the retention falls on the buyer unless the agreement says otherwise.
This article is one calculation from Closing the Deal. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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