Escrow Agreement

What is the meaning of escrow agreement?

An escrow agreement is a legal arrangement where a neutral third party, known as the escrow agent, holds assets or funds until predefined conditions are met. In doing so, both parties are able to eliminate third-party risk; ensuring that each side fulfils their obligations before the exchange occurs. It is commonly used in M&A transactions.

How do escrow agreements work?

In an escrow agreement, assets such as money, property, or documents are deposited with the escrow agent, who releases them only when the conditions set by both parties are satisfied. These conditions can include completing a transaction, meeting milestones, or concluding due diligence. If the terms are not met, the assets remain in escrow, protecting the interests of both parties.

What are common uses of escrow agreements?

Escrow agreements are used in various industries. In real estate, they ensure that funds are held while the necessary paperwork is completed before a property changes hands. In mergers and acquisitions, escrow accounts protect buyers from undisclosed liabilities by holding part of the payment until the deal conditions are confirmed. In software transactions, escrow agreements ensure that customers have access to source code or updates if a provider fails to meet their obligations.

Seyfarth’s 2023/2024 M&A Survey also highlights that, in acquisition deals, the typical escrow amount is around 8% of the purchase price for non-insured transactions, and 1% for insured deals. Most deals, whether insured or not, had an escrow period of 12 to 18 months, providing a secure framework for both buyers and sellers during the transaction process. The escrow agreement spells out these conditions.

What are the benefits of an escrow agreement?

The main benefit of an escrow agreement is security. It ensures that neither party can access the asset until the terms of the agreement are fulfilled, reducing the risk of fraud or default. Additionally, escrow agreements foster trust between parties, as a neutral third party manages the transaction. For complex transactions, they provide risk mitigation, ensuring that both sides meet their obligations before the deal is finalized.

What are the major risks of escrow agreements?

While beneficial, escrow agreements also come with risks. The most significant is the reliability of the escrow agent. If the agent mishandles the assets, it can lead to disputes. Additionally, escrow arrangements involve costs, which can add to the overall expenses of the transaction. Drafting the agreement can also be complex, as it must cover all possible conditions and contingencies to avoid future misunderstandings.

In conclusion

An escrow agreement provides a safeguard in transactions by ensuring that assets are only released when all conditions are met. It offers security, trust, and risk mitigation, making it an essential tool in real estate, mergers and acquisitions, and software transactions. However, the agreement must be carefully crafted, and a trustworthy escrow agent should be chosen to minimize potential risks and ensure a smooth process.