How do escrows work?
An escrow is a contractual agreement whereby a third-party agent receives, holds and disburses money (possibly also assets or documents) on behalf of the principal contracting parties. This is generally for a certain amount of time and subject to the fulfilment of certain independent conditions. The escrow agent will be in charge of administering an escrow account, in its most common form a segregated bank account that holds cash.
So, simply put, something of value is given to a qualified third party who will distribute that value over time either to the seller or the buyer depending on the conditions agreed.
What purpose does an escrow serve?
The above underlines an escrow’s first and foremost purpose: to mitigate and allocate risk, i.e. to ensure that funds for potential post-closing claims and obligations are readily available independent of the other party’s future situation.
Main scenarios include the following:
- Indemnities & Warranties: In lieu of conducting a thorough and costly due diligence, sellers will oftentimes provide extensive indemnities, representations and warranties backed by an escrow account ensuring that coverage of potential claims is at least partially secured.
- Purchase Price Holdback: A portion of the purchase price may be held back in an escrow conditional upon the finalisation of the relevant metrics.
- Approval & Conditional Completion: Most commonly in relation to the approval by a government authority (in M&A most likely the competition commission) or other third parties, part of the purchase price may be placed in an escrow, subject to such approval.
Both the seller and the buyer can benefit from employing escrow arrangements for a transaction. Studies such as by Bhagat, Klasa and Litov (The Use of Escrow Contracts in Acquisition Agreements, 2014) show that escrows can promote overall value generation, e.g. by saving due diligence costs, eliciting a higher purchase price, and improving share price reactions to deal announcements of public companies.
Escrows allow mitigating risks and help overcome situations of considerable information asymmetry. Scientific research highlights the benefits of using the right escrow mechanisms at the right time – in terms of tangible value creation as well as deal certainty.