Protecting capital: Why venture capitalists and private equity firms should prioritise software escrow

In today’s volatile financial landscape, safeguarding investments has never been more crucial for venture capitalists (VCs) and private equity firms (PEs). The recent turbulence in global markets underscores the importance of being proactive in protecting capital, particularly when investing in the tech sector.

With the UK's tech funding showing signs of recovery, now is the time for investors to take decisive steps to make sure their investments are sound. One of the most effective tools at their disposal is software escrow—a crucial mechanism that ensures the security and continuity of their investments.

The role of Escrow in investment protection

Financial shocks can happen unexpectedly. So, VCs and PEs must adopt strategies that protect their investments from unforeseen risks. Software escrow provides an invaluable safety net that allows investors to verify the assets they are investing in and ensure that their capital is being used wisely.

By leveraging escrow agreements, investors can mitigate risks associated with the software lifecycle. This includes ensuring that source code and intellectual property (IP) are securely held by an independent third party, ready to be released if certain conditions are met, such as a default by the software developer. This mechanism not only protects the investors' capital but also gives them greater confidence in their investment’s long-term viability.

When should investors consider software escrow?

1. Single lender agreements: In high-risk software investments, a single lender agreement is invaluable. It ensures that a developer's IP is securely held and can be transferred to the lender in case of a default. This safeguard is particularly critical in scenarios where the success of the investment hinges on the continued operation and development of the software.
2. Mergers and Acquisitions (M&A): During M&A transactions, software escrow offers a layer of security by ensuring that the acquired code and platforms have been independently verified. This process not only strengthens the credibility of the vendor but also reduces the risk for the acquiring entity. The escrow agreement also consolidates all necessary documentation, simplifying compliance with legal and regulatory requirements.
3. In the due diligence process: During the investment process, an investor and their legal counsel can use Escrow as part of their due diligence. Escrow agreements can include regular verification testing, ensuring that the software being invested in remains functional and compliant with all regulations. For VCs and PEs, software escrow isn’t just about mitigating risks—it’s about ensuring the success and continuity of their investments. By putting these safeguards in place early, investors can protect their capital and ensure that their investments are resilient to any future disruptions.

Taking the next step

A well-structured software escrow agreement can be the difference between a successful investment and a costly failure. By preparing for potential disruptions early on, investors can safeguard their interests and ensure the long-term success of their investments. Escrow agreements not only protect the current investment but also enhance the prospects of a smooth and profitable exit for investors.

With the assurance of a secure investment, VCs and PE firms can focus on planning their exit strategies. Escrow agreements provide an additional layer of security, making the business more attractive to potential buyers. When selling a software company, having an escrow agreement in place reassures acquirers that, in the event of significant disruptions, the source code and other critical assets will remain accessible. This reduces perceived risks, potentially expediting the sale process and leading to a higher valuation.

A software escrow agreement signals that the company is proactive in mitigating risks, showcasing robust governance and risk management practices. This is particularly appealing to buyers and investors who prioritise stability and continuity in their acquisitions.

About the Author

Andy Ramsbottom, Director of Global Strategic Accounts at Escode, brings nearly two decades of expertise in working with businesses, including VCs and PEs. His work focuses on aligning investment strategies with the unique demands of the tech industry, ensuring that capital is safeguarded in an increasingly complex market.