What is the meaning of escrow agreement?

Let's say two parties wish to close a deal in which a large sum of capital is transacted for a majority stake in a company. To reduce the risk of the transaction, parties might wish to introduce an escrow agreement, which by way of 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 reduce 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, valuable assets (such as money, property, or documents) are deposited with an escrow agent, who releases them only when the conditions set out 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. It protects the interests of both parties.

What are common uses of escrow agreements?

Escrow agreements are used in various industries. For example, in real estate, agents ensure that funds are held while the necessary paperwork is completed before a property changes hands. Whilst property inspections and calculations are being completed, holding funds in escrow is symbolic of the seriousness of the transacting parties to strike a deal. 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 and ease of mind. It ensures that neither party can access the other's asset until the terms of the agreement are fulfilled, reducing the risk of fraud or default. Importantly, it ensures parties are working productively towards closing a deal, and an intention to make this happen. It is very important to foster trust in this process, which in this case is facilitated by a neutral third party that manages the transaction.

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.