Escrow Agreement

An arrangement for funds to be held by a third party until a certain condition is met.

Author: Sid Arora
Sid Arora
Sid Arora
Investment Banking | Hedge Fund | Private Equity

Currently an investment analyst focused on the TMT sector at 1818 Partners (a New York Based Hedge Fund), Sid previously worked in private equity at BV Investment Partners and BBH Capital Partners and prior to that in investment banking at UBS.

Sid holds a BS from The Tepper School of Business at Carnegie Mellon.

Reviewed By: Christy Grimste
Christy Grimste
Christy Grimste
Real Estate | Investment Property Sales

Christy currently works as a senior associate for EdR Trust, a publicly traded multi-family REIT. Prior to joining EdR Trust, Christy works for CBRE in investment property sales. Before completing her MBA and breaking into finance, Christy founded and education startup in which she actively pursued for seven years and works as an internal auditor for the U.S. Department of State and CIA.

Christy has a Bachelor of Arts from the University of Maryland and a Master of Business Administrations from the University of London.

Last Updated:November 29, 2023

What is an Escrow Agreement?

An escrow agreement is an arrangement for funds to be held by a third party until a certain condition is met. This contract also details the terms and circumstances of the transaction, as well as the parties' respective duties.

It is mainly used by issuers that require a holding account to deposit funds before all contractual commitments are completed temporarily. This guarantees that the contract is carried out in a secure and dependable manner since all of the terms will be clearly laid out for each party.

Escrow accounts vary from regular bank accounts in that they include an overarching agreement that defines the transactions and specifies the specific release mechanism for cash or valuable goods.

It often includes a third party called an escrow agent who keeps the funds and distributes them when the contract's stipulated conditions are satisfied. 

It is commonly utilized in high-yield bond deals or other financial transactions involving large sums of money, such as real estate.

What is Escrow Used For?

Because capital markets are susceptible to potential interruptions known as closures, escrow agreements are employed for large bond process transactions. As a result, an escrow agreement serves as a safety net to guarantee that transactions proceed successfully.

An issuer might want to raise funds for future projects to avoid this type of closure risk. They will then store these funds in a secure account, which is when the escrow comes in. 

This means that when an issuer attempts to complete a high-yield offering before all of the essential requirements of the funds used have been met, they will not be able to collect the funds. 

As an issuer, such as an investment bank, escrow helps to reduce the risks that the investment bank might face. For example, bridge loans are expensive due to the short-termism of the loan nature.

An escrow agreement can be especially useful for this type of financial transaction because closing a bond into escrow reduces (or eliminates) the likelihood of the bridge debt being drawn after the deal has closed. 

Despite some of the other guidelines explicitly required for bridge loans, the cash held in the escrow account will be readily available. 

Using an escrow account for a standard leveraged loan, on the other hand, is unusual. This is due to the fact that the funding requirements in a standard loan arrangement are less stringent. 

Lenders, for example, may have faster access to cash, or an investment bank may be able to pay lenders in advance to maintain a lower drawdown period.

On the other hand, escrow accounts will be utilized by long-term bondholders like pension funds, mutual funds, and hedge funds, who often have longer lead periods or difficulty converting assets into cash in a short period. 

Investment-grade bond issuances do not often use escrow accounts. This is because the higher the credit rating for a firm, the less protection it may seek for its financing structure. 

Different Uses of Escrow Agreements

Escrow agreements can be used by a number of processes as it is an effective tool in setting out agreements for different parties. Usually, the agreements are drafted in favor of the buyer as they are taking on more risks during the transaction process. 

However, escrow agreements should be outlined fairly and reasonably for both parties and thus, will require a long negotiation process. This is partly supported by the escrow agent, who should be an independent and trusted third party.

The third party should have a position of no material or emotional interest (i.e., no gain or loss from the transaction). 

For example, during a sale of art, the escrow agent is responsible for appointing a specialist who can ensure that the product is genuine. The conditions of the agreement should also be explained and stored properly during the transactions. 

The final step for an escrow agent is to ensure that all obligations and conditions are met before releasing the funds to the respective party. 

Escrow agreements are becoming more popular to oversee transaction processes because of the increased frequency of buying and selling personal assets. Individuals want to be able to protect themselves from unforeseen risks during their transactions. 

Having a process to monitor both parties to ensure the fulfillment of the agreement is invaluable for this kind of protection.

Mergers and acquisitions (M&A)

Escrow agreements are frequently utilized in the M&A process.

It is employed in 52.1% of purchases, with 12.2% of transaction funds held in escrow accounts for about 18 months.

In M&As, the escrow account will keep a portion of the funds used for the acquisition until the transaction's requirements are satisfied. This serves as a risk-mitigation tool, as well as a cost-cutting measure throughout the due diligence process.

The following are examples of clauses that can be added to an escrow agreement: 

1. Indemnities and warranties

  • Instead of undertaking thorough due diligence on the target firm, the seller will issue indemnities, representations, and guarantees. 
  • These will be backed up by funds kept in escrow to guarantee the buyer that there will be enough finances to meet the covenants. If the agreements are reached, this will be made available to vendors.

2. Good faith deposit: 

  • When a seller invests significant time, money, and risk in the sale process, they may ask for a deposit to be held in escrow. If the buyer backs out, the money will be returned to the vendor.

3. Adjustment of the purchase price: 

  • When the acquisition's purchase price is adjusted, a portion of the purchase price can be placed into an escrow account. 

4. Government approval/conditional completion: 

  • When completion is dependent on a third-party event, most commonly the consent of a government organization, such as the competition commission, some or all of the purchase money may be kept in escrow until such approval is achieved.

Repayment of debt

Escrow accounts commonly allow individuals to repay high-yield bond issuers who are not yet due or are not yet repayable until a premium is paid. 

As a result, an escrow account assists in keeping the funds in an account until the agreed-upon period for repayment of the applicable obligation.

Escrow accounts can also make separate payments to creditors at different periods. As a result, financial institutions frequently employ escrow accounts to shorten the repayment process, making it more effective and dependable.

Lenders for your home, for example, may want to guarantee that your property taxes and invoices are paid on time. 

This is due to the fact that cumulative tax liabilities can grow over time, resulting in the state tax office taking your property. As lenders, they may bear the responsibility of a prospective tax authority foreclosure, which would result in lenders paying even more money. 

Alternatively, if the insurance coverage is revoked, considerable damage or loss to the property might result in a quick decline in the home's value. This would render the property unusable if the lenders wanted to take it and resell it. 

As a result, having an escrow account protects lenders by ensuring that payments are paid on time.

Payment of a dividend

High-yield deals sometimes involve dividend payments, which can be held in an escrow account until they are distributed. 

The contract conditions will primarily focus on meeting specified ratios or key performance metrics. This is often employed when a company does not want to assume market risk in terms of financial statements not being synced with dividend issuing. 

This helps to safeguard investors by ensuring that their cash is not dispersed arbitrarily if certain criteria are not met. 

Similarly, it is possible to place funds into an escrow account that helps generate dividends at the share account rate. The cost of these payments will be included in the mortgage payments. Therefore, escrow services will help to pay insurance or taxes that are due through the escrow account. 

At the end of each year, the escrow service will produce a report that shows how much you were able to save from using an escrow account. The statement will also reveal if you owe more or less in taxes and insurance than was projected the previous year.

However, it should be highlighted that businesses rarely employ this technique since locking up dividends in an escrow account might send negative signals to the market, resulting in reduced trust in the firm.

Stock market 

Stocks are frequently issued in escrow. 

This implies that while the shareholder legally owns these shares, the shareholder's rights will be limited based on the escrow arrangement. Holding shares in an escrow account can also prevent losses from market fluctuations. 

Managers and executives who get stock options instead of cash for their bonuses must normally wait for their escrow term to expire before they may sell the shares. In these scenarios, this is often known as the 'vesting' period. Upon the vesting date, shareholders are allowed to sell their shares. 

Similarly, during an M&A transaction, the targeted company can request a holdback in the form of escrowed shares. This is done to protect against the acquirer failing to execute the business transaction. 

The practice of putting shares in escrow for a certain amount of time is typical for both public and private corporations.

Holding shares in an escrow account provides an extra incentive for employees to perform better and remain in the company for a longer term. These escrow shares can be held between 1 to 3 years, depending on the agreement.

This is popular for firms listed on the Australian Stock Exchange (ASX) since it signals to investors that the company is confident in its growth and that it will not simply 'sell out' after launching its IPO. 

For example, when Youfoodz (ASX: YFZ) floated its shares, 97.7 million shares were escrowed, the majority of which were owned by the company's founders, management, and key shareholder RGT capital.

Online sales

Similar to the stock market and real estate, escrow accounts can also help protect online sales. Escrow accounts operate as a middleman for purchasers and online sales platforms. 

With a greater emphasis on online transactions, there is an increase in fraudulent incidents and cyber attack cases, which can have a significant impact on buyer-seller confidence. Spotting an online fraudulent seller or buyer isn’t easy. There are many fake profiles and risky payment methods. 

For example, the most common fraudulent behavior is asking for payment upfront through the use of Paypal or untraceable transaction platforms such as cryptocurrencies. While the Internet may make buying things from any website quick and easy, dealing with overseas merchants and handling difficulties can be much more challenging.

As a result, escrow accounts can be utilized to mitigate these risks.

In the case of online transactions, purchasers often send money to an escrow service, which holds the money until the goods are securely delivered. Once the items have been delivered and all of their requirements have been met, the escrow account will release the funds to the online seller. 

Most online transactions will take between 1 to 20 days to complete. This will be specific to each transaction and will depend on the account verification, payment method, delivery time, inspection period, and disbursement method. 

This is ideally suited for high-value commodities like jewelry, art, domain names, and vehicles. The escrow firm will then charge the corporation a fee for its services.

Disadvantages of escrow Agreement

Disadvantages of the escrow accounts are:

1. Monthly mortgage payments that are too high

If you feel your escrow account with mortgage payments, your monthly charge will be greater. This may be a financial strain on individuals who rely on a fluctuating income to pay their expenses. 

2. Estimates that are incorrect

When escrow accounts are utilized for mortgage payments, the amount that must be paid might fluctuate. This is due to the fact that tax rates and interest rates change from one period to the next.

Furthermore, if the property is reassessed, the property taxes may climb significantly if the home's value rises. However, the escrow agent may not perform such inquiries, causing the estimate to fall short. The shortfall will subsequently be covered by personal costs.

3. Monthly payment adjustments

The escrow account is evaluated on a yearly basis. The escrow account's predictions for the next period will vary when there is an excess or a lack of cash. As a result, it might be difficult to forecast how much money can be saved or spent on escrow accounts.

Escrow services

Understanding the benefits and risks of escrow agreements and accounts will assist you in making an informed decision about which escrow services to choose. Escrow services are provided by a number of firms.

Buyers and sellers like the following top-rated escrow services:

1. offers a low-cost solution, a streamlined sales process, decreased risk, and protection for both parties that may be utilized on a wide range of items.

Some of the perks include: 

  • Supporting various payment quantities - whether this is a small or large number, can meet the demands of its clients
  • A variety of payment methods are available, including wire transfers, credit cards, PayPal, checks, and money orders
  • Provides WordPress support through a programmable plugin 
  • It can be easily customized to add support for Dokan 

2. Mango Pay

Mango Pay is a white-label system that focuses on adaptable workflow, quick user authentication, Ibanised e-wallets, and the ability to handle ten different currencies. 

It also has the following advantages:

  • Open source SDKs
  • Global payouts
  • WordPress plugin that can be converted into a full-featured e-commerce platform
  • Plugin for an e-commerce platform that can be scaled to a multi-vendor marketplace

3. ShieldPay

ShieldPay has collaborated with Visa to reduce the danger of pricing security. It can execute security checks by cross-referencing the Visa customer database. ShieldPay assists in simplifying and streamlining client due diligence, as well as lowering the risk and complexity of continuous compliance. 

Shieldpay, which is trusted by over 100 law firms and lenders, provides payment solutions to the legal, financial, and professional services industries.

4. Stripe Connect

StripeConnect provides a customizable onboarding procedure, allowing users to select their own payout timing to their preferred account. Its services also feature an integrated financial reporting system that will enable users to monitor their cash inflows and outflows. 

Finally, with their connect function, which is one of the most accessible APIs in the business, they provide a straightforward and easy way to link stripe into e-commerce sites.

Researched and Authored by Frieda

Reviewed and Edited by Colt DiGiovanni | LinkedIn

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