Many financial transactions involve escrow agreements as a part of the contract. There are factors surrounding why an escrow agreement is necessary, how to construct one to benefit both parties and ways in which it should be executed.
What is an escrow agreement?
An escrow agreement is a legal contract between two parties where one side will provide a deposit of one form or another to be held by a third party (otherwise known as an escrow agent) until a transaction is finalized and the conditions of the agreement are met.
Why is an escrow agreement needed?
For the most part, escrow agreements are used in business transactions as some form of a deposit, such as monetary funds, or it can be another type of asset, such as stocks, bonds, a mortgage or property title. This deposit is provided to the escrow agent to be held. In some cases, one party will only move forward with a business deal if it is absolutely sure that the other party can fulfill its obligations. This comes into play especially in international and IPO transactions.
What is included in an escrow agreement?
There are specific elements that go into an escrow agreement, including:
- Name and contact information of the escrow agent
- Any fees and expense which would be acceptable for the escrow agent to utilize
- The role the escrow agent will play during the agreement, and terms in which the escrow agent can utilize the funds
- A detailed explanation of the nature of the agreement
- In the event of legal action, the agreement should list the jurisdiction and location that the escrow is meant to serve
What is a holdback escrow and why is it needed?
There are several reasons why a company would want a third party to hold back funds in a separate account, including:
- Mergers & Acquisitions (M&A): The buyer and seller may have a difference of opinion as to the final purchase price of a company. They may still need to negotiate details of the valuation. Often, at the onset of the negotiations, a certain amount of funding is held in an escrow account to ensure coverage of any financial differences that may arise.
- Risk: The buyer may not be aware of certain tax issues or other financial representations, and the escrow funds can cover some of the unknowns that may come along after the deal is finalized.
Likewise, for the seller, there may be liabilities that the seller is not aware of and the escrow funds would create a cap for indemnification should there be a breach of representation.
- Stocks: In many companies that have decided to go the route of an Initial Public Offering (IPO), there are employees who own stock options. When the company goes public, there is a minimum amount of time before employees can trade or sell those stocks. The funds for those options are held in an escrow account.
What is the role of an attorney in an escrow agreement?
Your attorney understands from the outset of the negotiation exactly what percentage of the purchase price will need to be held in escrow. This would be determined based on the purchase price and the terms. He will also have a sense of how long the negotiations will likely take, and will work with the other party’s counsel to determine the duration of the escrow.
Other factors that an experienced attorney will consider:
- If you are the buyer, your attorney will be able to do some prework on your behalf to gauge if the original terms of the offer contain any landmines that could potentially change the escrow amount, including tax liabilities, maintenance issues or other liens against the company.
- If there are any post-closing obligations that need to be considered and addressed, including potential holdback issues, it is best to have an experienced attorney who can anticipate what they are to help in a smooth closing and transition.
What is the difference in roles between your attorney and an escrow agent?
Your attorney represents your interests. He will work with you to negotiate on your behalf with the other party. An escrow agent is the third party who remains neutral in the entire business transaction.
Once your attorney and the other party’s attorney work out the basic terms of the transaction, the funds for the transaction go to the escrow agent. This way, no one involved in the negotiation holds the funds.
There are also terms that each party needs to fulfill during the course of the transaction. This could be disclosing certain documents, files and other information that are pertinent to closing the deal. The escrow agent makes sure that each party, and their attorneys, fulfill their obligations to provide the necessary deliverables.
If both parties move through the process successfully and the transaction closes, the escrow agent dispenses the funds accordingly. If, for some reason, the deal is not agreed upon and falls through, the escrow agent will return the funds to their original party.
Having a knowledgeable attorney help guide you through a business transaction is the best way to ensure that deals are successfully closed. Having an experienced escrow agent can also ensure that both parties stay on track and fulfill their obligations to make the deal happen.