Escrow

What is an Escrow?

An Escrow is an arrangement for a third party to hold the assets of a transaction temporarily. The assets are kept in a third-party account and are only released when all terms of the agreement have been met. The use of an escrow account in a transaction adds a degree of safety for both parties.

The main purpose of an escrow is to ensure that everybody sticks to their end of the bargain. It can be seen as a mediator of the transaction. It asserts that the transfer of assets only happens when all the obligations of the transaction have been met.

Why Use an Escrow?

Escrow is commonly used for contracts that have the following characteristics:

• A large transaction value – such as the purchase of a home
• The buyer needs to confirm the quality of work before payment
• The seller doesn’t want to undertake massive amounts of work without assurance of payment.

An escrow is also beneficial when the transaction needs to be completed in steps. The service provider may need funds to continue the project, but it may be unwise for the buyer to pay the full amount before completion. Funds can, therefore, be partially released as predetermined milestones are completed.

Usage of Escrow

Online

When performing an online transaction, there is little transparency on who we are dealing with. For this reason, there are licensed online third parties who offer internet escrow services to safeguard both the buyer and seller. Terms are agreed upon and submitted to the third party, which include the purchase amount, time for goods to arrive, and allowable return period. Once all the terms are met, and this is agreed upon by both parties, the online escrow provider finalizes the transaction by transferring funds to the seller.

Whenever there are disagreements, a dispute resolution protocol takes effect to ensure the fairness of the transaction. It will decide who will keep the money for the transaction. With the rise of cybercrime, bogus online services have increased. One must be careful and make sure that the service provider is trustworthy and not someone with malicious intent.

Real estate

Escrow is commonly used in real estate purchases. This safeguards the buyer, who will be able to check if the property being purchased is of the standard that was advertised, and that there is not a malicious attempt of the seller to scam him. Without this service, the buyer is taking a significant risk, in that there is little to stop a seller from cashing the check immediately without the buyer knowing whether or not all concerns regarding the transaction have been addressed.

How it Works

The buyer of the property transfers funds to an escrow provider. If all the requirements and terms of the transaction are met, then the funds shall be further transferred to the seller of the property. If not, then either partial funds are transferred to the seller, or they are all returned to the buyer.

Mergers and Acquisitions

Escrow accounts are also used in mergers and acquisitions (M&A), to decrease risk in transactions by holding a percentage value of the deal. This allows the buyer to make claims against the seller and retrieve the funds if the seller does not meet certain terms of the agreement.

M&A uses a mechanism that is known as holdback escrow, where a portion of the purchase price is put in a third-party account to serve as security for the buyer. This is used for both asset and stock sales.

The benefits of a holdback escrow are twofold:

1. Allows disagreements in value to play out during the duration of the escrow account
2. Allows risk mitigation by assuring access of capital for issues that may arise post-deal, such as working capital adjustments, tax issues, and financial statement misrepresentations

A study of 250 deals by JP Morgan’s escrow services department revealed the following main characteristics:

• The average amount placed in a holdback escrow account was 9%.
• The average duration of a holdback escrow account was 18 months.
• A quarter of the escrows did end up having a claim made by one party, against the other party.

Source

Additional Resources

CFI is the global provider of the Commercial Banking & Credit Analyst (CBCA®) certification, which will teach you the skills to help you advance your career. If you want to learn more about other similar terms, please check out the following CFI resources:

• Real Estate Financial Modeling
• Financial Modeling for Start-Ups
• Debt Schedule
• Escrowed Shares
• See all commercial lending resources