Indemnity vs Escrow: A Promise Against Funded Money

An indemnity is a promise to pay and an escrow is money already set aside. On Harivansh Packaging Limited's purchase the cap of Rs 227.40 crore is the promise and the escrow of Rs 113.70 crore is the money, with both amounts set against the same Rs 1,137 crore adjusted equity value. Exactly half the ceiling is funded and the other half must be collected.

The two-part answer above rests on three things worked elsewhere. A counting floor and a threshold settle, before anything here applies, whether a claim gets paid one rupee, and those two are covered separately, so every claim in this guide has already got past them and is assumed good. The escrow is 10.0 per cent of the adjusted equity valueThe price the buyers actually receive for the shares once the corrections agreed in the paper have been run. Here it is Rs 1,137 crore, and how it got there is covered separately. of Rs 1,137 crore, or Rs 113.70 crore, and the account is held for eighteen months. And the sellers of Sundarban Polymers Private Limited are private holdersShareholders in a company whose shares do not trade on an exchange. There is no market price for what they hold and no continuous public record of what they are worth. rather than a listed company. Being private is why the second half of the argument has anything to say at all.

What is the actual difference, said in one line?

An indemnity is somebody promising to pay money. An escrow is money that is already out of that somebody's hands. Every other difference below follows from that one.

Consider a house that is being rented out. The tenant signs an agreement saying that any damage will be made good. The agreement is a promise, and a promise is worth exactly as much as the tenant is willing and able to pay when the tap has been ripped out of the wall. Then consider the deposit taken at the start. The deposit is not a promise. The deposit is money that left the tenant's account months ago and sits somewhere the tenant cannot reach. When the tap goes, nobody has to be persuaded about the deposit. The landlord already holds it.

Both the promise and the deposit appear in the paperwork as numbers, and only one of them is cash. The distinction is that simple, and it is the first thing lost when a transaction is summarised into a single protection figure. On Harivansh Packaging Limited's purchase of Sundarban Polymers Private Limited the promise is a ceiling of Rs 227.40 crore and the money is an account of Rs 113.70 crore, and a memo that adds them together, or quotes only the larger, has described two quite different assets as though they were one.

The left panel does not say the promise is weak, or bad, or worth nothing. A promise from somebody solvent who still wants a working relationship with the other side is worth a great deal. The narrower and harder point is this. A promise has no money standing behind it today, so a promise is worth whatever the promisor turns out to be worth, and no clause can fix that and no arithmetic can settle it.

Why is a ceiling not the same thing as money?

A ceiling answers one question and one only: what is the most that can ever be claimed under this document. A ceiling is a limit on the top of a claim. A ceiling is silent on every question a person actually has once something has gone wrong.

Ask the three questions that matter and watch the ceiling refuse to answer two of them. Does the seller still have the money? The ceiling does not know; it was written before anybody knew. Will the money be paid when it is asked for? The ceiling does not say; a limit is not an undertaking to pay, it is a boundary on what an undertaking could ever come to. Is any of it already set aside? Here the ceiling is silent again, and the only reason the transaction has an answer is that a second and quite separate clause put Rs 113.70 crore in an account.

The buyer's real question is never how large the ceiling is; it is how much of the ceiling is already in an account and how long it stays there. A larger ceiling with no escrow behind it can be worth less than a smaller one that is fully funded, and nothing in the ceiling figure itself distinguishes the two.

Here counterparty riskThe chance that the other side to an agreement does not pay what it agreed to pay, whether because it cannot, because it has gone, or because it argues. It is a fact about who the agreement was made with rather than about what was written in it. stops being a phrase and starts being arithmetic. A promise from a large listed acquirer with a public balance sheet is one kind of asset. A promise from a group of individuals who have just sold the only business they had is a different kind of asset entirely, and the paper looks identical in both cases.

How much of this ceiling is actually funded?

Now the arithmetic, and it is short. Both marks on this transaction are struck on the same Rs 1,137 crore adjusted equity value, the figure left after the two completion corrections have been run. The ceiling is 20.0 per cent of it, or Rs 227.40 crore. The escrow is 10.0 per cent of it, or Rs 113.70 crore. Take the account away from the ceiling and what is left over has no money behind it, and that leftover comes to Rs 113.70 crore.

Exactly half of this ceiling is cash and exactly half of it is a promise, and a memo quoting the ceiling alone has described the two halves as though they were the same asset. The tidiness of the split is an accident of these two percentages and not a rule; a transaction with a 20.0 per cent ceiling and a 5.0 per cent escrow would be one quarter funded, and the arithmetic would be done the same way.

One caution before the split gets over-read. Over-reading it is the commonest mistake made with these two figures. The escrow is not half of every claim. The escrow is a fixed amount of cash sitting underneath a recovery, paying out from the bottom until the balance is exhausted and contributing nothing at all after that. A recovery of Rs 40 crore is entirely funded. A recovery of Rs 220 crore is funded up to Rs 113.70 crore and no further. The halves are halves of the ceiling, not halves of a claim, and the worked claims below are where that distinction earns its keep.

What happens to a claim that sits above the funded amount?

Picture a claim climbing. While it is under Rs 113.70 crore the buyer is dealing with an account. There is an instruction, a holder, a balance, and a payment out of that balance. Drawing on an account is closer to a bank transaction than to a dispute.

The moment the claim passes Rs 113.70 crore something changes that has nothing to do with the size of the number. The account is empty. A promise is all that remains, and the people who gave it have been paid in full, have handed over the business, and no longer have a commercial reason to keep the buyer comfortable. The buyer has moved from drawing on money to asking for money.

At Rs 113.70 crore the amount does not change but the buyer's position does: on one side of that mark the buyer takes, and on the other side the buyer asks. An unanswered ask becomes a legal question about obligations and how they are pursued. A lawyer answers that question, and the company law side of an obligation to pay sits with the Ministry of Corporate Affairs.

Then there is a third zone. Above Rs 227.40 crore the claim is outside this route altogether. Such a claim is not underfunded and it is not unpaid, and at no point is it a claim under this part of the paper at all, however good the underlying loss is. Three zones, three completely different positions, and one figure in a board pack that covers all three.

Getting this wrong in the other direction is just as bad. Notice what does not change across the three zones. The loss is the same size in all three. The claim is just as good in all three. The seller has promised exactly the same thing in all three. Nothing about the merits moves at Rs 113.70 crore or at Rs 227.40 crore. The buyer's options that afternoon do move, and those options are a completely different sort of fact, the one a summary tends to drop.

The everyday version is a deposit again. If the damage comes to more than the deposit taken, the extra is not a weaker claim, and the tenant does not owe less because the deposit ran out. The extra simply has to be asked for, and asking is a different activity from deducting, with a different chance of ending in the money.

What do three different claims look like once they are split?

Take three payable claims of different sizes on Harivansh Packaging Limited's purchase of Sundarban Polymers Private Limited. Each is tested on its own and none of them is added to the others. Each is assumed to have already got past the counting floor and the threshold, both covered separately. All three meet the same two marks: Rs 113.70 crore of account and Rs 227.40 crore of ceiling.

Read the rows one at a time. The Rs 15 crore claim never leaves the account, so the buyer instructs a payment and the matter is closed. The Rs 150 crore claim takes the whole Rs 113.70 crore in the account and leaves Rs 36.30 crore that has to be asked for, so the buyer is now in two different positions on one claim at the same time. The Rs 250 crore claim empties the account, leaves the full Rs 113.70 crore of promise, and puts Rs 22.60 crore outside the ceiling where nothing in this route reaches it at all.

Protection is not one number, it is a funded amount, an unfunded amount and a ceiling, and the three behave completely differently the moment a claim is real. Down the middle column of the table the funded figure stops moving at Rs 113.70 crore while the claim in the left column keeps growing. The flat middle column is the whole point.

Do the money and the promise end on the same day?

The two clocks do not have to end together, and on this transaction the two ends are not even measured in the same way. The escrow runs for eighteen months from completion, a stated stretch of time that can be put in a diary. The promises run for whatever period the document fixes for them, and that period is a drafting matter settled between the two sides.

Each clock is started by the same event, the day of completion. Only one of them has an end that can be written down. The other end has to be left open rather than guessed at. Nothing requires the account and the promise to expire together. A claim can be live in a stretch where no funded money remains behind it. The gap between the two is invisible in every figure a summary carries, and that makes it the most expensive stretch on the transaction.

Why would anybody agree to a gap at all? Because the two periods are negotiated for different reasons. A seller wants the money back as soon as it can reasonably be released, and pushing the account out costs the seller in a way it can price. The risks behind different promises surface at different speeds, so the period the promises run is argued over separately, often clause by clause. The two conversations happen at different tables and the result is two lengths that were never set against each other.

None of that is a defect to be fixed by a reader. The gap is a fact to be noticed and stated. A gap that has been written down is priced and a gap that has not been written down is discovered, so the job is not to close the gap but to name it. Naming it takes one line, and that line is the third of the three set out below.

What does the escrow cost the seller?

A buyer who cannot state the seller's cost will not understand why an escrow is negotiated as hard as it is. The arrangement is worth reading from the seller's side of the table too.

Rs 113.70 crore of the price is money the seller has sold the business for and cannot use for eighteen months. An escrow is not a fine and not a forfeit. The held amount is deferred considerationPart of a price that is agreed now and handed over later. The amount is settled at the same time as the rest; only the moment it arrives is pushed out.. Part of the agreed price arrives late rather than never, and whatever is left when the hold ends goes to the sellers. The cost is the use of that money for that stretch: whatever it would have paid down, funded or earned in the meantime.

A wedding caterer will recognise the shape immediately. The full price is agreed, most of it is paid, and a slice is kept back until the day has gone off properly. The caterer has been priced for the whole job and is not being punished; the caterer simply cannot spend that slice yet, and prices the job knowing that. An escrow is consideration deferred rather than a penalty, it is not lost, and whatever the held amount earns during the wait belongs wherever the document sends it rather than wherever a rule might.

The seller's cost is also why the buyer cannot simply ask for a larger escrow and treat it as free. Every rupee added to the account is a rupee of the price the seller cannot touch, and a seller prices that. An escrow is bought, not granted, and the price is paid somewhere else in the negotiation.

What happens to the percentages when the earn-out pays?

Here is the twist this reading order keeps coming back to, and it catches careful people. Both marks take their size from the Rs 1,137 crore adjusted equity value. But the adjusted equity value is not necessarily everything the buyer ends up paying. The transaction also carries an earn-outA further amount payable after completion only if a stated result is met. Until the result is known, nobody can say what the total price will turn out to be. of Rs 60 crore, and it falls due only if Sundarban Polymers gets earnings before interest, tax, depreciation and amortisation (EBITDA) up to Rs 145 crore in the year that follows completion.

Suppose it does. Total considerationEverything the buyer hands over for the business, added together, whenever each part of it is handed over. It is a wider figure than the amount that changes hands on the day of completion. becomes Rs 1,137 crore plus Rs 60 crore, or Rs 1,197 crore. Nothing in the document moved, so the escrow is still Rs 113.70 crore. Against Rs 1,197 crore, that same amount reads 9.50 per cent where it used to read 10.0 per cent. The ceiling of Rs 227.40 crore reads 19.0 per cent against everything eventually paid, having read 20.0 per cent against the completion figure.

The rupees stayed still and the base under them grew, so both protection percentages fell without a word of the document changing. The old trap arrives in a new coat: a percentage is meaningless until what it is a percentage of has been stated, and a transaction with a contingent payment has two honest bases rather than one.

Who actually uses this split, and for what?

Four readers pick up the same two figures and do four different things with them, and none of the four is the drafting exercise.

An analyst covering Harivansh Packaging Limited wants to know what could still come back at the acquirer and how visible it would be. An amount sitting in a held account is money that has left the buyer already and is doing nothing for the business; an unfunded promise running the other way is an amount that may never be asked for and may never be paid. The two are different questions for a reader of the accounts, and how each is presented is settled by the Institute of Chartered Accountants of India. The analyst's own job is to name which is which.

A lender to the buyer reads it as availability. If part of the purchase price is going into a held account rather than to the sellers, the money still leaves the borrowing side on the day of completion. At eighteen months the account goes to the sellers unless a claim has taken it. Either way the borrowing side never sees the money again. Money in that account is restricted cashMoney that sits in a bank account the holder is not free to use, because an agreement, an instruction or a condition stands in front of it. It looks like cash and cannot be spent like cash. from the day it is funded, and treating it as ordinary cash overstates what the borrower can actually draw on.

The seller's own advisers read it as a cash flow question. Rs 113.70 crore that arrives eighteen months late is worth less than Rs 113.70 crore that arrives on the day, and how much less depends on what the sellers would otherwise have done with it. No single figure prices that, and nobody should pretend one does.

The buyer's transaction team reads it as the only line that matters when a problem actually turns up: what can be taken without asking, and what has to be asked for. Two people at Harivansh Packaging Limited get asked exactly that question by their board on the day a claim appears: Ashwin Rege, who runs its transaction team, and Devyani Kulkarni, who runs its finance. The answer either of them can give depends entirely on whether somebody split the figure before signing.

One thing joins all four readings. Each of them stops being possible the moment the ceiling and the account are added together, or the moment only the larger of the two is quoted. A single protection figure is not a compression of the two numbers; it is the loss of the distinction that every one of those four readers needs. The lost distinction is why two lines are needed where a summary wants one.

Which three lines come before quoting a protection figure?

None of this needs a lawyer, a model or an hour. Three lines do it, and they are the same three lines on every transaction with a ceiling and an account in it.

1. Name the baseThe base the percentages are struck on comes before any of them is quoted. Here it is Rs 1,137 crore, being the adjusted equity value after the completion corrections, and the same percentages on the headline figure would give different rupees.
2. Split the ceilingPut the funded amount and the unfunded balance on separate lines. Here that is Rs 113.70 crore in an account and Rs 113.70 crore that would have to be asked for, and writing them on one line is what causes the whole problem.
3. Compare the two lifetimesSet the escrow period beside the period the promises run. Here the account is held eighteen months and the promise runs for whatever period the paper sets, and the difference between those two is where a live claim can meet an empty account.

A single quoted number hides all three of these, and the three of them together take about a minute and change what a board is told. If a fourth line is wanted, it is the one just worked above. Rs 113.70 crore is 10.0 per cent of one honest base and 9.50 per cent of the other, so name the base used whenever the transaction carries a contingent payment.

Harivansh Packaging Limited, Sundarban Polymers Private Limited, Ashwin Rege and Devyani Kulkarni are invented.
Educational material. Not advice on any investment, tax, budget or market position.