Escrow – What is it, and How is it Used?

In Short

• Escrow involves a neutral third party holding funds or assets until predetermined conditions are met.
• It provides security for parties in a transaction, ensuring obligations are fulfilled before release.
• Utilised in various transactions, such as property deals and mergers, to manage risk and increase trust.

Tips for Businesses

Consider using escrow services in transactions where trust or risk is a concern. This approach secures payments or assets until all parties meet agreed conditions, reducing potential disputes. Clearly define the terms of escrow in agreements to ensure smooth processing and understanding among all involved parties.

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Table of Contents

• What is Escrow?
• When is it Used?
• Escrow Agreement
• Example
• Key Takeaways
• Frequently Asked Questions

If you are entering into a legal transaction, you have probably heard of the concept of escrow. However, many people often misunderstand or struggle to grasp this concept. This article explains what it is and how and when to use it.

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What is Escrow?

This is a legal arrangement in which the primary parties to a transaction (generally a buyer and a seller) engage an independent, neutral third party (the escrow agent) to hold relevant assets on their behalf and transfer them once specific criteria are met. This arrangement ensures transaction fairness and prevents parties from withholding assets upon completion of a deal. In essence, it offers protection to both parties. 

For instance, you can transfer the following to an agent:

• money;
• securities (shares or bonds);
• real property (houses, buildings or land); or
• other business or personal assets.

The transacting parties will agree to the specific conditions they must satisfy before the agent releases the assets or funds to the appropriate party. 

These specific conditions are often the contractual obligations in the transaction agreement (for example, a share or asset purchase agreement). The assets or funds are held ‘in escrow’ while the agent holds them.

When is it Used?

Parties use escrow when completing a transaction. It helps prevent fraudulent transactions and ensures that each party can fulfil its obligations. 

Real Estate Transactions

For example, escrow is commonly used in real estate transactions. In this case, an agent holds the deed to the property and the deposit or purchase price until completion, at which point the funds can be released to the seller.

For example, a buyer may deposit the amount needed to buy a house into an escrow account, to be released when all the set conditions are met. This could be any enquiries by their solicitors and the transfer of the necessary documents. The money is then released to the seller. 

Business Transactions

Escrow is also frequently used in business sales, mergers and acquisitions (M&A). In these transactions, the agent usually holds the deposit or purchase price until both parties satisfy all their obligations under the transaction agreement and completion has occurred. 

This can, for example, involve a seller shipping a product to a buyer. Prior to this, the buyer has deposited the purchase amount into an escrow account. Once the buyer has received and inspected the goods, the funds are released to the seller. 

In an M&A, significant amounts of money may be involved, and the use of an escrow account may reassure both parties. For example, there can be a ‘buffer period’ following the acquisition of a business, where the buyer can claim against the escrow account if any liabilities arise. 

Essentially, escrow can be used in any transaction. However, it is most useful for transactions involving significant sums of money (which cannot be transferred easily or immediately) or for complex transfers that require numerous steps, such as transferring property, which involves registering the transfer of title with several different bodies.

Escrow Agreement

The primary parties to the transaction and the escrow agent usually enter into an escrow agreement. The agreement includes the terms under which the agent must hold and eventually release the relevant assets or funds. 

The critical matters of an agreement include the:

• details of the account in which the agent holds relevant funds;
• conditions on which the agent must hold the assets and any fees;
• escrow conditions, which each party must satisfy before the agent releases the assets;
• process the agent must follow in releasing the assets; and
• process allowing the parties to instruct the agent to release the assets if the escrow conditions have not been met.

Example

Suppose Fred has a very successful technology business that he wants to sell, and he has an interested buyer. Fred and the buyer have negotiated a sale agreement. However, due to the technical nature of Fred’s business, many complex and time-consuming processes must be carried out to properly transfer the business and its assets.

Both Fred and the buyer want certainty that the business transfer will finalise before they start transferring the assets. So Fred and the buyer agree to execute the sale agreement, and the buyer pays the purchase price to an escrow agent, such as their lawyer, to be held on their behalf until completion occurs. 

The escrow agent will hold the purchase price until both parties have successfully transferred all of the business and its assets. Once all the escrow conditions have been satisfied and completion has been confirmed, the escrow agent will release the purchase price to Fred. 

Key Takeaways

In essence, escrow is the use of a third party who holds an asset or funds before they are transferred. The agent holds the funds until both parties have fulfilled their contractual requirements. Escrow is generally associated with real estate transactions and is used in M&A transactions. Finally, you can also use this method to secure transactions of personal assets (such as cars, jewellery or art). 

If you need help with business transactions, our experienced corporate lawyers can assist as part of our LegalVision membership. For a low monthly fee, you will have unlimited access to lawyers to answer your questions and draft and review your documents. Call us today on 0808 196 8584 or visit our membership page.

Frequently Asked Questions