An escrow agreement refers to a contract that outlines the terms and conditions of a transaction for something of value – such as a bond, deed, or asset – which is held by a third party until all conditions have been met. The terms and conditions outlined in the agreement will have been agreed to by the transacting parties before escrow.
The independent third party involved, called an escrow agent, is responsible for holding documents and regulating the payment of funds required in the transaction. The third party then hands over the retained asset to the party entitled to receive it once all terms have been fulfilled.
Escrow agreements outline the terms and conditions of large transactions.
The transaction is mediated by an independent escrow agent, who holds all funds and documents until both sides have fulfilled their promises.
Escrow agreements are used in mergers and acquisitions, certain issuance of stocks, real estate, and legal settlements.
What is Escrow Used For?
Escrows are useful for transactions where a large amount of money is involved, and several obligations must be fulfilled before payment is released. For example, escrow is used in real estate for the sale and purchase of a property.
It is also often used in mergers and acquisitions and other corporate transactions. In the legal system, they can be used to distribute money in a class action for settlements.
Different Uses of Escrow Agreements
Mergers and Acquisitions
Escrow agreements are employed in a large number of private companies and subsidiary acquisitions made by publicly-traded firms. It is used largely to protect the buyer from risks associated with the acquisition, especially when the seller or target company has concerns relating to credit risk.
The bidder uses the contracts by setting aside a percentage of the total purchase price, which is held in escrow for a negotiated period of time after the completion of the acquisition. Bidders will receive the escrow funds back if the target company fails to meet certain terms in the agreement or hid critical information before the sale.
Hence, escrow contracts act as a warranty offered by the seller to protect against common information asymmetry problems and acquisition-related risk experienced by bidding companies.
Escrow can also be used in the sale and transfer of shares in the stock market. Companies put shares into an escrow account for different reasons. If shares are used as part of a payment in a merger with another company, the buyer company will put shares into escrow until the deal has been completed.
Shares issued to employees as a benefit may be restricted to the employee for a certain period. During such a period, employees cannot trade the stock on the market, so the shares sit in escrow.
In real estate, escrow is used to facilitate the closing of a real estate transaction. The escrow company creates a short-term account to hold the money and all documents related to the transaction rather than letting the buyer and seller deal directly with each other.
The mediating company then distributes all funds and documents to their rightful owners once the agreement has been fulfilled on both sides.
In the judicial context, escrow funds are commonly used in cash settlements for a class action. Usually, the defendant will pay the total amount of the settlement to a specified escrow fund. The fund will then distribute money to the individual plaintiffs or for any other specified use.
Benefits of Escrow Agreements
Before any money or property exchanges hands in a two-party transaction, escrow agents ensure that both sides follow their promised agreements. The agent acts to protect both buyers and sellers from potential defaults or fraud. In particular, escrow services ensure that the buyer does not bear the same risk as in open trade.
Risk of Escrow Agreements
Escrow agreements are provided by independent escrow services whose trustworthiness must be assessed carefully. The agent is to be trusted with the holding and releasing of funds, which is a large responsibility and a noteworthy risk to both buyers and sellers.
Due to several instances of fraud in the past, users should conduct proper due diligence into escrow services to protect against any wrongdoing.
Take your learning and productivity to the next level with our Premium Templates.
Upgrading to a paid membership gives you access to our extensive collection of plug-and-play Templates designed to power your performance—as well as CFI's full course catalog and accredited Certification Programs.
Already have a Self-Study or Full-Immersion membership? Log in
Access Exclusive Templates
Gain unlimited access to more than 250 productivity Templates, CFI's full course catalog and accredited Certification Programs, hundreds of resources, expert reviews and support, the chance to work with real-world finance and research tools, and more.